Should a large amount short interest condemn an investment? I do not believe so, and actually want to caution you to avoid automatically disqualifying a stock like that–some could be great opportunities for long term investors.
Finding the Stocks that Deserve Love
When you are investing against the shorts, who do you want to have on your side? Well, management would be nice. When I see a heavily shorted stock, I immediately look at insider ownership. If shorts are piling up and management has no skin in the game, this should represent a red flag to investors. However, if management has large stakes in the business, I view that as a signal of confidence that the short’s case is either insubstantial or short-term oriented.
Here are three stocks that have a significant short-interest, but I believe could be long-term winners—and it seems as though insiders agree.
| Stock | Market Cap | Insider Ownership | Short Interest |
|---|---|---|---|
| Arcos Dorados Holding Inc (NYSE:ARCO) | 2.5 b | 40% | 14% |
| Proto Labs Inc (NYSE:PRLB) | 1.6 b | 26% | 16% |
| Under Armour Inc (NYSE:UA) | 7.1 b | 24% | 13% |
Arcos Dorados
Arcos Dorados Holding Inc (NYSE:ARCO) has the exclusive right to operate and franchise McDonald’s restaurants in Latin America. This represents a great opportunity in a region that has approximately 590 million people and just fewer than 2,000 full-service McDonald’s restaurants; the United States has a population of roughly 314 million, but over 14,000 McDonald restaurants. This leaves an ample amount of room for Arcos Dorados Holding Inc (NYSE:ARCO) to increase its restaurant count. So why are the shorts piling in?
The major reason is the economic and political instability of the region. Arcos Dorados Holding Inc (NYSE:ARCO)’s largest market, Brazil, seems to have fallen in love with protests, while Venezuela and Argentina continue to prove unfriendly to businesses. Combine this with a majority of the countries across this region seeing their currencies weaken against the dollar, and it has significantly hampered revenue. An example of how much this has hurt Arcos Dorados Holding Inc (NYSE:ARCO): in 2012 it had organic revenue growth of 14%, but with currencies in the region depreciating, growth in nominal terms came in at just 3.6% recently.
The bright side, and what I tend to focus on, is that Arcos Dorados Holding Inc (NYSE:ARCO) continues to generate more than $200 million in operating cash flow. It then plows this back into the business to fund new restaurant growth and take advantage of its growth opportunities in this emerging region. If this continues, long-term oriented investors should be rewarded.
Proto Labs
Often lumped in with 3D printer stocks like 3D Systems and Stratasys, Proto Labs Inc (NYSE:PRLB) is an entirely different kind of animal. Proto Labs is more focused on the traditional injection molding, but is breaking away from the competition by reinventing the process. Rather than seeing a company that is moving away from the pack, shorts are seeing a company that is riding the momentum of 3D printing stocks to a lofty valuation. What the shorts are missing out on is the growth opportunities Proto Labs could take advantage of in the future.
Proto Labs Inc (NYSE:PRLB) has grown revenue to over $130 million from $44 million in 2009, while also increasing its net income margin from 10% to over 20%. It has found an edge in a very large, fragmented market through revolutionizing the process by refining ordering with more transparent and instant quotes and shortening turnaround time with a focus on smaller runs. Proto Labs Inc (NYSE:PRLB) has significantly enhanced the customer experience, which is demonstrated by the fact that 84% of revenue in 2012 came from repeat customers.
I am not going to argue that some great expectations are baked into the stock with multiples like 60x earnings, 12x sales, and 56x cash flow. Instead, I am focusing on a great business with a long runway for growth and the ability to reward patient investors, especially if an earnings miss presents a more attractive price.
Under Armour
Inventory levels may scare away some investors, but I see a different story than shorts do. I see a company, led by its founder Kevin Plank, which continues to invest in its future and still has a long avenue for growth. Even though Under Armour Inc (NYSE:UA) can be viewed as an underdog to Nike, it has established itself has a leader in performance apparel and is starting to challenge Nike’s dominance in footwear. With revenue growth coming in at 23% and footwear at 21%, Under Armour Inc (NYSE:UA) continues to show that it is up-and-coming, just like the athletes it sponsors.
Bottom Line
Stocks can be unloved and heavily shorted for numerous reasons: poor performance, being overvalued, the threat of new disruptive technologies emerging, etc. Instead of just ignoring these stocks, investors can use this as an opportunity to better understand the business and associated risks. If you just ignore these shorted stocks, you could be missing out on some great long-term market beaters.
Nick Pugleasa owns shares of Arcos Dorados and Proto Labs. The Motley Fool recommends Proto Labs and Under Armour. The Motley Fool owns shares of Arcos Dorados and Under Armour. Nick is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
The article The Market Dislikes These Stocks–Should You? originally appeared on Fool.com is written by Nick Pugleasa.
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