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Steven Romick Ups Short-Selling in 4th Quarter

Steven Romick (Trades, Portfolio) recently released the portfolio update for the FPA Crescent Fund. During the quarter, the fund's four largest transactions were short sales of U.S. exhange-traded funds, including the iShares Core S&P 500 ETF (IVV). Its only new buy was Alibaba Group Holding (NYSE:BABA). The fund also sold out of its holding in Mylan NV (NASDAQ:MYL).


The Crescent Fund operates under First Pacific Advisors (Trades, Portfolio) and is managed by Romick, Brian A. Selmo and Mark Landecker. The fund's objective is to seek returns with less risk than the market while avoiding permanent loss of capital. Its strategy combines deep research with a focus on strong fundamentals, attractive risk-reward and diversification across geographies, market caps, sectors and capital structure. As of the end of the quarter, it has $14 billion in assets under management, including the $7.94 billion in the equity portfolio.

As interest rates have decreased and the U.S. economy has expanded on the wings of national and corporate debt, the Crescent Fund has increased its cash and cash equivalents while decreasing its fixed maturity securities and, more recently, its equity securities.

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The fund's top holdings are Arconic Inc. (ARNC) at 6.21%, American International Group Inc. (AIG) at 6.1% and Analog Devices Inc. at 4.45%. In terms of sector weighting, it is most heavily invested in financial services, communication services and technology.

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Mylan NV

The FPA Crescent Fund sold out of its 6,262,230-share stake in Mylan NV, impacting the equity portfolio by 1.42%. During the quarter, shares were trading at an average price of $18.63.

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Mylan is a global generic and specialty pharmaceuticals company based in the Netherlands. Its goal is to increase the standards of global health care by making medications more accessible. The company markets and sells both branded and non-branded drugs.

As of Feb. 7, Mylan has a market cap of $11.75 billion, a price-earnings ratio of 253.01 and a price-book ratio of 1.01. According to the Peter Lynch chart, the stock is overvalued.

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Mylan's revenue and net income declined in 2019, as per the chart below. Net income has been in a steady decline for longer, since around 2015. A more alarming signal may be its earnings per share without non-recurring items, which has dropped 26.3% per year over the past three years.

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The company faces headwinds from competition and decreasing sales, and according to CEO Heather Bresch, it is experiencing "unprecedented volatility" in its markets.

Alibaba

The fund established a new equity holding in Alibaba, which it has sold short and bought to cover in the past. The 328,555-share purchase impacting the equity portfolio by 0.87%. Shares traded at an average price of $188.59 during the quarter.

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Alibaba is a Chinese e-commerce, retail, internet and technology conglomerate that sells individual and bulk products to customers around the world. It also hosts third-party sellers and provides services such as logistics and production monitoring.

As of Feb. 7, the company has a market cap of $577.86 billion, a price-earnings ratio of 25.7 and a price-book ratio of 6.61. The share price, revenue and net income have shown strong increases in recent quarters.

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GuruFocus has assigned Alibaba a financial strength score of 6 out of 10 and a profitability score of 9 out of 10. Although it has a strong cash position with a cash-debt ratio of 1.65 and high profitability with a return on capital of 190.13% and an operating margin of 18.29%, the company's Beanish M-Score of -2.5 indicates that it is potentially an accounting manipulator, meaning that more complicated metrics such as the equity-to-asset ratio cannot be relied on.

Alibaba has a strong market position as the most dominant player in the Chinese e-commerce space, and its diversification across individual consumer and corporate markets has the potential to give it more room to grow.

Short-selling ETFs

In total, the FPA Crescent Fund shorted five U.S. ETFs during the fourth quarter: the iShares Core S&P 500 ETF (-3.07% impact on the equity portfolio), the iShares Russell 1000 ETF (IWB) (-2.76 impact), the Vanguard Financials ETF (VFH) (-1.91% impact), the iShares U.S. Financials ETF (IYF) (-1.88% impact) and the Vanguard Utilities Index Fund (VPU) (-0.86% impact).

According to the fund's fourth-quarter update for shareholders, it "added short positions in various ETFs to reduce net equity exposure."

In other words, it's not that the portfolio managers expect the U.S. market or any particular company to decline in value in the immediate future. Rather, the positions are to reduce the overall volatility of the equity portfolio, sacrificing some upside potential for more protection in case the U.S. does see a stock market crash.

According to the fund's fourth-quarter commentary, the primary reason for the increased caution is the amount of debt that the U.S. government, along with its businesses and individuals, are taking on at unprecedented levels:


"At the end of 2019, the U.S. national debt stood at over $23 trillion, exceeding the country's estimated $21.4 trillion GDP...

Corporate debt growth has been another contributor to U.S. GDP growth, almost trebling since 2008 without a commensurate increase in GDP. Relative to the size of our economy, we now have more debt on corporate books than at any point in time in history. In good times, leverage enhances corporate earnings, but the opposite is true in an economic downturn...

Debt accumulation at the sovereign, corporate, consumer and state and local levels has bought economic growth, but at an as-yet-to-be-determined cost."



Warren Buffett (Trades, Portfolio)'s favorite indicator of market valuation, total market cap to gross domestic product, also shows that U.S. businesses have been growing their valuations on borrowed money. When the total market cap of a country's businesses is higher than its GDP, it means that the stock market as a whole is overvalued and thus vulnerable to correction. According to the indicator, the ratio of total market cap over GDP is 156.1%, meaning that the stock market is likely to return -3.1%.

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Disclosure: Author owns no shares in any of the stocks mentioned.

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This article first appeared on GuruFocus.