The 3 Most Controversial Stocks in the Market

Herbalife (NYSE: HLF)

A crowded and dangerous short. Much has been written about hedge fund manager Bill Ackman's high-profile battle against this seller of nutritional supplements. As a quick recap, Ackman thinks Herbalife is a glorified pyramid scheme, with a multi-level sales force that only prospers by signing up yet more sales people further down the rung. Indeed, these types of businesses often implode once a fresh wave of re-sellers can't be convinced to sign on. In effect, the music finally stops, as was the case in the past decade with a number of fruit-based drink businesses that promised stunning health benefits -- and big profits for its sales force -- but ended up washing out.

Is Ackman right? He's likely correct when he says that many Herbalife sellers lost money as they failed to sell enough products to recoup their upfront sign-up costs. Yet he's also ignoring the fact that many Herbalife sellers have made money on product sales. To suggest that this company has never actually sold products seems to greatly over-simplify matters.

Regardless, this is precisely the kind of stock you should never short for some obvious reasons. First, it's what's known as a "crowded short," which means that it's already so heavily-shorted that a short squeeze is often the end result.

Also, Herbalife appears driven to derail shorts by buying back lots of stock (the company claims to have a $1 billion buyback in plan, but with net debt of $180 million, that figure is likely quite over-stated). Still, share buybacks of any size force short sellers to return borrowed shares, which has the same effect as a short squeeze. Indeed, shorts have recently been burned on this stock.

There is an ideal strategy for those who still want to short Herbalife: Wait for the short squeeze to play out, which is likely to continue as long as the market is in its current rally mode. When trading volume drops, and shares start to drift lower, then it's likely safer to put on a short position. By then, this short may not be as crowded.

Netflix (Nasdaq: NFLX)

Carl Icahn's folly? Mimicking the moves of hedge fund manager Carl Icahn is often a losing game, at least according to my cursory review of his actions in recent years. The legendary hedge fund manager has a habit of trying to goad a company to seek a sale, but he eventually tires of the effort and simply walks away, leaving a lower stock price in his wake. That appears to be the backdrop for Icahn's high-profile effort to force Netflix to seek a buyer. Yet as Netflix's CEO has repeatedly stated, there is no interest in selling the company. For that matter, it's unclear if there are any potential buyers either.

"Although Icahn's entrance brought fresh acquisition speculation, we believe potential acquires would rather wait than acquire Netflix at current levels given deteriorating fundamentals," note analysts at Merrill Lynch.

Yet hopeful investors have bid this stock up anyway, from under $60 at the start of the third quarter to a recent $90. That 50% gain has pushed Netflix's market value above $5 billion, which is hard for any potential acquirer to justify, considering Netflix has yet to reach $200 million in annual free cash flow. And that $5 billion market value figure understates matters. "The real cost to acquire NFLX is closer to $10 billion in our view. Management's investment expense guidance and a large $5 billion content liability could quickly turn a light meal into a strategic corporate ulcer, in our view," suggest analysts at Albert Fried & Co.

At this point, this stock's heady run seems to have locked in all of the potential reward, and the downside looks much more apparent. Merrill Lynch analysts think that even if Netflix were acquired, the purchase price would be around $73 a share.

Sirius XM Radio (Nasdaq: SIRI)

The shorts smell trouble. Shares of this satellite radio provider posted one of the strongest gains in the market over the past six months, rising roughly 50%. Rising auto sales have been a clear boost (as the service comes pre-installed on many new cars), and the company's debt woes vanish. Indeed, a number of sell-side analysts have $3.50 or $4 price targets, implying another 15% to 30% upside from current levels.

Yet short sellers are unconvinced: They now hold 370 million shares in short accounts, which is a 9% rise in just the two weeks ended mid-December. That's the largest position on either the Nasdaq or the NYSE.

Short sellers appear to be focusing on the fact that Sirius XM is spending nearly $300 million a year on customer service. This is a high churn business, as the free service that comes with new cars eventually expires, so the company must spend heavily to retain its customer base. Shorts may also be focused on the fact that shares trade for around 30 times projected 2013 profits, and this is for a business that is seeing growth slow to around 10-12% a year.

Still, this is a very profitable business (free cash flow was $400 million in 2011 and likely higher in 2012), and Sirius is in the midst of a $2 billion share buyback -- which can always cause pain for short sellers. Betting against Sirius may prove foolish.