Cliffs Natural Resources Inc (CLF), United States Steel Corporation (X): Is Short Interest Warranted?

August was the first time that the broad-based S&P 500 (INDEXSP:.INX) has looked vulnerable in more than a year. Yet, even with a 3%-plus drop for the month, the S&P 500 (INDEXSP:.INX) is up 14.5% year to date — a figure that would trounce the annual average return for stocks.

The reason for the rally since the recession is both tangible and apparent. The financial sector has rebounded in a big way thanks to banks’ improved capital position and historically low lending rates, which have allowed businesses to expand and consumers to refinance at favorable rates. With the foundation under the housing sector strengthening and unemployment levels dropping, there are numerous reasons to assume that the rally will continue.

But as you might imagine, there’s always another side to the coin. The expectation that the Federal Reserve will pare back its monthly bond-buying program has investors on edge that interest rates will continue to rise and stymie any hope of business expansion, as well as the ongoing rally in the housing sector. In addition, numerous macro-scale uncertainties ranging from the effects of the Patient Protection and Affordable Care Act to ongoing concerns with Middle East nations have investors concerned that U.S. growth may come to a grinding halt.

With that in mind, let’s take a look at which companies within the S&P 500 (INDEXSP:.INX) have drawn the biggest interest from short sellers — or what you might call the S&P 500 (INDEXSP:.INX)’s most hated stocks. More than just despised, these five stocks can give us insight into what short sellers dislike about these companies so that we can avoid buying into similar businesses in the future.

Source: S&P Capital IQ.

Cliffs Natural Resources
Why are investors shorting Cliffs Natural Resources Inc (NYSE:CLF)?

• With the S&P 500 having its worst month since May 2012, it shouldn’t be a surprise to see Cliffs Natural Resources Inc (NYSE:CLF)’s short interest down 2.51% from the previous month’s reading of 36.51% as pessimists take some profits. What hasn’t changed is that it still remains the most shorted S&P 500 stock of them all. The case against Cliffs Natural is still based around weak iron ore pricing and demand related to a slowdown in China’s GDP growth. The thesis for short sellers is that unless Cliffs Natural Resources Inc (NYSE:CLF) were to seriously reduce production, or China were to see a miraculous turnaround in iron ore demand, its share price is bound to head lower.

Is this short interest warranted?

• Without question, I still understand why short sellers have piled into Cliffs Natural Resources Inc (NYSE:CLF). The company slashed its dividend by 76% in February and iron ore prices have been generally weak for much of the year. However, many of the reasons to bet against Cliffs are beginning to fade. Iron ore prices hit a five-month high in August, and iron supply was way down in China thanks to curbed production from Chinese steel mills. Remaining profitable at just 66% of book value and paying out a yield of nearly 3%, I’d say that Cliffs Natural Resources Inc (NYSE:CLF) is more likely to see $30/share than $10/share at this point.

U.S. Steel
Why are investors shorting United States Steel Corporation (NYSE:X)?

• Similar to Cliffs Natural, weakness in steel demand and pricing combined with an oversupply of existing steel has been the thesis behind short sellers’ attack on United States Steel Corporation (NYSE:X). In addition to existing demand and pricing concerns, U.S. Steel announced in mid-August that current CEO John Surma, who’s held the position for the past decade, will be retiring at the end of the year. While some shareholders might be thrilled to see him go given United States Steel Corporation (NYSE:X)’s underperformance, it creates added uncertainty that short sellers love to pounce on .

Is this short interest warranted?

• Unlike Cliffs Natural, the pessimism surrounding United States Steel Corporation (NYSE:X) absolutely seems warranted. The first reason for pause is that U.S. Steel hasn’t turned an annual profit since 2008. This isn’t to say that it isn’t improving, because it has taken steps to drastically reduce its costs and pare back its production more in line with global demand. But when push comes to shove, United States Steel Corporation (NYSE:X) still isn’t profitable. Also, the company is carrying significantly more debt that many of its peers. With net debt of $3.16 billion and only $99 million in positive free cash flow over the trailing-12-month period, there are plenty of concerns that should fuel pessimists to pile into U.S. Steel.

J.C. Penney
Why are investors shorting J.C. Penney Company, Inc. (NYSE:JCP)?

• I’ve said it before and I’ll say it again, “Why wouldn’t you short J.C. Penney?” Ever since former CEO Ron Johnson changed Penney’s pricing structure from regular sales to everyday low pricing, the share price has been in the tank. Over the past six quarters, Penney’s has produced an average same-store sales decline of 21.6% and it’s been burning through cash at an exceptional rate. Unless recycled CEO Mike Ullman has some magic tricks up his sleeve, Penney’s underperformance is going to play right into the hands of pessimists.

Is this short interest warranted?

• Ab-so-lutely! Clearly, the amount of pessimism built up in J.C. Penney Company, Inc. (NYSE:JCP) could result in a short squeeze that sends shares higher, but the company hasn’t shown me much of anything that would suggest a turnaround is in order. In the second quarter, its same-store sales still fell by 11.9% year over year and another 470 basis points from the sequential quarter. The bottom line is that Penney’s customers are walking out the door and they’re not coming back. Until we have concrete evidence that this trend reverses, I’d suggest that shorting Penney’s is the more prudent course of action.

Pitney Bowes
Why are investors shorting Pitney Bowes Inc. (NYSE:PBI)?

• The bet against Pitney Bowes remains the same practically every month: As a provider of mail logistics hardware and software, short sellers suspect that the proliferation of email and smartphones will continue to erode the need for Pitney Bowes’ products. Pitney Bowes has been doing its best to move its products into the cloud and sold its management service division last month for $400 million, but it also hasn’t delivered an annual revenue increase since 2008.

Is this short interest warranted?

• On the bright side — and the one reason short sellers should be skeptical of Pitney Bowes Inc. (NYSE:PBI) — the company is paying out a forward yield of 4.6% and it now has an additional $400 million in cash to buoy the payment of that dividend. Beyond this payout, though, it offers little safety to its shareholders. Nothing has changed within its product line that would dictate a turnaround is in the cards or that the U.S. Postal Service is in any better shape than it was last year. With negative revenue growth still in the forecast, I see no reason to believe why Pitney Bowes’ rebound is sustainable.

Frontier Communications
Why are investors shorting Frontier Communications?

• Short sellers remain steadfast in their pessimism of Frontier Communications because of its steady landline subscriber losses. Frontier purchased landline assets in 14 states from Verizon three years ago for $8.5 billion in the hope that it would supply the company with steady cash flow from rural customers. The problem has been that the reach of wireless technology is improving and customer attrition from its landline business is threatening to reduce its cash flow.

Is this short interest warranted?

• I’d certainly say that short sellers have every reason to be skeptical of Frontier’s ability to generate strong growth going forward. But if I were short, I’d also be concerned that the rate of customer attrition is way down and broadband customer additions are still strong. Frontier has stuck by its cash flow and dividend in recent months, which places a lot of pressure on short sellers since Frontier is currently paying out a 9.2% yield. Remember, short sellers are responsible for paying that dividend out of their pocket, and 9.2% is a fairly steep price to pay to bet against Frontier. I still believe Frontier has a slow-but-steady rebound written in its cards.

The article The S&P 500’s 5 Most Hated Stocks originally appeared on Fool.com and is written by Sean Williams.

Fool contributor Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.The Motley Fool has no position in any of the stocks mentioned, either.

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