In the last two weeks of May, short sellers boosted their bets on many companies. They hold a dim view for stocks in general during the coming months, as evidenced by the fact that short interest in the SPDR S&P 500 ETF (NYSE: SPY) and the iShares Russell 2000 (Nasdaq: IWM) rose roughly 5% in those two weeks to all-time highs.

Their aggressive moves are understandable: the economy has hit a soft patch and consumers are feeling more cautious. Many retailers have delivered very weak results recently, and an imminent turnaround is unlikely. But a pair of retailers that are being targeted by short sellers already look sufficiently punished and arguably represent some of the better values in the retail space. Kohl’s (NYSE: KSS) and Aeropostale (NYSE: ARO) saw the size of their short interest rise more than 50% in the last two weeks of May alone (which is the most recent available data). By my math, short sellers may be scrambling to cover their short positions later this year, bringing additional buying support to a pair of stocks that may also benefit from rising interest from the bullish crowd.

Kohl’s
This department store operator is boring. Annual results are always solid, and management very clearly telegraphs what investors should expect for coming quarters. Kohl’s has delivered quarterly profits exactly in line with consensus forecasts for the past three quarters. The company’s earnings per share (EPS) grew 12% in fiscal (January) 2010, another 12% in fiscal 2011 and are expected to rise 20% in fiscal 2012 and 15% 2013. The slight uptick in the earnings growth rate is partially due to a large $3.5 billion stock buyback that was announced in February 2011. (The company is buying back about $450 million every quarter.)

Short sellers are likely focusing on two issues. First, they assume consumer spending may grind to a halt in coming months as gasoline prices remain high and employment trends remain weak. Yet Kohl’s already proved in 2008 and 2009 that business remains decent even in tough times, thanks to the retailer’s reasonable prices. Second, they may be focusing on a slight sales shortfall in the most recent quarter as a sign of more weakness to come. What the shorts may have missed is that Kohl’s continues to shift its sales mix to private-label apparel (now 50% of sales), which carries better profit margins. That’s why Kohl’s was able to meet profit forecasts even with a slight sales shortfall.

If short sellers hope to make money, then they should target stocks that carry very lofty price-to-earnings (PE) ratios or are headed for a major slowdown. That simply doesn’t seem to be the case with Kohl’s, which trades for just 10 times projected fiscal (January) 2013 forecasts. For a retailer with such a long and strong track record, that kind of multiple looks like a better entry point for long investors than shorts.

Analysts agree. Sterne Agee predicts shares will rise more than 20% to $62. Despite the recent modest sales shortfall, “We have a high degree of confidence that KSS will again perform admirably,” wrote its analysts in a May 12 note to clients. Citigroup is even more bullish, predicting 40% upside to $70, which equates to 16 times Kohl’s projected fiscal 2012 profits.

Aeropostale
This teen retailer had been as impressive an operator as Kohl’s until 2010, when sales and profits started to slump in the face of lost market share. Rivals such as Abercrombie & Fitch (NYSE: ANF), which had been the laggard in prior years, came up with a more impressive set of merchandise for teen shoppers.

Yet as I’ve noted in the past, shares are already so cheap that you have to wonder what short sellers are looking at. They’ve boosted short interest in the stock by more than 50% in late May, to almost 10% of the float, even though Aeropostale is valued at a much lower level than any other teen retailer, in the context of the price-to-sales (P/S) ratio (which is 0.6).

Short sellers may be focused on the fact that Aeropostale has yet another tough quarter or two ahead of it as it clears out poorly-selling merchandise at discounts and preps fresher inventory for the fall. These shorts should know that analysts and investors already anticipate this coming near-term weakness and have lowered their profit expectations accordingly.

Another concern for shorts: Aeropostale is also buying back a lot of its own stock. That kind of buying pressure can blunt any downward pressure that shorts like to exert. It’s never wise to short a stock while a buyback is underway.

Action to Take –> It makes ample sense to add more short positions to your portfolio as the two-year bull market looks to be at an end. Yet it’s wise to focus on overvalued stocks that are likely to miss quarterly expectations in the periods ahead. For Kohl’s and Aeropostale, that doesn’t appear to be the case. Their shares could actually rise much higher when the current pall over retail stocks finally lifts. Investors looking for hidden value in this tepid market would do well to consider these two names.

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