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Why smart investors will avoid these heavily shorted sectors and stocks

Let the trend be your friend is an often quoted investment maxim. This is true when buying or selling, in fact negative trends are often more obvious as they tend to be driven by clear structural shifts or technological change. These changes tend to be permanent and likely to accelerate.

Hedge funds spend time identifying these trends and employ prime brokers to lend them identified stock to sell with the intention of buying it back at a lower price at a later date.

ASIC reports short positions as a percentage of outstanding stock and here are some of the most heavily shorted sectors and companies according to a report last week.

Mining services

The likely long-term decline in mining investment is no secret and companies that rely on mining support work for business have issued a string of profit warnings recently. Heavily shorted stocks include Monadelphous Group Limited (ASX: MND) with 14.14% of outstanding stock shorted, Bradken Limited (ASX: BKN) with 10.96% of its stock shorted and Downer EDI Limited (ASX: DOW) with 3.48% of stock shorted.

Traditional retail

The internet has let shoppers by everyday apparel at prices cheaper than those available at mainstream retailers like David Jones Limited (ASX: DJS) with 5.91% of its stock shorted and Myer Holdings Ltd (ASX: MYR) with 14.09% of its stock shorted.

Traditional Australian retailers had it their own way for much longer than those in other parts of the world, but now the direct competition from foreign fast-fashion retailers with super efficient supply chains may only just be beginning to take effect.

Traditional apparel retail will not die but evolve. If you want to be a successful 21st-century bricks-and-mortar apparel retailer you better have products that are unique, elite, or quintessential, as this provides the competitive advantage, draws the buyers and maintains the margins. Retailers like Kathmandu Holdings Ltd (ASX: KMD) or OrotonGroup Limited (ASX: ORL) may tick these boxes.

Traditional media

Another victim of the internet and globalisation is the old media sector with English language news now a global commodity traded alongside an increasingly fragmenting global advertising market. Businesses like Fairfax Media Limited (ASX: FXJ) with 5.69% of its stock shorted and Ten Network Holdings Limited (ASX: TEN) with 5.39% of stock shorted have floundered in the face of fragmented advertising revenues and digital competition. Fairfax may have more escape routes than Ten, but it’s hard to see their headwinds softening.

Foolish takeaway

It mightn’t seem rocket science but the golden rule of investing is to do everything you can to avoid losing money, start with the basics and everything else should fall into place. Don’t invest in hope, or on the assumption that it can’t get any worse, it normally can.

It follows that investors should pay attention to sectors and stocks that are heavily shorted and would be well advised to think carefully before attempting any turnaround plays in stocks or sectors that appear in long-term decline.

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Motley Fool contributor Tom Richardson owns shares in Kathmandu. You can find him on twitter @tommyr345

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