If you have any true confidence in the shipping business of DryShips (NASDAQ:DRYS), then you are making a mistake by owning Ocean Rig UDW (NASDAQ:ORIG). Do a little math, and the market is currently pricing the shipping business DryShips owns at negative value.
It's not arbitrage
Some will say it's an arbitrage trade, but it's not. An arbitrage trade is where you can buy and sell the exact same asset nearly risk free. An example might be if one pawn shop was selling ounces of gold for $1200 and another pawn shop down the street was buying them for $1250, you could buy an ounce from one and sell to the other and pocket $50 almost instantly. That's arbitrage.
Arbitrage situations are quite rare. In the case of Ocean Rig UDW and DryShips, you do indeed actually indirectly own more Ocean Rig UDW by buying DryShips than by buying Ocean Rig UDW itself. However, since you can't separate it out your Ocean Rig UDW stake from your DryShips stake, it's not exactly arbitrage. Confused? Let me explain.
DryShips owns Ocean Rig UDW
What many people don't understand is that although Ocean Rig UDW trades publicly, only a minority of its shares are available. Of the 131.9 million shares of Ocean Rig UDW outstanding as of Dec. 31, 2013, DryShips owns 78.3 million of them or 59.4%.
Based on the current share price of Ocean Rig UDW, the value of DryShips' stake is $1.42 billion. Now, consider that there are essentially two parts to the stock that is DryShips -- there is its $1.42 billion Ocean Rig UDW stake, and there the DryShips shipping operations. But the value of both combined, which is the market cap of DryShips, is only $1.31 billion at the time of this writing.
This means that the market is essentially telling you that the value of the shipping operation is negative $110 million. By buying DryShips instead of Ocean Rig UDW, you are essentially getting the shipping operations for free and then some.
Now be warned -- the market may be right by assigning a negative value to the shipping business. After all, the shipping business alone has $1.6 billion in debt while losing money every quarter. Unless that turns around, the true fundamental value of any business that loses money forever is zero to negative.
Where it can get interesting for Foolish investors is if you disagree with the market on the negative value of the shipping business. Since the $1.42 billion DryShips stake in Ocean Rig UDW is 8.4% higher than the entire market cap of DryShips, each dollar invested in DryShips basically owns $1.08 in value of Ocean Rig UDW plus the "free" shipping business.
But "free" can be expensive
The danger and risk here is twofold. First, if the shipping business does fail it could be forced to liquidate Ocean Rig UDW to support its losing shipping operations. For that reason, its shipping business in theory could actually be worth less than zero, unlike a regular stock.
The second risk entails something that DryShips has been known to do for many years. That is, raise money by selling common shares and diluting investors' stakes. It's possible that the market views this risk as very high and could be why there is a discrepancy in pricing.
Foolish final thoughts
While I'm not a huge fan of DryShips, if I were a long-term shareholder in Ocean Rig UDW with any degree of solid confidence in George Economou, CEO of both companies, and DryShips' shipping operations, I would sell my Ocean Rig UDW stake and go long DryShips.
As the late Benjamin Graham used to say, in the short term stock prices behave like a voting machine, but in the long term they behave like weighing machines and will eventually correct themselves to proper fundamental value. It seems extremely unlikely that the disconnection between stock prices could get much wider if the shipping business does even mildly OK.
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Nickey Friedman has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.