Shorts Are Piling Into These Stocks. Should You Be Worried?

The best thing about the stock market is that you can make money in either direction. Historically, stock indexes have tended to trend up over the long term. But when you look at individual stocks, you'll find plenty that lose money over the long haul. According to hedge fund institution Blackstar Funds, even with dividends included, between 1983 and 2006, 64% of stocks underperformed the Russell 3000, a broad-scope market index.

A large influx of short-sellers shouldn't be a condemning factor to any company, but it could be a red flag from traders that something may not be as cut-and-dried as it appears. Let's look at three companies that have seen a rapid increase in the number of shares sold short and see whether traders are blowing smoke or if their worry has some merit.

Company

Short Increase April 15 to April 30

Short Shares as a % of Float

salesforce.com

276.1%

9.2%

Caterpillar

78.5%

4.5%

Bally Technologies

52.1%

22%

Source: The Wall Street Journal.


Is this valuation in the clouds?
I'm very much looking forward to the day when cloud-computing companies don't present many of the same concerns endemic in the late 1990s and early 2000s of Internet companies.

Salesforce.com, in its most recent quarter, delivered incredible growth yet again: Revenue jumped 32% to $835 million as businesses continue their transition into the cloud in both social and mobile markets. Furthermore, Salesforce's revenue stream is almost entirely recurring, meaning there's safety in its quarterly cash flow statements.

On the flip side, Salesforce also presents catch-22s such as needing to expand rapidly in order to secure new clients. The higher-than-normal expenses related to customer capture have constrained Salesforce's profit potential and place the company at a frothy 74 times next year's EPS projections. The other factor to consider here is that the law of big numbers says Salesforce's growth rate is going to slow. In fiscal 2013, revenue grew by 32%. In the upcoming year, Salesforce is projecting sales growth of just 27% to 28% -- and who knows how that might be affected by the sequester or the Patient Protection and Affordable Care Act, which have caused many businesses to remain cautious in their spending habits.

While I have a hard time denying that Salesforce is a cloud juggernaut, I have an easy time understanding why short-sellers are skeptical with its astronomical valuation. I do believe the short-sellers may have some room to be pessimistic over the near term until Salesforce's bottom line catches up to its current market value.

Will weak metal prices prove short-sellers right?
Caterpillar might be a monster among its peers with regard to manufacturing heavy machinery, but it's acted more like a kitty-cat in recent months.

In September, Caterpillar lowered its 2015 EPS outlook to a range of $12 to $18 from a previous outlook of $15 to $20 because many global miners had reduced their capital expenditures forecast. I'm certain most capex budgets have become even sketchier with gold prices dipping $200 per ounce over just the past couple of weeks. Yet, Caterpillar -- in spite of its 2013 outlook being cut in the first quarter -- and its heavy-manufacturing peer Deere  both look poised to take advantage of any strength overseas.

While certain aspects of mining may struggle to find their footing until global stock markets stop their perpetual uptrends, there are ample growth opportunities in overseas markets for Caterpillar and Deere's construction equipment -- especially in Asia and South America. Sales growth in China, while slower than expected for Caterpillar, did point to lower machine inventory and a steady trend of outperformance to many other overseas markets. For Deere, sales outside the U.S. rose by 9% in its first-quarter results reported last week.

We're certainly seeing cautious outlooks for both companies, but with the share price of both having reflected that uncertainty, I feel now could be the time to look for an entry point; and not as a short-sale!

The smartest way to play online gaming
Bringing in $36 billion in revenue, the online gaming industry is certainly the talk of the town, with Bally Technologies and International Game Technology being the first two companies to be awarded online gaming licenses in the U.S. last year. Let me make it clear that this doesn't clear the way for the legalization of online gaming in the U.S., but it's certainly a nice first step in the process.

Short-sellers aren't sold on Bally's success, though. With many hurdles left to leap, online gaming will remain just a pipe dream domestically and Bally's will remain reliant on the gaming replacement cycle of casinos in order to beef up its bottom line. I, however, think Bally's and IGT are the two smartest ways you could possibly play an online gaming legalization in the U.S.

If you think about it, trying to select which domestic casinos would benefit the most is like picking a needle out of a haystack. Some, like Sheldon Adelson, CEO of Las Vegas Sands, have made it very clear that they aren't interested in potential online gaming revenue. Many others, however, have positioned themselves to take advantage of Americans' insatiable urge to gamble if and when online gaming is approved.

That's where Bally's and IGT come in. As pure software and programming plays, they'll get the business of practically every casino because... ding, ding, ding -- you got it... they have the licenses! Even if online gaming is still five years away, these two make for an intriguing cash flow play as new and old casinos are buying and/or replacing old machines constantly.

In short (no pun intended), this isn't a stock I'd bet against.

Foolish roundup
This week it's all about asking yourself, "Does this make sense?" In the case of Caterpillar and Bally Technologies, a trend toward overseas industrialization and the legalization of online gaming seems inevitable, so both companies appear fairly valued, if not undervalued. As for Salesforce, with its growth rate slowing and the company needing to spend vigorously on its own expansion, I'd probably keep to the sidelines and let the short-sellers have their way over the interim.

What's your take on these three stocks? Do short-sellers have these stocks pegged, or are they blowing smoke? Share your thoughts in the comments section below.

Can Caterpillar transform into a butterfly and soar once again?
Caterpillar is the market share leader in an industry in which size matters, and its quality products, extensive service network, and unparalleled brand strength combine to give it solid competitive advantages. Read all about Caterpillar's strengths and weaknesses in The Motley Fool's premium report. Just click here to access it now.

The article Shorts Are Piling Into These Stocks. Should You Be Worried? originally appeared on Fool.com.

Fool contributor Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong. The Motley Fool recommends Salesforce.com. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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