Do the Shorts Have It Wrong?

Do the Shorts Have It Wrong?

Short squeezes can be very profitable, and with prices moving 10% to 20% in one day, the risk-to-reward ratio is tempting. However, picking stocks that are ripe for a short squeeze is hard and risky. Indeed, Foolish investors should never invest just to benefit from a squeeze.

Having said that, I personally will invest in a fundamentally solid company even if 50% of its stock is out on loan for shorting. So what are some of the most hated companies on the market right now, and do they offer potential for long-term profit?

A hated refiner
First up is Western Refining . With 44% of its total float on short, it seems as if the market really dislikes this company. Unfortunately, the first thing I notice is that the company's president recently sold 500,000 shares at an aggregate price of $30.70 for a total consideration of $15.4 million. Still, moving on.

Western owns two refiners and 200 retail stations in the south of the country. The key risks here are the company's dependence on one refinery that accounts for 85% of production and its dependence on light sweet crude. I believe this is the reason for the market's strong dislike of the company. The dependence on what is effectively WTI means that the company cannot switch to heavier and cheaper oil from Canada and other regions that have become popular among refineries over the past year as the Brent-WTI differential has collapsed. Heavier crudes from Canada are usually priced at a discount to WTI, so there is more opportunity for profit.

Apart from that, there is little to suggest that Western deserves the market's lack of faith in it. Since the company's near-fatal purchase of Giant Industries in 2007, net debt has more than halved (the majority of this happened since 2011), shareholder equity has doubled, and the company has $250 million in cash on its balance sheet. In addition, during the past year alone, the company has been working hard to restructure debt, reducing cash interest expense by approximately 70% -- more than $90 million annually. Western also increased its dividend by 50% recently and started buying back stock.

So overall, apart from the declining Brent-WTI spread, I see no particular reason to disregard Western Refining.

Short-order cooking
Next up, with 39% of its float short, is Arcos Dorados Holdings . Arcos owns and operates McDonald's franchises in South and Latin America. The company is hated because of the political instability rising across the region. Couple this with deteriorating exchange rates, and Arcos rapidly starts to look unattractive.

Having said that, unless that region of the world falls into total anarchy, Arcos still has plenty going for it. Protesters still need to eat, and the best dining option for the on-the-march protester is naturally McDonald's (I kid -- I am in no way basing my analysis on this).

Based on second-quarter results, Arcos looks attractive in the long term and ugly in the short term. Firstly, excluding the negative effect of currency devaluation, adjusted EBITDA expanded 18.2% year on year. However, including the effect of currency devaluation, growth was nil. Adjusted revenue expanded 16.9%, and sales notched double-digit growth thanks to aggressive marketing tactics. Indeed, management noted, "The achievement of double-digit comparable sales and organic revenue growth, despite low consumer activity in Brazil and continued economic weakness in Venezuela, underscores our brand strength."

So, all in all, the company looks attractive. The ability to grow sales while economic activity is so disrupted is not the mark of a failing company. It would appear that the high short interest owes to short-term beliefs that instability in South America will slow sales, but that doesn't seem to be the case. The long-term investment thesis for Arcos remains intact.

An overbought housing-recovery play
Radian Group
has 27% of its float short, and after a 461% rise since the lows of 2012, I can see why. The company's stock is up 124% year to date, but this in itself is no reason to go short. However, I am concerned about the confidence the market has shown in Radian over the past two years. In particular, Radian is still loss-making, reporting a $33 million loss before tax for the second quarter of this year. Moreover, recent speculation has raised the issue that Radian could be required to raise additional capital if U.S.-backed housing-finance companies tighten their demands, increasing the ratio of risk to capital from 25-to-1 down to 18-to-1.

Still, analysts remain positive, estimating that Radian will return to profit during 2014, generating EPS of $1, which puts the company on a forward earnings multiple of 13.7, although this is expensive compared to peer Genworth Financial, which trades at a forward earnings multiple of 8.8 but has a more diversified business model and is still cash-generative.

All in all, I would be wary of Radian. They say the trend is your friend, so I think the company's stock price will go higher, but the company is still struggling fundamentally, and I would not invest in it for the long term just yet.

Foolish summary
Shorts all have their reasons for holding large positions in these companies, but these stocks' longer-term investment theses remain intact, and for that reason I would have no problem with taking a position.

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Fool contributor Rupert Hargreaves has no position in any stocks mentioned. The Motley Fool owns shares of Arcos Dorados and WNR. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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