The Perfect Short

I'm a long-term, buy-and-hold investor.

That doesn't preclude me, though, from having fun with some thought experiments, like what the perfect short would be. I've done it once before with Morgans Hotel Group, and I just closed it out in my CAPS profile after beating the market by a whopping 25% over the past three months!

My inspiration
Recently, I was rereading one of Tom and David's very first books: The Motley Fool Investment Guide.

I noticed something I must have missed on my first read-though: a section on shorting stocks. Though the references in the book may be dated (they explain how to use ... the Internet), the guidance on shorting stocks hasn't changed.

Short candidate
After running through the numbers, I believe I've found another solid candidate for shorting: DryShips (Nasdaq: DRYS  ) .

The company owns and operates fleets of ships that transport dry bulk commodities such as iron ore, grain, and fertilizers.

Below, I'll run the stock through the four criteria the brothers lay out.

1. High ratio of debt to cash
DryShips currently has $129.5 million in cash, while sporting a debt load of more than $2.86 billion. That's over 20 times more debt than cash!

To be fair, DryShips is in an industry that's been hit hard. During the boom times of 2005-2007, there weren't enough ships to carry the world's goods. By the time the industry had caught up to demand, the recession of 2008 had hit. Instead of supply equaling demand for shipping, now supply far outstrips it.

But when compared to other shippers such as Diana Shipping (NYSE: DSX  ) , Navios Martime (NYSE: NM  ) , or Paragon Shipping (NYSE: PRGN  ) , it's clear that DryShips is swimming in debt.

Company

Total Cash

Total Debt

Debt-to-Cash Ratio

DryShips $129.5 $2,860.0 22
Diana Shipping $375.6 $349.6 1
Navios Maritime $180.2 $1,470.0 8
Paragon Shipping $41.9 $313.6 7.5

Source: Yahoo! Finance. Cash and debt in millions.

2. Low levels of cash flow
Over the past three years, the company has only brought in a depressing -$1.4 billion in free cash flow. This mostly has to do with the aforementioned build-out that occurred in the industry in 2008. During the period, DryShips spent $2.70 billion in capital expenditures.

3. A closed situation
When the Brothers Gardner wrote their book, they meant that it would be unwise to short a company that had an open-ended future. Think of Amazon, Apple, or Google; they don't fit nicely into any one industry or field. Whether moving into cloud computing (Amazon), all things movies and music (Apple), or even alternative energy investments (Google), all three of these companies could have their hands in a dozen different fields 10 years from now. It's not very Foolish (big F) to short a stock with such potential.

In DryShips, I highly doubt that we need to worry about this. They're having enough trouble turning a profit with their shipping business as it is now. This is probably a closed situation.

4. Low short interest
When a stock is heavily shorted, it poses a serious threat to those hoping to profit from its downfall. An earnings surprise -- or a herd mentality to cashing in profits -- can lead to a ballooning stock price. That's a shorter's worst nightmare. With only 4.6% of DryShips' float being shorted, this isn't a concern.

Foolish takeaway
Like I said, I'm a buy-and-hold investor. I believe in owning companies, not just pieces of paper. For now, I'm happy to give the company a red thumb in CAPS and see how it plays out.

If you want to keep up to date on all the happenings within this troubled sector, add these companies to your watchlist.

Fool contributor Brian Stoffel thinks Tom and David look like teenagers on the cover of their early books. He owns shares of Google, Apple, and Amazon. The Motley Fool owns shares of Apple and Google. Motley Fool newsletter services have recommended buying shares of Google, Amazon.com, and Apple, and creating a bull call spread position in Apple. 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.


Read/Post Comments (16) | Recommend This Article (6)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 11, 2011, at 11:15 AM, MAYASWEET wrote:

    Clearly you are a FOOL!! Stocks under $5.00 are not shorted. Why are you chasing this stock, why don't you pick on some of the fatter stocks. Its obvious that all of you have been bribed! So who's throwing money at you to trash this company??? When you see it climbing a few cents you post something negative!

  • Report this Comment On August 11, 2011, at 11:39 AM, dontwin wrote:

    It might be a good short except fot their drilling rigs they are investing in which should bring them a big gain in six months!

  • Report this Comment On August 11, 2011, at 2:50 PM, azumpire wrote:

    Mayasweet, please tell me you are kidding? I cannot begin to tell you how many times Ive shorted stocks, not only under $5.00, but under .25 cents. It only makes you look badly, when you make statements that everybody knows are inaccurate, and not true.

    I am not short DRYS, and with the stock bouncing right now, to me, it does not fit my criteria to short. That can change quickly however.

  • Report this Comment On August 11, 2011, at 3:38 PM, sevasanakid wrote:

    Zzumpire, please tell me you are kidding!

    When did you short this stock under 25 cents?

    You are short ... short on brains.

  • Report this Comment On August 11, 2011, at 4:29 PM, brownayns wrote:

    When was the last time you were able to financing for a Pananmax tanker? Obviously you are going to have higher debt ratio after making capital investments. What do you get with Chipotle Mexican grill have? Broken down reefers?

    This company has equipment and contracts coming back into place. Consolidation will allow Drys to SET PRICES. China and India's need for goods will not receed. They have an emerging middle class that does not want to poop in a hole anymore.

    Don't kick Drys when it's diversifying it's business interests.

  • Report this Comment On August 12, 2011, at 9:59 AM, HumbleMan2 wrote:

    In a previous post, somebody commented that you are short on brain. Well, I would not go that far. Maybe you just are in the wrong business. Try the local McDonald. They may have the perfect job for you. The article you wrote is a pure disgrace. Even somebody paid to bash the stock would use better arguments than the pitiful ones you came up with. It is sad nobody from the "Fools" organization is looking at what you write.

  • Report this Comment On August 12, 2011, at 1:41 PM, dlgblc wrote:

    Let's see:

    8/10 - close @ 2.47. Right now, >2.7

    I don't "do" shorts, but I would wager there are a few people out there who are glad they didn't follow the advice on this article...

  • Report this Comment On August 12, 2011, at 3:20 PM, XMFConnor wrote:

    Brian,

    Let me foolishly address some of your points:

    First, I think shorting is a bad business. Even if you find complete fraud, it can go so much against you that it is tough to really make money. I'd much rather buy long-term puts on something I hate.

    Second, how is this the perfect short? Yes, there are many things to hate, such as management and their debt levels, but how does that relate to the current valuation?

    For me, the risk/reward is heavily skewed to the upside. Yes, it is risky, but this thing could easily triple from current prices. If you look at recent ship sales, they are selling for less than liquidation value (and that is conservatively assuming a 50% haircut to book value.. which is more conservative than their recent sales).

    Also, how can you write that something is the "Perfect Short" without addressing their most valuable asset-- their stake in Ocean Rig?

    Management, for all of their shortcomings, has two catalysts in place to realize SOTP-- the dual listing of Ocean Rig and the spin-off of the tanker business.

    Yes it is risky, but is it the "perfect short?" Not at these prices! In fact, I think this situation.. where it could easily triple, most of the bad news seems to be priced in, there is still long-term demand for their services, etc. is the perfect recipe for a MARGIN CALL-- not a perfect short.

    Just my $0.02.

    Foolishly,

    Connor

  • Report this Comment On August 12, 2011, at 4:35 PM, TMFCheesehead wrote:

    Connor,

    I appreciate the feedback and insight. I think what most are missing is the format this article is in. Simply put, it says, "These are the four signs the Gardner Bros. outlined for a short, DRYS not only meets these four criteria, it passes by a long shot."

    I think the bigger critique should be in my use of such simple criteria for evaluating shorts--which I have absolutely no problem agreeing with.

    Brian Stoffel

  • Report this Comment On August 15, 2011, at 5:18 PM, TSIF wrote:

    sevasanakid ; He didn't say he shorted DRYS at $0.25, he says he's shorted stocks at $0.25, in contrast to the statement that you can't short under $5. I don't know where Mayasweet got his informaiton, but it's incorrect. There is no price limit to short stocks if you have the right brokerage account.

  • Report this Comment On August 15, 2011, at 5:21 PM, TSIF wrote:

    Brian, I understand your example and the four criteria you are explaining. Perhaps a fifth criteria should be solid DD on whether there are any pending catalysts.

    I don't trust Drys management and the spinoff of Ocean Rig has been touted for three years now. IF it does happen this quarter, however, DRYS share price could spike. In addition they will shed most of their debt to Ocean Rig.

    Those wanting a piece of Ocean Rig may want to look at Ocean Freight which is also "new news" for DRYS. Many are apparently doubting that deal closing as well as Ocean Freight (OCNF) is trading over 30% lower than the $11.25 cash and 0.52 shares of Ocean Rig.

    I upthumbed DRYS, as much as I dislike them here in CAPS at $3.00 on the technical/News play.

    So, again, I see your point, but some solid DD on possible catalysts should be added to your list! ;)

    TSIF

  • Report this Comment On August 15, 2011, at 5:26 PM, TMFCheesehead wrote:

    TSIF,

    Thanks for the feedback, and I agree--some more DD is a good idea.

    Thank goodness I don't actually short stocks, the last few days would've been VERY painful!

    Brian Stoffel

  • Report this Comment On August 16, 2011, at 12:40 AM, promommyfool wrote:

    Been trading this company off and on for two years. It moves up and down a lot. I'd hate to try to figure shorts on something that swings around so much. As for DRYS business sense. I think taking on debt to do a bunch of building when interest rates are in the dirt isn't such a bad idea. Like some others have said, they have contracts coming on line. I'm hopeful for them and very long of this company.

  • Report this Comment On August 16, 2011, at 5:20 PM, openhandedgrouse wrote:

    Hey Brain, I usually don't bash people but what's up with the inconsistancey?

    First you write "I'm a buy-and-hold investor. I believe in owning companies, not just pieces of paper."

    Later you write " I cannot begin to tell you how many times I've shorted stocks, not only under $5.00, but under .25 cents"

    If you were running for office people would call that a huge flip-flop.

    Maybe you should have made an argument to buy DSX because their debt to equity is a lot lower than their peers. Just a suggestion.

  • Report this Comment On August 16, 2011, at 5:25 PM, openhandedgrouse wrote:

    Whoops... Sorry Brain I thought azumpires comment was your response. When I re-read it I realized that I was wrong. I still would be hesitent to short DRYS at $3 with their ocean oil rigs. GLTA

  • Report this Comment On August 30, 2011, at 2:12 AM, Lordrobot wrote:

    For a moment contemplate the Greek shippers. First they are run by rude managements that don't care about shareholders. They engage in amazing conflicts of interest with ownership in shell corporations and lending agencies.

    They specialize in dilution to cover debt and the survive on cash flow. They suspend dividends without warning and they usually issue themselves a class of stock which gives them complete control to dilute with redemptive rights given to their hand picked lenders.

    Most recently COSCO the Chinese bulk operator has defaulted on a number of long term unfavorable Greek shipping contracts.

    The Greek shippers have taken advantage of China and the european rudeness doesn't play well in China. So China is now playing hardball.

    Don't get the Chinese to hate you they will either let you be their slave or they will cut you off.

    The present situation with Greece is that default is imminent. This means that soon, creditors will own all these Greek ships and insurance companies and China will cut them off.

    The reason this will not work out for any of the bulk shippers is that there are two disreputable players involved. Greece is a dishonest player in the EU and will default. The Greek shippers are basically dishonest and have way to many conflicts of interest. Their stock dilution games are completely dishonest and lacking in disclosures.

    They sell or lease back assets at an alarming rate which always carries a raw deal for the shares and a good deal for the CEO.

    COSCO is treating the Greek shippers to a lesson in Chinese manners. The Chinese believe they have been taken on these long term charters and they will assert leverage and surely they will cut off those they don't like.

    Even if spot rates go up, China is still going to squeeze those out of business that they feel were leveraging them unfairly.

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