Have the Shorts Got It Wrong?

It's always handy to take a look at what the rest of the market is doing, and although we all have our own opinions (that's what makes us Foolish), it helps to get some indication as to what other investors think the market will do.

One of my favorite ways to scout out the market is to look at companies that are heavily shorted. This gives a great indication of where the market believes the company in question will move in the near future.

So, let's have a look at some of the most shorted companies in the S&P 500 right now to see if we can learn anything.

Diggers and dumpers
First up with18.3% of its float short is Joy Global . Now, the bear argument for Joy is pretty simple, the market is betting on the fact that as capital spending within the mining industry is slowing, Joy is going to suffer. What's more, Joy specializes in the production of equipment for coal mining, a commodity that has fallen out of favor recently as countries turn to the cheaper, cleaner natural gas to produce power.

However, the bull argument for Joy is pretty strong. Firstly, if we use history as a guide, the last time the mining industry was this depressed was 2008/2009; though this period however, Joy remained profitable, while many of its peers, such as Caterpillar, suffered.

Why did Joy remain profitable? Well, it turns out that the company generates a significant portion of revenue from aftermarket services. This means that the company does not have to rely upon new equipment orders to support revenue. In addition, the company remained cash flow positive throughout the financial crisis and has continued to do so, with management recently authorizing a $1 billion stock repurchase program to take place over three years. $1 billion is around 17% of Joy's current market capitalization.

So all in all, Joy is not suffering as much as many would think. Yes, the company is being affected by the slowdown in mining capital spending. However, Joy's aftermarket services division helped the company pull through 2008/2009 and I see no reason why it cannot help the company do the same this time around; the $1 billion buyback should really drive earnings higher too. In this case, I believe the shorts have it wrong.

Forging steel
Next up with 27% of its float short is US Steel . In the case of US Steel, I believe that the bear argument has more to do with the company's recent share price performance than anything else. Indeed, looking at the fundamentals, US Steel appears strong, the company recently reported its first quarterly profit, excluding exceptional items, since the third fiscal quarter of 2013. In addition, the US domestic steel market is showing some signs of improvement. Actually, according to numbers from 2012, demand for steel within the United States expanded 8% during 2012, while supply only increased by 3%, indicating that the market is currently undersupplied.

On the other hand the bear argument does have some support. For example, due to a writedown of goodwill on the company's balance sheet, US Steel's net-debt-to-equity ratio exploded from 83% during the second fiscal quarter to 180% during the third fiscal quarter. Moreover, the company's stock price has risen 50% during the last three months alone.

More importantly, although the company was profitable, excluding exceptional items during the last fiscal quarter, it remains to be seen if this is a seasonal affect, as during the third quarter last year a similar profit was reported.

All in all, the two sides of the argument for US Steel are both compelling. That said, I would like to see a more sustained recovery in profitability before I could fully commit to the bull argument. In this case, I'm going to sit on the fence, I'm just unsure if US Steel's recovery has started yet. 

Old king coal
Company number three is shunned by the market for similar reasons to Joy Global. Cliffs Natural Resources has nearly 30% of its float borrowed for shorting and it's easy to see why.

Cliffs has not had a good year. At the beginning of the year the company slashed its dividend after raising it only a few quarters before and then the company forced a secondary issue upon its investors to pay down debt. Cliffs has also had to grapple with falling coal and iron ore prices, which have hampered the company's operations.

Still, there are numerous factors emerging that give me confidence in Cliffs' outlook. Firstly, the company is slashing costs across the business in an attempt to become more competitive and improve margins. The company's cost of goods sold declined 11% during the fiscal third quarter.

In addition, the company's iron ore cash-cost-per-ton of production is in line to be in the region of $65 to $70 for full-year 2013. Depreciation, depletion, and amortization is expected to add approximately $6 per ton. However, even with the cost depreciation and depletion Cliffs still looks profitable considering that the current price of iron ore sits at $130 per ton.

What's more, global demand of iron ore is still running far above that of supply. Even a 43% jump in shipment volume from Australian iron ore terminal during September has failed damped demand for the commodity.

So overall, once again it would appear that the bull side of the argument for Cliffs has some real foundations. That said, persistent macroeconomic uncertainty means that the Chinese iron ore boom could quickly go into reverse, and that would cloud Cliffs' future. Still, over the longer term demand for iron ore is sure to bolster Cliffs' fortunes. In this case, I believe the shorts have it wrong.

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The article Have the Shorts Got It Wrong? originally appeared on Fool.com.

Fool contributor Rupert Hargreaves owns shares of Joy Global. The Motley Fool has no position in any of the stocks mentioned. 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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