Should you steer clear of these 16 heavily shorted stocks?

Short sellers borrow a stock and sell it on market immediately, with the aim of buying back the stock at a lower price in the future. Usually a high level of short selling indicates that sophisticated participants believe a certain stock is overvalued. However, crowded shorts are very dangerous for short sellers if the share price begins to increase significantly, because they may be forced to buy back in before the losses become too great. This risk in itself leads to short sellers 'covering' their trade earlier, which itself pushes up the share price. So-called 'short squeezes' are rare, but lucrative for shareholders.

Without further ado, here are 16 heavily shorted stocks on the ASX:

These figures are true at 10/4/2014 (the ASX takes a few days to release the number of shares sold short). As you can see, half of the most heavily shorted stocks are exposed to mining, indicating that short sellers think others continue to underestimate the difficulties facing the industry. Not only do lower commodity prices impact miners' profits, they also result in less appetite for risky new mines. This lower rate of capital expenditure reduces demand for mining services. Not only does this decrease the volume of work, but it also increases competition, leading to decreased margins among mining services companies. Low margins and debt can be very dangerous for any company: investors will recall that the once-popular Forge Group (ASX: FGE) fell victim to that lethal combination.

More interesting to me is the relatively high short selling on growing telecommunications company M2 Group Ltd (ASX: MTU). Although the company does have debt, it also has quite predictable cash flows and decent margins so the chances of it turning into a real disaster seem very low. Furthermore, the share price has dropped lately, and I'd be surprised if short sellers aren't already thinking about covering. In any event, they will have to cover at some point because it seems highly unlikely that M2 will go to zero.

Also interesting is the high level of short interest in Cochlear Limited (ASX: COH). As with M2, the core business is sound, so short sellers will have to cover at some point. Whereas mining services companies have macroeconomic headwinds (lower commodity prices), Cochlear has tailwinds – older people are more likely to have hearing impairments and the population is ageing. Again, the shorts will have to cover at some point, and if the company announces an increased earnings forecast, they could be in trouble.

Foolish takeaway

I'd steer clear of most of the companies on this list, although I consider Cochlear and M2 Telecommunications to be worth holding. Indeed, I think the short sellers could lose out on those bets. I find it interesting to keep an eye on short sellers because it helps me keep track of where bargains might be, and indicates what (generally) sophisticated market participants are thinking. My current theory is that the aggressive selling of mining services stocks in 2013 lead to some aggressive buying of telecommunication and tech stocks, sending their share prices soaring. If the short sellers are right about mining and mining services, then the money won't be flowing back there. My guess is that healthcare and property will be be good sectors in 2014, but in the end, I invest in companies, not sectors.