Are Your Stocks Heading For A Plunge? This One Number Could Tell You


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As the market surged ever higher over the past five years, short sellers were knocked off their game.

#-ad_banner-#Every time they targeted a seemingly overvalued high-flier such as Tesla (Nasdaq: TSLA ) or Netflix (Nasdaq: Nasdaq : NFLX) , they were forced to cover their positions as these stocks scaled new heights.

Such repeated bruisings left the short sellers gun-shy, and in recent months, they simply steered clear of the most richly valued stocks. As I noted in late March , "short sellers are going after the major tech firms that represent much better value."

That turned out to be unwise. Value-oriented tech stocks, such as Intel (Nasdaq: INTC ) and Cisco Systems (Nasdaq: CSCO ) saw big short interest spikes in recent months, but actually held up fairly well in the recent tech stock rout. The high-flying dot-com stocks that the shorts should have been targeting turned out to deliver the most downside in recent sessions.

Still, it pays to track the actions of short sellers. They may not be doing so well with their macro calls lately (such as value-versus-growth tech) but their company-specific targets are worth monitoring. I like to see which stocks have more than 40% of their stock held by short sellers.

These are "crowded shorts," which means that a short squeeze could prove to be painful. But it also means that a number of investors smell a rat. Here's a look at three heavily shorted stocks.

1. NQ Mobile (NYSE: NQ )
47% of shares held short
This China-based app developer has been subject to wild swings. Shorts pounded this stock into submission six months ago on allegations made by research firm Muddy Waters that NQ's executives were operating sham companies and that stated cash balances were quite overstated.

Yet further research appeared to validate the company's claims that it was legitimate, with real contracts in hand and a growing list of blue-chip customers.

Shorts covered as shares rebound, but in recent weeks, the shorts have returned as quarterly results fell well short of expectations. That led to concerns that the recent contract signings aren't yielding the revenues that they should. Investors also had been expecting to hear about the results of an internal audit that would address Muddy Waters' allegations. Management's decision to delay any response until the annual report is filed suggests to short sellers that the company's books are indeed being cooked.

My take: This isn't a pure scam, as Muddy Waters suggests. But it's a worthwhile short anyway as management is building an unprofitable business that is unlikely to deliver the kinds of profits that the company's backers are hoping for.

2. Walter Energy (NYSE: WLT )
53% of shares held short
There's an interesting showdown taking place in the coal industry. Some investors, such as my colleague Dave Goodboy , note that thanks to China, "It is clear that coal usage isn't going to decline anytime soon." Dave sees Peabody Coal as a way to play this oversold commodity.

Yet looking beyond Chinese demand, coal used in steel-making, known as metallurgical coal or "met coal," is showing signs of a deep glut. Analysts at UBS recently lowered their 2015 price forecast for met coal from $150 per metric ton to $130. And they note that Walter Energy, which has a hefty 50% exposure to this market, is especially vulnerable. (Dave's preferred pick, Peabody Energy (NYSE: BTU ) , has just 14% exposure.)

Analysts at UBS recently cut Walters Energy to a "sell," with a $5 price target, representing 35% downside. Short sellers, which have already ridden this stock down from $23 a year ago, see further weakness ahead as well.

3. World Acceptance Corp. (Nasdaq: WRLD )
44% of shares held short
This company has been targeted by short sellers for nearly a year, after investigative journalists at Pro Publica revealed a wide range of seemingly predatory lending practices . Short sellers predicted that these practices would eventually attract scrutiny from regulators.

Belatedly, regulators have finally taken up the cause. Last month, World Acceptance received a subpoena from the federal Consumer Financial Protection Bureau (CFPB), seeking more information about the company's operations. It's unclear if the CFPB is targeting the company's practices in particular or the payday lending industry in general. (Privately held MoneyMutual is also being looked at by the CFPB.)

World Acceptance generates eye-popping profit margins from its customers. In fiscal 2013, the company generated $224 million in free cash flow on a sales base of less than $600 million. Still, regulators don't go after consumer-facing businesses simply because they are wildly profitable. Instead, any questions likely focus on the clarity of terms spelled out in payday loans. In other words, the CFPB can't stop consumers from making bad choices, but they can stop deceptive sales practices.

At a minimum, look for a set of changes for the payday loan industry that reduces interest rates on loans, and new policy thresholds that make those loans harder to obtain. Net/net: World Acceptance's profit margins have likely peaked and are probably headed down in coming years, which could be bad news for a stock that is still up nearly 300% over the past five years.

Risks to Consider: As noted earlier, these shorts are so crowded that any good news could push them well higher.

Action to Take --> Two of these three stocks profiled may be engaged in dubious business practices, which is always very appealing to short sellers. Although all of these stocks have moved down from recent peaks, short sellers appear to be correct in anticipating further downside in coming months.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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