Investors need to be careful when it comes to stocks that are being heavily shorted. Shorting is the process of betting on a company's share price to fall. It's mainly done by hedge funds and other sophisticated investors when they have suspicions that a company is in trouble. Quite often, they get it right. Just look at Carillion last year. The heavily-shorted construction services company lost 90% of its value.
So who else do the hedge funds want to see trip up?
One well-known company that is heavily shorted right now is Debenhams(LSE: DEB). According to shorttracker.co.uk, the high street retailer is currently the second most shorted stock in the UK with 14.3% of the shares shorted.
That high level doesn't surprise me, to be honest. Debenhams is struggling at the moment. In my view, the retailer is caught in no-man's-land. It doesn't sell premium fashion like Burberry or Hugo Boss, nor does it sell value clothing in the same way that H&M or Zara do. Even its Designers at Debenhams offer can't convince consumers to shop there in sufficient numbers rather than at any another department store or specialist chain.
Consumer habits have changed over the last decade. Debenhams has insufficient competitive advantage. This is illustrated by the retailer's low return on equity (ROE) of just 5%. By contrast, ASOS and JD Sports Fashion have ROEs of 26% and 40% respectively. Premium products are in demand, as are value products. The retailer selling something in between is in a dangerous position.
Its recent Christmas trading update confirmed my view. Like-for-like sales fell 1.3% for the 17 weeks to the end of December. The company found the early weeks of the quarter "disappointing" as the market remained "volatile and competitive." Prices were slashed in response, which resulted in a sharp fall in margins.
Looking ahead, analysts expect a 38% drop in earnings for FY2018. A substantial dividend cut is also anticipated. While the stock has lost almost 50% of its value over the last year, hedge funds clearly expect the shares to continue falling. For this reason, Debenhams is a stock to avoid, in my view.
Another company that the hedge funds want to see fail is Aggreko(LSE: AGK). The firm is a global provider of rental power, temperature control and compressed air systems. Currently, the company is the 10th most shorted stock in the UK, with 10.4% of its shares being shorted.
Net profit has declined significantly over the last three years as a downturn in the oil and gas sector has impacted profitability. The company also announced in November that it was seeing delays in payments from some customers, particularly in Africa, where "liquidity remains a challenge."
Looking at analysts' current estimates, an earnings decline of 10% is anticipated for the year just passed. That's following on from a 14% fall last year. Momentum is not strong at present.
Aggreko shares experienced a poor 2017, losing almost 20% of their value. The stock is down around 50% over the last three years. There may be a turnaround at some stage. Yet with the shorters continuing to bet on the stock falling, I'd be hesitant to invest in the power solutions company at present.
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Edward Sheldon owns shares in JD Sports Fashion. The Motley Fool UK owns shares of and has recommended ASOS. The Motley Fool UK has recommended Burberry. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.