Short Candidates for Contrarians: Vale SA (VALE), Fossil, Inc. (FOSL), Discover Financial Services (DFS)

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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 SA (ADR) (NYSE:VALE)Vale SA (ADR) (NYSE:VALE), the enormous Brazilian mining company with a market cap of $107 billion, is a 4.4 percent position 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.”

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