Pity the Short-Seller in a Market Like This

"The market can stay irrational longer than you can stay solvent."
-- attributed to John Maynard Keynes

"The maximum gain you can take from a short sale is 100% … the maximum loss is theoretically infinite. ... Using a strategy that has more risk than potential gain means you must ... have an iron stomach.
-- Jeff Fischer, The Motley Fool

As I was thumbing through the pages of The Wall Street Journal a bit ago, I came across this headline: "GE, BofA Advance as Coca-Cola Fizzles." And I have to admit -- I did a bit of a double-take when I read those words. I mean, it wasn't all that long ago that we were hearing that Bank of America (NYSE:BAC) was going to get itself nationalized, that General Electric (NYSE:GE) was in full retreat, but Coca-Cola (NYSE:KO) was a stalwart that would survive any economy.

"What gives?" thought I. "Has the world turned upside down?"

And then it hit me: The market can stay irrational longer than you can stay solvent. ("You," in this sense, refers to the short-sellers whom Mr. Keynes was chastising.) Oh. Yeah.

Pity the short-seller
In essence, what Mr. Keynes was telling us all those years ago is that in the short term, it doesn't necessarily matter whether BofA will eventually go broke, whether GE's commercial real estate holdings are worth the paper its balance sheet is printed upon, or conversely, whether century-old Coca-Cola will survive this crisis and go on to celebrate its 200th birthday, then its tricentennial, then …

However the long-term thesis plays out, a short-term bettor against stocks rising -- a short-seller -- has more immediate concerns:

• In order to "short" a stock, a trader must first borrow it from someone else -- and pay interest on the loan for as long as it continues.
• After selling the stock short, the trader must pay the stock's original owner any dividends that come due while the short position remains open.
• Third, finally, and most frightening of all -- the short-seller runs the risk of encountering a "short squeeze" if his targeted company reports unexpectedly good news. The doubling off their March lows of stocks like Suntech Power (NYSE:STP) and Wells Fargo (NYSE:WFC) illustrates the danger of betting against beaten-down stocks.

These are the risks. They're ever-dangerous and omnipresent. In contrast, the rewards of shorting a stock have rarely looked less attractive than in today's environment. After all, the Dow Jones Industrial Average is trading 40% below its recent highs. The Nasdaq's doing as badly -- begging the question: Why bet that stocks will go down after they already have?

Longs rock, opportunity knocks
It also got me to thinking that anyone foolish (small 'f') enough to be short stocks in today's environment probably deserves what's coming to 'em -- and maybe I should get in on the fun and profit from their misery. So, I got busy drawing up a stock screen that would identify stocks that short-sellers are targeting -- but might soon be forced to abandon. I screened for:

• Percentage of float sold short: Greater than 5% (to ensure there are actually shorts to be squeezed).
• Rising share price over the past month (which increases pressure on the shorts).
• Dividend yield: Greater than 5% (to ensure that as each quarterly dividend payment comes due, more short-sellers have an incentive to throw in the towel).
• Payout ratio under 50% (to ensure that the shorted company can afford to maintain its dividend -- and the pressure).
• Operating profit margin greater than 5% (same purpose).

The end result was a list of about a dozen short-squeeze candidates, including a few names that I suspect you'll recognize:

Source: FinViz.com and Motley Fool CAPS.

Why do shorts hate these stocks? Well, each and every one of them carries a hefty slug of debt, and with the nation's financial system still in critical condition, it's easy to understand why investors might worry about whether they'll be able to roll that debt over as it comes due. But Fools have faith that at least one of these companies will weather the storm: Caterpillar.

The biggest company on the list, Caterpillar also carries the biggest debt load -- more than $33 billion in total. Yet with more than $4.4 billion in operating profit earned last year, Caterpillar can afford to pay the annual interest on its debt 16 times over. Short-sellers may have a long wait ahead of them if they're expecting to see Caterpillar default on a loan. And while they wait, they'll be shelling out to pay Caterpillar longs a beefy 5.1% trailing dividend -- and that's the good news.

The bad news is that with less than 30% of its net income tagged for dividend payments, not only does Caterpillar have no need to cut its dividend any time soon, it could conceivably raise it -- increasing the pain for shorts.

Foolish takeaway
Pity the trader who sells Caterpillar short.

(Or not. We're equal opportunity arguers here at the Fool. If you've got a bear argument to make against Caterpillar, we've got a soapbox for you to stand on. Click on over to Motley Fool CAPS and sound off.)

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