Should you sell the City’s most shorted shares Carillion plc, J Sainsbury plc and Tullow Oil plc?

Roughly a fifth of construction and support services firm Carillion’s (LSE: CLLN) shares are being borrowed by short sellers, betting that prices will plummet. These short sellers see several years of relatively stagnant revenue and earnings translating into trouble for the highly indebted company. During 2015 average net debt was 1.9 times EBITDA, a troubling number for a low-margin business unless growth is high. Thankfully for Carillion, 2015 surprised with 10% organic revenue growth, although underlying margins dropped to 5.3%.

Looking ahead, the company’s £17bn order book portends well for future revenue growth and analysts forecast earnings to continue covering a 6.6% yielding dividend. Carillion’s shift from construction to support services has also paid off as 55% of revenue now comes from contracts for facilities management, infrastructure maintenance and the like. This provides a greater cushion to a possible downturn in the global economy than focusing purely on construction would. At the end of the day though, Carillion’s low margins and relatively tepid earnings growth will leave me sitting on the sidelines, neither short nor long.

Too many risks

Grocer Sainsbury (LSE: SBRY) has long been a target for short sellers as the grocery industry as a whole confronts the rise of value-focused rivals, online-only outfits and changing customer habits. Now that the £1.4bn deal for Argos parent Home Retail Group is going ahead, I can hardly blame the short sellers. Sainsbury’s plan is to close a significant number of Argos shops as their leases run out and move them into their own large, out of town supermarkets. The logic behind this is to get Argos click and collect customers to shop for groceries after picking up their goods.

While the plan makes sense viewed in this light, there are significant warnings sign that make me think it will end in disaster. First off, Argos is itself a business in trouble as it faces increased competition from Amazon and other e-commerce sites that have contributed to operating margins falling to a dismal 2% in 2015 from 7.1% in 2009. Being owned by Sainsbury’s will do little to reverse this inexorable decline. Second, this is a critical time for the big four traditional grocers as margins are squeezed by vicious price wars. Distracting Sainsbury management with the Argos integration and transformation couldn’t come at a worse time. I may not be actively shorting Sainsbury’s shares, but I find it hard to disagree with those who are.

Back in the black?

Traders in the City have also made significant bets against the future well-being of Tullow Oil (LSE: TLW). Many of these positions were taken this year as Tullow shares surged 45% despite $4bn in net debt. A mountain of debt this large is certainly a worry, but Tullow is still in a better position than many of its small rivals.

A focus on relatively cheap offshore West African assets means that most of Tullow’s operations break even when crude prices are below $40/bbl. Now that the Brent crude price has been at least 10% above this marker for several weeks, Tullow is looking in better shape. This is particularly true when you consider its massive TEN Field in Ghana is coming online this year, which will see capital expenditure plummet and add 50% more production by next year. At current crude prices, analysts are expecting Tullow to once again turn a profit this year and next, which means I won’t be taking a short position any time soon.

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Ian Pierce has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.