Avoid These Hated Stocks

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

Shorting a stock that’s already heavily shorted can be a terrible idea. When short interest gets excessive, these stocks can be prone to short squeezes, rallying to new highs as bearish traders cover their bets.

But after a stock has been squeezed, investors are inclined to wonder: when will it stop? Tesla (NASDAQ: TSLA), Netflix (NASDAQ: NFLX) and Herbalife (NYSE: HLF) are all stocks that have recently traded to new highs, based in no small part on their excessive short interest.

Tesla has nearly doubled

Tesla’s recent run has been nothing short of incredible. The stock closed the month of May with a gain of over 80%. An investor who bought in April could have doubled their money in just a few weeks.

There were a number of positive catalysts to send the stock higher. The company’s earnings report came in better than expected, it paid off its government loan ahead of schedule, and CEO Elon Musk has laid out plans for a nationwide network of wireless charging stations.

But of course, the sheer magnitude of the move was likely due to the short interest, which at the beginning of the month stood at over 27 million shares (down from over 30 million at the beginning of April). By mid-May, short interest had dropped to 23 million shares -- still a substantial position, but down significantly.

Short interest is not reported in real-time, so it’s hard to see it change from session to session. But, when the next report comes out, I would expect to see that more shorts have decided to cover.

If Tesla cannot attract new buyers, then once short sellers are done covering, the stock should tumble (as it did on Monday). Ultimately, the question comes down to wondering if the investment story has fundamentally changed.

There’s still plenty of reason to doubt Tesla. Despite the fact that the company posted solid earnings, it was only profitable because of tax credits -- Tesla didn't make money on its cars.

Overall, Tesla is still fundamentally risky and and unproven company. In total, it has to date produced less vehicles than General Motors makes in a single day.

Netflix is expensive

Netflix’s run has been arguably even more impressive than Tesla’s, though it’s taken place over a longer period of time. In just the last six months, shares of the video streaming giant are up nearly 200%.

Midway through last November, Netflix’s short interest stood at about 15 million shares. Today, it’s closer to 9 million, and was as low as 7.5 million in March.

Over that time, Netflix has benefitted from two successful earnings reports and the launch of two new original series. Meanwhile, evidence has begun to mount that cord cutting could, finally, be emerging as a real trend.

But, despite the fact that Netflix is making money, it still trades at an obscene valuation -- its price-to-earnings ratio of over 500 is many times greater than the broader market. Further, there’s growing evidence to suggest that Netflix will not be acquired, once seen as a bullish catalyst for the stock.

When Netflix CEO Reed Hastings stepped down from Microsoft’s board last fall, some saw it as evidence that the Windows-maker was about to put in a bid for the streaming video giant. But, Microsoft now developing its own content, that seems far less likely.

At the same time, not all of Netflix’s original content has been received favorably. House of Cards has generally been given positive reviews, but critics have not been kind to Netflix’s exclusive season of Arrested Development.

Moreover, all this content is particularly costly. There are questions of off-balance sheet obligations, and Netflix is opting to back out of some of its bulk content deals, which could drive some subscribers away.

Herbalife is a hedge fund battleground

Herbalife is perhaps the most interesting stock on this list. On the one hand, there’s Pershing Square’s Bill Ackman, who has called the company a pyramid scheme and continues to argue that its shares should fall to $0.

On the other hand, there’s activist investor Carl Icahn, who has slowly acquired a big chunk of the company and has warned that Herbalife shares could soon see the “mother of all short squeezes.”

Since Dec. 24, shares of Herbalife are up nearly 70%. Short interest peaked at the end of the year with around 37 million shares -- it has since fallen to about 33 million. But the vast majority of that short position (some 20 million shares) is held by Pershing Square, and Ackman has vowed to hold onto that position for the foreseeable future.

As I've written before, I think there are significant, fundamental problems with the multi-level marketing business. At the same time, if Ackman was successful, it would be unprecedented -- the FTC has allowed Herbalife to run its business for decades.

Trading hated stocks

In all honestly, most investors should probably avoid these stocks. Although they are flashy and exciting, they are equally as risky -- both from the long and the short side.

Their recent runs are testament enough to the dangers of betting against a stock that’s already heavily shorted -- and given that short interest remains relatively high, their incredible runs could easily continue.

But at the same time, investors buying them are playing the lottery: Tesla’s business model remains fundamentally unproven, Netflix’s stock is trading at an absurd valuation, and Herbalife could see significant downside risks in the off chance Ackman happens to be right.

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Joe Kurtz has no position in any stocks mentioned. The Motley Fool recommends Netflix and Tesla Motors . The Motley Fool owns shares of Netflix and Tesla Motors and has the following options: Long Jan 2014 $50 Calls on Herbalife Ltd.. 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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