Pity the Short Seller

"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

Short sellers betting against America's big banks saw their bets pay off big yesterday, as Citigroup (NYSE:C) slid 19%, while Bank of America (NYSE:BAC) transformed into Bank of Falling-Off-a-Cliff, dropping 24% in a single trading session. Some would say it was high time for come-uppance -- but the truth of the matter is that it's been a difficult few weeks for short-sellers. Even after Monday's relapse, both Citi and B of A have more than doubled since their March lows.

Pity the short-seller
As Thomas Hobbes might have put it, life is often "nasty and brutish" for shorts. 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, he 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 is personally responsible for paying the original owner any dividends that come due.
• Third, finally, and most frightening of all, the short-seller runs the risk of encountering a "short squeeze" -- especially if his targeted company reports unexpectedly good news. Oracle's takeover bid for Sun Microsystems (NASDAQ:JAVA) illustrates how badly that can hurt.

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 2007 highs, begging the question: Why bet that stocks will go down after they already have?

Longs rock, opportunity knocks
Personally, I don't see a lot of sense in "using a strategy that has more risk than potential gain." But finding a way to profit from others' foolhardiness -- now that's a strategy I can get behind. To implement it, I've preserved the essence of the screen I used last week, while tweaking the parameters (see below) to expand the range of targets for a short squeeze. Here are the results:

Source: FinViz.com and Motley Fool CAPS. Screen parameters: 5% or more of the float sold short; dividend yield greater than 5%; payout ratio under 80%; share price trending upwards over the past month.

Why do shorts hate these companies? Well, most of them carry sizeable debt loads. With the nation's financial system still on life support, I can understand investors' worry. That said, when I run the numbers, that worry seems out of place in at least one instance: Polaris Industries.

Now don't get me wrong. Polaris does carry some debt. About $200 million of the stuff. And yet, with more than $180 million in operating profit earned last year, Polaris can afford to pay the annual interest on its debt 18 times over. Considering that it earned these profits in the midst of the worst economic storm in recent memory, short-sellers had best buckle up for a long wait if they hope to see this company default on a loan. And while they wait, they'll be shelling out to pay Polaris longs a beefy 5% dividend.

Worse still (for shorts), both Polaris and fellow motorcycle maker Harley-Davidson (NYSE:HOG) reported better than expected earnings last week, suggesting that a turnaround may be taking hold in this industry. With Polaris still paying out barely 43% of its net income in dividends, not only does the company 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 Polaris short. It's a sucker bet.

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

Motley Fool CAPS: It's fun, it's free, and it just might make you famous.