The Perfect Short

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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 (NAS: 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 (NYS: DSX) , Navios Martime (NYS: NM) , or Paragon Shipping (NYS: PRGN) , it's clear that DryShips is swimming in debt.

Company

Total Cash

Total Debt

Debt-to-Cash Ratio

DryShips$129.5$2,860.022
Diana Shipping$375.6$349.61
Navios Maritime$180.2$1,470.08
Paragon Shipping$41.9$313.67.5

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.

At the time this article was published Fool contributorBrian Stoffelthinks 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 serviceshave recommended buying shares of Google, Amazon.com, and Apple, and creating a bull call spread position in Apple. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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