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Should you avoid these heavily shorted sectors and companies?

The Australian Securities and Investment Commission regularly reports on what percentage of a company’s outstanding stock available on market has been reported as short sold.

Hedge funds and other speculators will borrow stock from prime brokers to short sell on market in the hope of buying it back cheaper in the future to make a profit on the difference before returning the stock to the lender.

It’s worth paying attention to what stocks and sectors are heavily shorted as this provides insights as to market sentiment and areas to avoid. Here are a selection of disclosures on ASIC’s April 7 report.

Small-cap biotechnology stocks feature heavily on the list, as while they’re still in the product development stage they have few or no earnings streams to shelter them from those who feel they are overvalued on their potential.

Companies to come under pressure include innovative condom-maker Starpharma Holdings Limited (ASX: SPL) with 5.32% of its stock shorted. Starpharma has licence agreements with health giant Ansell Limited (ASX: ANN) with 3% of its stock shorted and a partnership with agribusiness Nufarm Limited (ASX: NUF) that has 6.68% of its stock shorted.

Others in the health and biotechnology sectors with relatively large positions of stock shorted include regenerative stem cell technology pioneer Mesoblast Limited (ASX: MSB) with 6.68% of stock shorted.

Hearing-aid developer Cochlear Limited (ASX: COH) has a massive 17.28% of its stock shorted as some bet its weaker-than-expected FY 2014 first-half results are a symptom of competitive pressures set to take a toll on a highly valued company.

Cochlear’s had a disappointing year or so but remains a market leader with very solid long-term growth prospects and signs of a turnaround could create a short squeeze and quick profits for those who own the stock. A short squeeze occurs when short sellers are forced to buy stock back with egg on their face after their gamble turns sour and a company performs better than expected.

Other sectors heavily shorted include retailers Myer Holdings Ltd (ASX: MYR) and JB Hi Fi Limited (ASX: JBH) with 11.92% and 12.82% of their respective stock in issue shorted.

Traditional media businesses also seem to be in the hedge funds’ sights with 11.5% of News Corp (ASX: NWS) shares shorted and its traditional rival in the Australian media sector Fairfax Media Limited (ASX: FXJ) seeing 4.47% of its shares shorted.

Foolish takeaway

Good news can propel shorted stocks higher quickly as those with short positions are forced to close them out and buy them back in haste to minimise losses. Fairfax Media a recent example of this phenomenon after posting better than expected half-year results. Keep an eye on price volatility around Cochlear for this effect, while Starpharma holdings also appears to have potential to prove the doubters wrongs.

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Motley Fool contributor Tom Richrdson has no financial interest in any company mentioned in this article. You can find him on twitter @tommyr345

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