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JC Penney Aside, Short Sellers Have an Unlucky ’13

Michael Santoli

The bears have been greedily feasting on what’s left of J.C. Penney Co. (JCP) for months.

The most heavily shorted stock in the Standard & Poor’s 500 Index, Penney shares have collapsed by 50% so far this year to a 13-year low, as its disastrous merchandising changes under former CEO Ron Johnson deflate sales and drain the company’s cash rapidly.

J.C. Penney store

Yet Penney is a glaring exception rather than the rule in the 2013 market, in which short-sellers have largely gone hungry. In fact, the most heavily shorted stocks in the market have gone up on average more than the broad market has, a trend most gaudily shown by the rocket flights of Tesla Motors Inc. (TSLA) and Netflix Inc. (NFLX), up 430% and 240% this year, respectively. The AdvisorShares Ranger Equity Bear ETF (HDGE), a short-selling fund, is down 20.3% in ’13 -- more than the major indexes are up.

The stocks that have drawn the largest number of skeptics extended their advantage in the September market rebound. Bespoke Investment Group calculated that the 32 most-shorted stocks in the S&P 1500 index (which includes companies of all sizes) were up an average of 7.6% in September through Wednesday, one-and-a-half times the rise in the S&P 1500 itself.

Shorting stocks is never an easy game, with company management and most analysts motivated to push stock values higher, and in a bull market, it requires patience and discipline. Remember, with popular shorts, buying pressure can come both from investors who love the company, along with those who hate it but need to buy to cover. This year, the relentlessness of the rally thus far, with only brief and shallow pullbacks, has lifted most stocks and emboldened bidders targeting “crowded short” trades to engineer an upward squeeze.

And the extreme generosity of the credit markets, enabling most every risk-laden company to be refreshed by cheaper debt, has kept even flawed balance sheets and business models from blowing up. (Over the course of a market cycle, it should be noted, heavily shorted stocks do worse than the average stock, according to academic research.)

Through the floor

With all that said, the list of crowded shorts can serve as decent hunting ground for short-snubbing contrarian buys, solid long-term positions or appropriately targeted overvalued shares ripe for a fall. Here is one of each, as I discussed Friday on CNBC’s Fast Money Halftime Report.

Among the big stocks with more than 20% of their tradable shares sold short are some industrial-materials plays that suffered badly as China and other emerging markets have slowed. United States Steel Corp. (X), for one, has been good to the shorts, down more than 18% this year. But the stock has lifted nicely off its August lows, the company has excellent leverage to reviving industrial demand and the shares appear reasonably valued at less than 90% of book value.

Toy-maker Hasbro Inc. (HAS) had about a sixth of its shares sold short at last report. Rival Mattel Inc. (MAT) has always been the class of the toy industry, and many investors have been skeptical of Hasbro’s move to produce films and TV shows itself based on its characters. Yet the stock has defied the skeptics, climbing 33%, is a bit cheaper than Mattel based on cash-flow levels and offers a nice 3.2% dividend yield. It appears to be a solid hold heading into the holiday season.

A blistering performer for most of this year, wood-flooring retailer Lumber Liquidators Holdings Inc. (LL) nonetheless looks to have plenty of downside potential. It carries a towering valuation for a home-improvement chain selling cheap commodity products, more than 30-times forecast 2014 earnings. Short sellers, who have long stalked Lumber Liquidators, have raised flags about poor product quality and possibly dangerous chemicals in its flooring. Corporate insiders have sold a big slug of stock this year.

Friday, the shares dropped about 10% after news broke that the U.S. Fish & Wildlife Service executed a search warrant on its offices, apparently looking for evidence of wood imported in violation of certain trade rules. This issue may not be of enduring significance. But with the stock still up more than 100% this year and the home-improvement recovery theme a secret to no one, the shares seem to offer more risk than likely reward at these prices.