Why Investors Are Short-Selling GoPro Stock

Images like this can be captured effortlessly with GoPro's devices. Photo courtesy Chris Kuga via Creative Commons license.

Since a late June 2014 IPO, popular video capture device maker GoPro has witnessed a volatile, vertiginous ride in the stock market, reminiscent of an adventurous biker scaling up and plunging down hills with a "HERO4" camera strapped to his or her helmet. After more than tripling from a debut price of $28.65within its first four months of trading, the company's stock proceeded to lose 61.5%, bottoming out this spring at $37.95, before recovering to trade currently for more than $55 per share.

GoPro's volatility has attracted the attention of short sellers, and its price swings are perhaps more pronounced due to their activity. Currently, short sales represent more than 8% of outstanding shares. Below, we examine three reasons why GoPro has its share of detractors.

1. Torrid revenue expansion is always a good targetCompanies with revenues that rise with a brisk wind behind them never seem to have trouble attracting investor interest. GoPro's wearable video cameras have proved a hit with consumers, and the company's sales reflect this popularity -- revenue grew by 54% in the first quarter of 2015 versus the prior year.

As soon as a company is established as a growth stock, however, shareholders move on to worrying over the sustainability of revenue growth. And if demand pushes a stock to an inflated valuation, it doesn't take much to send more speculative proponents toward the exits at the first sign of a slowdown. Short sellers have been accumulating positions since GoPro went public on the expectation that a revenue "miss" compared to quarterly analyst expectations will achieve just this effect.

Yet GoPro's results aren't only propelled by revenue. Although it is young, GoPro is also profitable, having posted a 4.6% net profit margin in Q1 2015and an overall profit margin in 2014 of 9%.

Fast-growing companies often sacrifice margin initially to scale as quickly as possible and dominate a particular market niche.Alleviating the concerns of investors somewhat, and providing caution to the shorts, GoPro has so far mastered the art of rapid expansion alongside profitable operations.

2. Short-sellers flock to well-defined price trendsTraders who sell stock short typically aren't market makers out to calibrate the delicate balance between supply and demand. Rather, they're trend followers, borrowing shares to sell today, in the hope that they can follow a lengthy slide down before repurchasing shares on the open market.

As you can see, GoPro's ascents and descents have so far followed clear trend lines lasting months at a time. Note the inverse correlation of price with short interest (the number of outstanding shares sold short) and the percentage of shares sold short, as the definable trends both attract and repel short sellers:

GoPro Price vs. Short Interest, data by YCharts

As GoPro stock swooned through fall and winter, the shorts piled in, and were only chased off after a solid Q1 2015 earnings report in late April. More recently, the skeptics appear to be regrouping. The company's upcoming July 21 earnings report should bear heavily on both the trend and short interest.

3. Valuation is a battlegroundGoPro's current stock price is richly valued when compared to competitors such as navigation and video capture device maker Garmin Ltd. . GoPro's 1 year forward price to earnings, or PE, ratio of 37, is more than two and a half times the 13.7 times forward earnings investors currently pay for Garmin.

Garmin is a mature company with a revenue growth curve that has flattened in recent years. While GoPro deserves a richer valuation, how much more investors should pay for earnings versus a company like Garmin is interesting to contemplate. In attempting to diversify its revenue stream beyond GPS navigation devices, Garmin has rolled out numerous high definition video capture cameras priced similarly to GoPro's HERO line, with the added attractiveness of real-time data collection and display.

For example, Garmin's "Virb XE" action camera, introduced this spring, is loaded with sensors that display a wide range of data, including GPS tracking, acceleration, orientation, and even a wearer's heart rate. The company supplements this potential in the video capture market with an extremely solid balance sheet,lending it significant resources to compete against GoPro in the coming years.

The elevated level of GoPro stock illustrates why valuation is often a battleground between those who take long and short positions. Patient investors often happily pay a premium to own shares of a company with tangible growth prospects. Short sellers live to disprove lofty valuations, and risk their money in the belief that the market will recognize and correct mispricings.

Oddly enough, this is not necessarily a zero-sum game, where one side has to lose at the expense of the other. Both can be right. Long-term investors are motivated by the potential for stocks, at the very least, to combat the effects of inflation on their money. They're inclined to hold through periods of volatility.

Short sellers often have a much shorter time horizon for profit. This is due in part to the inherently upward bias of stock markets over long periods. In addition, a short-seller's losses can theoretically be unlimited, as stocks have a floor at which they stop declining (zero!), but no upward limit keeping them from appreciating. So those who short are incentivized to make profits quickly, moving in and out of positions against other traders.

Thus, an investor with a years-long holding period may recognize that the slew of new products churned out by GoPro bodes well for the future. For example, the HERO4"Session" camera, which debuted this month, appears to be a well-thought out extension of the company's products. Boasting a form factor that's 40% lighter and 50% smaller than the flagship HERO4devices, waterproofing to 33 feet, and a $399 price tag, the Session should contribute meaningful revenue for the company in the coming years.

Yet as long as investors willingly pay a steep premium now for future results, short sellers may indeed be handed a plethora of short-term opportunities. The short seller knows that it can take several quarters for new products like the Session to make a meaningful impact on the profit and loss statement. In the meantime, he or she reasons, there's that high forward P/E ratio of 37,waiting like a target to be taken down.

The article Why Investors Are Short-Selling GoPro Stock originally appeared on Fool.com.

Asit Sharma has no position in any stocks mentioned. The Motley Fool recommends GoPro. The Motley Fool owns shares of GoPro. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.