The Debate About Hedge Funds, Short Interest And Arena

| About: Arena Pharmaceuticals, (ARNA)

Over the past couple of days, there have been a couple of articles outlining the role hedge funds are playing in Arena Pharmaceuticals (NASDAQ:ARNA). It is no secret that hedge funds make up a great portion of the trading of an equity, but with Arena there seems to be competing debate over whether these funds are bullish or bearish on the equity. The real answer likely falls somewhere in the middle.

Last week I published an article titled Arena Short Interest Declines - So Do Hopes Of A Squeeze. The article was not meant to be bullish or bearish. In fact it was meant to point out a dynamic oft discussed by retail investors. The short squeeze.

I am often asked about the short interest in equities and often see investors that cite the short interest and from that derive that at some point those "shorts are gonna fry" because "this equity is gonna skyrocket."

What my article was trying to point out is that short positions exist for many reasons, not all of them bearish, and that it is not necessarily the number of shares that matters, but rather the number of days to cover the position. My baseline for Arena is 190 days to cover. I only see potential of a squeeze, and a small one at that, if the days to cover the short interest exceeds 10. My article was simply about the dynamic of light volume over the holidays causing the days to cover to increase to a level above 10, and that it was an anomaly due to unusually light volume. The days to cover now stands at about 6, and that is within a normal range for Arena. There were a few commenters on that article that took exception to my piece, feeling that it was bearish, and the discussion went to the crux of the shares short debate and into Hedge Fund participation.

This week we have seen The Motley Fool and The Street weigh in on Arena with differing points of view. Michael Meyer of the Motley Fool wrote an interesting piece outlining that Hedge Funds are interested in Arena. His theory is that institutional investors have been increasing their stake in Arena over the past few months and that hedge funds have as well.

Adam Feuerstein of TheStreet posed a response indicating that if Hedge Funds are interested in Arena it is from the short side. Adam goes on to point out that while institutional ownership is up, hedge funds are making up only a small portion of that and indeed, many are interested in shorting Arena.

With such opinions being polar opposites, what is an investor to believe?

The first thing to understand is that the truth of the matter is probably somewhere in the middle. Several hedge funds do see Arena as a short candidate. Then again, several do not. This brings the dynamic, and thus the battle into focus. Wall Street is torn between the possibility that Arena's not yet launched anti-obesity drug Belviq will be a blockbuster or an average drug with average revenues. Some believe in the potential and some do not.

It Is A Waiting Game

What this boils down to is the numbers Arena can put up on Belviq. The company is expected to launch Belviq sometime in Q1. The early numbers will actually tell the tale of whether people jump on board or decide to go short. The problem is that with the betting pool divided, there is a balance that can tip one way or the other in a speedy fashion. Those that are already invested (long or short) have placed early bets and simply await the photo finish. Those that are still on the sidelines can still win by simply waiting to see the initial results and placing a more certain bet at that time.

On January 14th I sold half of my position in Arena at a 40% profit. That sale is not based on whether or not I believe the company will succeed or fail. In fact, by maintaining a long position I am indicating a belief in the potential of more upside. For me the sale was about locking in some profit and identifying another investment, Retrophin (NASDAQ:RTRX), that I feel has more potential upside at the moment that was worthy of my investment dollars. I could wait about 10 or 12 weeks for some Arena numbers, or get some funds into another equity that I am interested in.

I am not saying that Arena cannot appreciate from here, but it is getting to the point where investors want some concrete sales data to assess chances of blockbuster status. This dynamic is happening because competitor Vivus (NASDAQ:VVUS) got off to a slow start with its own anti-obesity drug Qsymia. That slow start should have been enough to give any investor in the anti-obesity sector of pharma pause. It did for me, and I openly discussed that in articles and comments.

The "potential" of Arena has been bandied about for years now. It is now time to see real numbers. The potential can be realized, but only if the numbers are very impressive. The hedge funds and short side are not necessarily the bad guys. They are simply a facet of the market. If anything the sharply contrasted opinions serve to hold the equity in check. Being held in check is not fun for either side, and the ultimate judge will be in the numbers.

The Moral Of The Story

Patience may be a virtue, but knowledge is what can be the differentiator between investment success or failure. We all have knowledge of what Arena's Belviq does. We have knowledge that it will launch soon. The knowledge that we need to consider is why the opinions of some are lofty and others are grave. We may not know which side is right for a few months, but if we at least understand why the other side is thinking the way they are we can be one step ahead of many that are invested on a philosophy of hope and blind faith. Savvy investors will develop a strategy that considers both sides and have specific goals for the company that will determine whether to invest more, stay invested, sell off, or short.

I decided to lock in a portion of my gains by selling half of my stake. I know that when the numbers come out I can always jump back in or finish my selling based on actual performance. What I know is that the battle lines are essentially drawn at this point and some betting is on the table. The numbers represent the big catalyst most are waiting for. Yes, approval of Belviq in Europe may swing the betting a bit, but it is now down to actual performance.

Disclosure: I am long ARNA, RTRX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I have no position in Vivus