Hedge Funds: Going short in a bull market and winning
-- By Jamie LaReau,
Bridge News Chicago--Mar 8
Only a handful of short-selling managers have survived the quadrupling of the US stock market over the last 9 years. But with no signs of market bullishness letting up, continued survival will hinge on those who are fittest being able to evaluate the fundamentals and survive the volatility. Many in the hedge fund arena said there was plenty of money to be made going short in a bull market, but it takes a perfect sense of timing, diversification and thorough research.
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Although several market analysts believed a substantial correction to the downside was due in the broad US market before the end of the year, many hedge fund managers--even those who practice short-selling strategies--remained bullish.
Many said the average valuation of most companies was not sustainable in terms of their real earnings and on that front some stocks would have to drift downward. One hedge fund manager believed that could lead to a market decline of more than 20% over the next 5 years.
BEARISH STRATEGY IN A BULL MARKET
But despite the bull market, short-selling hedge fund strategies aren't suffering from any form of vertigo as early indications show short-sellers up about 16.4%, according to Managed Account Reports Hedge index, a performance tracking database.
Paul McEntire is the chairman of Skye Investment Advisors, a short-selling hedge fund that has about $10 million in assets. He said their allocation was always short, all the time, "we don't try and time the market."
But Skye Investment Advisors managed to buck the trend among many short-sellers and distinguished themselves as one of the short-selling funds to succeed in a bull market.
McEntire said Skye has had mostly positive returns for the past 9 years. In 1994, 1995 and 1996 Skye finished up 46%, 2.5% and 4.7%, respectively. Last year, Skye was down 6.8%, but McEntire said that was still acceptable considering the average short seller was down 12% or more while the NASDAQ 100 index ended the year up 39% and the S&P 500 index ended up 27%.
"We kept sufficiently diversified to avoid having particular companies that go up a lot hurting us too much," McEntire said. "The other key is, I think by focusing on companies that are extremely high in their valuations, our stocks have not gone up nearly as much as the market."
Diversification and knowing the companies to invest in appear to be two essential keys to successful short selling in a skyrocketing market. But there are two other essential elements.
"What people don't understand in general is that when you're shorting stocks, your research has to be that much more comprehensive and your timing has to be impeccable," said Alex Shogren, CEO of Tuna Capital.
Tuna Capital LLC is an information and investment services provider for the hedge fund industry.
Shogren said he would have shorted Amazon.Com and Yahoo to the hilt last year had he had a good sense for the timing of when they were going to go down.
"We know one fund that had a big short position in Amazon and he was right. The only thing was he covered 2 days before the stock got cut in half. It's all in the timing," Shogren said. "You could be the best researcher in the world on the short side and if your timing is off, you're horrible."
MARKET VOLATILITY CREATES MONEY-MAKING OPPORTUNITY
Shogren works closely with The Flowers Fund, a US equity hedge fund that has about $20 million under management. Half of the assets were invested in a long/short portfolio while the other half was in a short-term day trading strategy in about 20 stocks using both long and short positions.
The Flowers Fund has been so successful that in February, Tuna Capital launched a new fund, the Mako Fund. With $12 million in assets raised in only 1 month, the fund specializes in a short-term day trading strategy. It takes long and short positions in about 40 stocks, mostly in the most volatile and liquid technology sector, Shogren said.
He's expecting the market volatility to continue, making it a good time to utilize short strategies in moneymaking maneuvers.
McEntire agreed, adding the US equity market was in a unique position right now in respect to international business. He said the US has every reason to continue in a bull market given the stable economy, prime real estate and English as a common language.
"It bodes well for us long term as the world economy becomes or as business becomes more global," McEntire said. "But on the other hand, in terms of a particular valuation right now of the US stock market, I think a substantial correction is more likely than not sometime over the next few years."
McEntire said he can't predict when that correction will take place or by how much, but he said historically nearly every time the US market has gotten fundamental multiples similar to where they are today, it subsequently saw a negative return in following years.
"I think even though long term, let's say a 10- to 20-year horizon, I'm still extremely bullish on both American companies and the economy. I think the market right now is likely to see a substantial correction and it can be pretty prolonged," he said.
McEntire said the US market right now reminded him of the Japanese market, which peaked around January 1990.
"It's now 9 years later and it's declined 60% from there," he said. "I think we're probably in a little better shape than they were at that time. But I do think it certainly wouldn't be a shocking scenario for the market to decline 20% over the next 5 years."
Another predictable scenario is to see valuations decline, he said.
"The average valuation of the companies is not sustainable in terms of their real earnings," McEntire said. "If something, and I don't know what it is, goes wrong one way or another with the US economy or world political developments or so forth, I think the decline could be more substantial. But even without any significant catalyst, it's more likely than not that many of the companies will drift downward."
SMART STOCKS TO SHORT
Both Shogren and McEntire agreed many Internet and technology stocks are overvalued on the surface and could be attractive shorts with the proper timing. But it's a tricky and risky maneuver.
"It's an area where I saw a lot of short sellers in this industry get killed last year," Shogren said. "When you look at these stocks, all these technology and especially Internet stocks, you think, 'oh my God, they're overvalued.' But we've learned the hard way that you can't use traditional valuation methods on these stocks."
Shogren said he's not interested in any fund manager who has short positions in technology stocks right now because there's no way to accurately gauge the value of them.
McEntire said there are a few of the large-cap companies whose price-to-earnings ratios are overvalued.
"Like Gillette for example is at a 55 PTE ratio based on its last 12-month performance. Even though it's a great company and it's likely to see sustained growth, I don't think the company is worth its 55-to-1 price to earnings multiple right now."
McEntire said he expected Gillette's PTE ratio to settle down on the 25- to 30-to-1 PTE range, which he said would still be high compared with long-term and historical averages.
Unlike Shogren, McEntire said there are a host of companies in the Internet area that are likely to see substantial declines. But he warned that the volatility of those stocks are so high, if an investor decides to take a short position there, they should take one-fifth or one-tenth of the size they would normally take in the same position if they were betting the long side.
"So an investor who might feel comfortable putting maybe $20,000 into some tech stock, we think should put no more than $2,000 or $3,000 in the same stock if he wants to short it," McEntire said.
McEntire realizes that his short-selling product was something like insurance for most investors and maybe accounted for about 20% of most investors' entire portfolio investments.
He said a good short selling strategy could add quite a bit of value to a portfolio provided the stock selection was on target.
"For example, had we been shorting indices over the last 10 years, stock indices, as a way to hedge, probably we would have been losing 10% a year-- perhaps even more--with the markets going up the way they have," McEntire said.
"But with the particular stocks we've picked that are overvalued, we've actually managed to keep small positive returns even though it's short only."
Another hedge fund manager and partner, who spoke on the condition of anonymity, said when his fund does short stock they look for stock that is fairly defensive.
"(Those) who are operating businesses or have market positions such that if we do continue to or do have an accelerated slowdown of the economy, they're businesses inherent market positions where we think they'd do well in a downturn. On top of that, we're trying to buy things that we think have pretty compelling evaluations."
He cited as an example, Payless Shoe Source, which his fund owns. He said the company was spun out of May Co. a couple of years ago and even if the country heads into a
recession, people will still need shoes at a discount price.
"It is one of the largest shoe companies in the country and their price points are about $5 to $10 and they have no leverage in their balance sheet, they increased about $400 million in cash flow we like the name a lot because what they've done since the spin out is they've been buying back a lot of their own stock," he said.
He said the company tended to trade at about 4 to 4 1/2
times cash flow, which was very cheap.
"We think if the stock were to fall to a certain level, the LBO guys (leverage buy-out firms) would come out of the woodwork to buy this company," he said, noting it has no debt and stable cash flow, which give it a natural floor.
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