This is the second in a series reviewing the favorite short candidates of the AdvisorShares Active Bear ETF, co-managed by John Del Vecchio and Brad Lamensdorf. The managers have a background in forensic accounting and analyze factors such as earnings quality and relative strength to determine which shares to short.
The fund is down 28 percent over the past year as the market has steadily gained ground. But with the Dow approaching its all-time high, contrarian investors may be looking to hedge their portfolios against a correction. Part 1 of this series covered the Active Bear fund’s top three short positions at the end of January. This post will cover the next three largest short positions in the fund.
Vale’s share price shot skyward during the commodities boom of the early and mid-aughts, splitting three times and touching $40 a share just before the global financial crisis came down. Since then, the stock price has been cut nearly in half. Like Cliffs Natural Resources Inc (NYSE:CLF), the largest short position in the fund, Vale took a substantial hit when demand for iron ore tumbled as a result of the global slowdown, particularly in China, which had been consuming nearly half the world’s steel production during its construction boom.
Vale offers a dividend in excess of 3 percent, but declining iron ore revenues have increased its payout ratio to nearly 70 percent of earnings. Although Vale has benefited from a recent recovery in the spot price of iron ore, analyst estimates of the price of the metal for the remainder of 2013 vary as widely as estimates of the pace of the global economic recovery. While China is committed to major infrastructure spending to boost slowing economic growth, it is not expected to resume the heady growth rates it enjoyed prior to the financial crash.
Some analysts believe iron ore supply increases in the latter half of 2013 will bring another retreat in spot prices, again reducing cash flows for the miners. In any event, HDGE’s skepticism about Vale’s earnings does not seem widely shared. Short interest represented less than 1 percent of the float in January.
Fossil, Inc. (NASDAQ:FOSL), the $6.2 billion fashion watch and accessories maker, is a 3.5 percent short position in the Active Bear fund. Del Vecchio explained his view in a recent interview with SumZero.
“My best short idea right now is Fossil,” Del Vecchio said. “Its relative strength has declined dramatically, though its stock has climbed slowly back from its prior fall. Europe has been a part of its growth story, and it dropped 8.3 percent in the most recent (reporting) period versus 30 percent growth a year ago. North American growth dropped from 15.8 percent a year ago to 5.3 percent in the most recent quarter.
“The only bright spot was strong Asian growth at 24 percent, and anything (negative) there would eliminate the only good news for the company. One of the strong earnings quality predictors of poor performance is where cash flow lags net income, and it has at Fossil for five quarters year over year. Plus, for 10 quarters, days sales in inventory have grown year over year, leading eventually to likely heavy discounting and crashing earnings. It’s hard to see anyone wanting the stock, and especially after the high probability all the numbers will hit the wall.”
Fossil shares collapsed last spring when it reported disappointing first quarter sales and cut full year targets based on tumbling European sales. The stock fell from over $130 a share to less than $70 by summer. It has since recovered about half of its lost value, to just over $100. It currently trades at about 21 times trailing earnings and 17 times forward estimated earnings. Short interest in January represented 6 percent of the company’s float.
Discover Financial Services (NYSE:DFS), the bank holding company behind the Discover and Diners Club credit cards, represents a 3.5 percent short position in the Active Bear fund.
Discover shares are up 37 percent over the past year as economic conditions have rebounded, nearly three times the rise in the S&P, but they still trade at less than nine times estimated 2013 earnings. The company bought back 10 million shares at a cost of nearly $400 million in its fiscal 2012 fourth quarter (Sept.-Nov.) and has $800 million remaining under its current buyback authorization.
Growth has slowed dramatically. Discover reported net income of $2.3 billion in fiscal 2012 compared to $2.2 billion in fiscal 2011. Analysts expect single-digit growth again this year and an average of 10 percent annual growth over the next five years, a far cry from the 30 percent annual growth it enjoyed before the slowdown.
Unlike Mastercard and Visa, which merely facilitate transactions, taking their cut of each one, Discover bears the brunt of bad loans when hard times hit. In addition to its 50 million Discover cards, it has diversified into home loans, savings accounts and other areas of traditional banking. Discover makes money on consumer debt so long as consumers are in a position to pay it back. Discover trades at nearly two times book value, nearly double the multiple many banks have been getting since the financial crisis.
Last fall, Discover agreed to pay $200 million in refunds to 3.5 million card holders who bought credit protection services over the phone, plus $14 million in civil penalties, according to The New York Times. The settlement followed an investigation by regulators into what the Times called “deceptive telemarketing and sales practices, including misleading customers into thinking the services, like identity theft protection and credit score tracking, were free.”
The article Short Candidates for Contrarians, Part 2 originally appeared on Fool.com and is written by D J Krieger.
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