The 1-Star Stock With 5-Star Returns

Who says the market is efficient? Not me. Nor do most of the Fools who've bet against Greek cargo specialist DryShips (Nasdaq: DRYS  ) in our Motley Fool CAPS investor-intelligence database.

An impressive list of investors have given DryShips a thumbs-down in CAPS. Top Fool TMFEldrehad is down more than 500 CAPS points. So is Bill Mann, who leads our Global Gains service and co-advises Hidden Gems and Pay Dirt. And ctmedic00, the Fool who many thought did the best job of deconstructing the DryShips story (or lack thereof) is down more than 200 points.

This chart ought to explain the damage. Shorts, beware.

A short lesson in shorting
There's an old saw that applies here: The market can stay irrational longer than most investors can stay solvent. With shorting, you need to have some reason -- some catalyst -- that you believe will send the stock south like geese in winter.

Every one of my Foolish colleagues expressed excellent reasons for shorting DryShips. Every one of them also turned out to be wrong. Why? I mean, both Eldrehad and Bill are excellent stock pickers. And Chris, our Connecticut medic, is one of the highest rated investors in CAPS.

For the answer, I turned to our founders, David and Tom Gardner, who, in The Motley Fool Investment Guide, advise shorting only stocks that meet three criteria:

  1. A high debt-to-cash ratio with low cash flow. David and Tom explain that if "expansion isn't coming from the existing business, or if that core business slips up, growth through debt becomes unsustainable." Agreed.
  2. Short "closed" situations; avoid "open" ones. Businesses with an innovative streak, or that are prone to surprising Wall Street, can quickly become multibaggers and break the back of a short seller.
  3. Short stocks with low short interest; definitely avoid those with high short interest. Selling pressure can build quickly when short interest is low. But as it rises, pressure builds for bears to collect their gains, which means more buying and a rising stock price.

Now, how does DryShips stack up against David and Tom's tests? Let's review:

  1. For the past 12 months (as of its last quarterly report), DryShips had $6.1 million in cash and $537 million in long-term debt. That high debt-to-cash ratio seems to satisfy the first rule.
  2. Dry bulk transportation may not sound exciting, but the market opportunity has been huge. And increased demand for grain (to produce ethanol), iron ore, cement, and steel has taken Wall Street by surprise. Consequently, DryShips has beaten quarterly earnings estimates over the past three quarters.
  3. Finally, while DryShips still has plenty of detractors today, bears were everywhere in February. More than 2.8 million shares were sold short, and the average daily volume was roughly 490,000, giving DryShips a short-interest ratio greater than five days. With that many bears, positive news was bound to send the stock higher in a hurry. Indeed it did; DryShips is up 270% since Feb. 1.

With the stock going one-for-three in our test, I'm hardly surprised that some investors have been burned by betting against DryShips. Perhaps our top CAPS investors should have reconsidered slapping DryShips with an "underperform" rating so quickly?

Play the market before you pay the market
DryShips may yet prove to be a loser of a stock. Many of our best investors seem to think so. But sometimes even the best bear thesis isn't enough when it comes to shorting. Be sure to test your best ideas before they break you.

CAPS can help you with that last point. Test thousands of stocks against the market and pit your ideas against over 60,000 other investors. Get ideas from the best ideas of the top players. Get feedback. And do it all 100% free. Interested? Click here to get started with CAPS now.

Fool contributor Tim Beyers, who is ranked 1,666 out of more than 60,000 participants in CAPS, didn't own shares in any of the companies mentioned in this article at the time of publication. Find Tim's portfolio here and his latest blog commentary here. The Motley Fool's disclosure policy isn't here right now. Please leave a message at the tone. Beeeeeeep.


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