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 homebuilders had their heads handed to them in April, as Ryland roared ahead 44%, Centex (NYSE:CTX) soared 51%, and Beazer Homes (NYSE:BZH) elicited cries of "bejeezus!" as it doubled in price this month. Is this the beginning of the end of the housing downturn? Or has Spring Fever struck the market?

Personally, I think we can put a name to the inciter of all this exuberance: Pulte Homes (NYSE:PHM). It was Pulte's bid to purchase Centex that sparked this bull market in housing.

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" if his targeted company reports unexpectedly good news. In housing's case, it was the good news that Centex had found a savior that put the fear of the Almighty into housing shorts. Everyone's wondering when the next shoe will drop -- the next debt-laden homebuilder to be bought.

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, 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:

Sources: 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? Like the homebuilders, they all carry sizeable debt loads. With the nation's financial system still on life support, investors understand that cash is king -- while a pauper is just a pauper.

And yet, Fools have faith that at least one of these companies will weather the storm despite its cargo load of debt: Frontline. It carries plenty of debt and capital lease obligations, no doubt -- more than $3.1 billion, versus less than $200 million in cash. Yet with more than $700 million in operating profit earned last year, Frontline can afford to pay the annual interest nearly four times over -- its best ratio in three years.

In other words, short sellers may have a wait ahead of them if they expect to see Frontline default. While they wait, they'll be shelling out to pay Frontline longs a beefy 5.2% dividend -- and that's the good news.

The bad news is that the pain probably won't lessen any time soon, because Frontline has already cut its dividend (twice, in fact). With the projected $1.00 annual dividend fully covered by net profit, Frontline can afford to pay it. The question is ... can the shorts?

Foolish takeaway
Pity the trader who sells Frontline short. It may not look "shipshape," but I think it's looking better than it has in a while.

(Or not. We're equal-opportunity arguers here at the Fool. If you've got a bear argument to make against Frontline, 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.