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Short Candidates for Contrarians, Part 1

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“You can’t short anything in this market because of the amount of money-printing.”

Fred Hickey, editor of the High-Tech Strategist, made this remark last week to Barron’s as part of its 2013 roundtable. If you agree with Hickey, you need not read any further.

But some contrarians insist today’s happy consensus that the market can only go higher is exactly the sort of sentiment indicator that generally precedes a market correction, if not a period of stagnation that allows economic conditions to catch up to market exuberance.

So let’s say you want to hedge your portfolio but you’re not an options player and you’re not particularly interested in shorting some of the world’s biggest and best companies, which is what you end up doing with exchange-traded funds that purport to deliver the inverse of the major indexes, such as ProShares Short S&P 500 and ProShares Short QQQ. These funds also have compounding issues that make them ill-suited for long-term holds.

AdvisorShares Active Bear ETF (NYSEMKT: HDGE) attempts to circumvent these problems by actively managing a portfolio of short positions on equities chosen for low quality of earnings or other metrics particular to those companies. This is the first in a series of posts that will look at some of the firms HDGE is currently shorting.


Cliffs Natural Resources

At the end of January, HDGE’s largest short position, accounting for slightly more than 5 percent of the fund, was Cliffs Natural Resources (NYSE: CLF), a major producer of iron ore headquartered in Cleveland that operates mines in the U.S., Canada and Australia. Short interest in Cliffs as a percentage of the float was a whopping 17.8 percent in mid-January, with 25 million of 141 million shares sold short, according to Yahoo! Finance.

Although this looks like a bet against a robust economic recovery, particularly in Europe and Asia, where weak demand for steel has cut iron prices globally, HDGE co-manager John Del Vecchio focuses on quality of earnings in selecting his short positions.

“I’m a forensic accountant by trade, so I find publicly-traded companies where management is aggressive in the accounting and they’re using that accounting to mask a deterioration in their business,” Del Vecchio says. “We short those companies on the expectation that they’ll miss earnings or reduce guidance.”

Cliffs has seen its share price cut in half over the last 12 months. It has enjoyed a mild recovery since the lows of last fall, when it reported third-quarter earnings of $85 million, a drop of more than 80 percent from the $601 million it reported in the year-earlier period. Sales were also down as higher costs and lower prices squeezed many commodity producers. At the height of the boom, more than four years ago, Cliffs traded at $110 per stub.

Fourth quarter earnings, scheduled to be reported Feb. 13, will be impacted by a $1 billion write-down of goodwill related to a 2011 acquisition. This is the sort of balance sheet retrenchment Del Vecchio looks for.

Some analysts think the worst is over. Based on an expectation of higher iron ore prices, Bank of America/Merrill Lynch increased its price target on CLF to $39 in January, and Deutsche Bank upgraded the shares from hold to buy, with a target of $48.

With a trailing price/earnings ratio of about 6 and a 6.7 percent dividend yield (the company jacked up its quarterly payout 123 percent last spring, from $0.28 to $0.625 per share), Cliffs looks cheap, although analysts estimate a forward P/E around 12 amid a cloudy outlook for the price of steel.

With its continuing short position, HDGE is betting that Cliffs has farther to fall. This might be a macro bet on steel demand, but based on Del Vecchio’s specialty, it is more likely a judgment on the company’s earnings quality.



HDGE’s second-largest short position, at about 5 percent of the fund, is Chipotle Mexican Grill (NYSE: CMG).

Hedge fund manager David Einhorn laid out a short case for Chipotle last October at the Value Investing Conference. Einhorn described it as a great company on its way to being a good company. He mentioned the absence of a moat and the rise of copycats. But he said the main threat comes from Taco Bell’s move upmarket with its Cantina Bell menu to compete with Chipotle’s popular burrito bowl. This comparison prompted me to perform a taste test last fall.

Whatever your view of the relative merits of these menu offerings, the short case for Chipotle begins and ends with valuation. HDGE appears to have increased the size of its short as Chipotle’s P/E has crept back above 35 with the recovery of its stock price from both Einhorn’s presentation and an earnings disappointment last year. At the low last fall, the P/E slipped below 30 and the PEG to 1.49. The P/E is now about 36, the forward P/E about 30 and the PEG is approaching 1.8, meaning the price is about 80 percent ahead of the projected growth rate.

Einhorn and Del Vecchio are not alone in their opinion that Chipotle enjoys a market multiple too rich for its actual prospects. Short interest in mid-January represented 13 percent of the float. As growth slows, multiple contraction seems likely, but the multiple has expanded over the past three months as the market has risen, lifting most boats. HDGE is betting that sooner or later, the contraction is coming.



HDGE’s third-largest short is The Goodyear Tire & Rubber Co. (NASDAQ: GT). Its short case is based largely on Goodyear’s mountain of debt, approaching $6 billion.

“Goodyear may, in fact, implode under the weight of its leverage,” Del Vecchio told The Deal Pipeline last summer. “It could very well go bankrupt in the next two to three years . . . . It’s not a growth stock because there’s no growth. It’s not a momentum stock because the chart looks awful. Some people may see it as a value stock, but I see it as a value trap.”

A combination of high raw material costs, foreign competition and outsized legacy pension obligations contributed to a pattern of negative free cash flow over the past three years. Goodyear expresses confidence that investments in Asia and Latin America will pay off, restoring the balance sheet. The market seems reasonably sanguine, with short interest at just 3.8 percent of the float in mid-January.

Del Vecchio counters that a "combination of increased leverage, worsening cash flow and underfunded pension, combined with pressure on the top line and margins, makes me think they're in big trouble in a couple of years."

ultimatespinach has a long position in AdvisorShares Active Bear ETF. The Motley Fool recommends Chipotle Mexican Grill. The Motley Fool owns shares of Chipotle Mexican Grill. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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