Do These Hated Companies Offer Opportunities for Profit?

Rupert is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I tryto invest with a contrarian view, so I like to go against the market. To that end one of my favorite ways to find opportunities for investment is by looking through the most shorted stocks in the S&P 500, to see if I can spot anything others can't.

So, with that in mind, here are the three most shorted companies in the S&P 500 right now and their future outlook; is there something others have missed?

The most hated

The most shorted company in the index, with nearly 37% of the available stock on loan is Cliffs Natural Resources (NYSE: CLF). Traders are betting that falling coal and iron prices will hit the company hard. This is a very real prospect as the price of thermal coal is currently $55 per ton, the lowest it has been since April 2010. In addition, the price of iron ore pellets is down to $144 per ton, not as low as the $120 per ton seen back in mid-2012, but still lower than the yearly average price seen in 2010, 2011 and 2012.

Still, Cliffs is cash generative and profitable. Furthermore, the company has actually paid down net debt by 21% since the second quarter of last year. Unfortunately, the company has issued some stock to bolster its balance sheet and cash flows. Cash inflows from stock issuance totaled $995 million during the first quarter and $994 million during the second quarter. This allowed the company to both reduce debt and spend on CapEx without taking on additional borrowing; however, this is eroding shareholder value.

The outlook for Cliffs is cloudy, the steel industry is expected to start growing again this year, which should improves demand for iron ore and coal. That said, a brewing credit bubble in China as well as slowing economic growth in Latin America could rapidly throw the steel market back into contraction.

Overall, the uncertainty surrounding Cliffs makes me want to stay well away.

A bet on a declining industry

Second, with just under 31% of its free float short, is Pitney Bowes (NYSE: PBI). Actually, Pitney has seen somewhat of a short-squeeze over the past week after the company reported better than expected second quarter earnings.

Pitney has made several key steps to halt the decline in its stock price. For a start, the company replaced its CEO with IBM veteran Marc B. Lautenbach, who worked at 'Big Blue' for 27 years. Second, Pitney slashed its dividend by 50% and started to pay down debt - the company repaid $375 million in debt during the quarter from cash in hand.

Investors have been concerned about Pitney's exposure to the slowing mail market. However, during the second quarter, revenue from the company's mail services segment and production mail division expanded 10% and 18%, respectively. It seems as if the decline in the company's mail related revenue has been stopped for now. The company generated $147 million in free cash flow during the quarter boosting the cash position to $600 million.

On a long term basis, the concerns about the global slowdown in mail shipping seem to be overstated as many key documents, parcels and packages will need to continue to be shipped and Pitney is the best in its industry. In addition, one of the key factors to look for in a failing company is a weak balance sheet and continual loss of cash, Pitney has neither of these. The company is paying down debt with cash on hand, has a strong cash balance and is still producing a good free cash flow.

A short bet that looks risks over the longer term

The third company, with 30% of its free float short is US Steel (NYSE: X), which shows no real signs of weakness. US Steel's production capacity for the first quarter was 30.8 vs. 32.3 million tons in the same period last year, although the whole steel industry is reducing output as demand falls. The US steel industry is not expected to return to growth until 2015.

Still, US Steel is not in a precarious financial position and is well placed to wait for growth. Although the company made a loss for the second quarter, adding back in depreciation, cash generation from operating actives was $384 million and free cash flow was $180 million. Additionally, net debt has fallen 15% from the second quarter of 2012 without a noticeable increase in common shares in issue.

With a net asset value of $24 per share, debt to equity standing at 80% and the current ratio standing at 1.7 times, the company currently looks to be an undervalued stock, which is financially stable. So, unless the company takes a huge loss sometime soon, it has the ability to last until the steel market returns to growth in 2015. So, on that basis I believe shorts should beware US Steel, and as a long term play, the company looks appealing.

Foolish summary

These three companies are the most shorted in the S&P 500, but both Pitney and US Steel do not appear to be in positions that justify the market's hatred. Indeed, Pitney is turning itself around and US Steel has a strong balance sheet, well placed to ride the US recovery. On the other hand, Cliffs looks to be in a precocious position and I would stay away. 

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Fool contributor Rupert Hargreaves has no position in any stocks mentioned. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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