Skepticism has never been so profitable -- nor so chic. But even in this topsy-turvy world in which corporate accounting seems sexy and telecom couldn't be less cool, David Tice still finds himself a Cassandra among optimists.
Tice founded his eponymous research firm in 1988 to provide clients with earnings warnings and sell recommendations through his Behind the Numbers publication. He launched the (BEARX)Prudent Bear fund in 1995 to serve as a "net-short" hedge to the U.S. stock market, and the (PSAFX)Prudent Safe Harbor fund in 2000 to benefit from a weakening U.S. dollar and rising gold prices. Prudent Bear is up 20.5% in 2002; the fund's 8.47% gain last week made it one of the five best-performing funds according to Lipper.
So with the S&P 500 down 5.5% for the year and short-sellers appearing more savvy than vicious, is Tice feeling good? How good can a short-seller feel two years into a bear market? Read on.
1. The word "vindicated" seems to crop up alongside your name with amusing regularity. Have you ever counted how many times?
No, I haven't counted. I consciously don't use that word, because when we're right, other people are losing money. I don't ever take glee in that. We just try to do the best job we can.
2. First, the obvious question: Are stocks still overvalued, even after two years of a bear market?
Yes, we're quite confident they are. Sure, we've seen a small correction in the S&P and Dow
, which have been down in 2000 and 2001, and there are people who say it can't be down again in 2002. But they're missing the point about how big this bubble was.
Our theory on the market's overvaluation is based on three issues: macroeconomic theory, stock market history and individual company analysis. Under macro issues, we have consumer and corporate debt funding the boom market. There's also stock market history, which shows that after a long bull market, there's a long bear market. We haven't had that yet. The S&P is trading at 25 times expected earnings. Bull markets don't start from those levels. There's dramatically further to fall.
David W. Tice
Prudent Bear Fund
|Managed Since: inception, December 1995
|Assets: $192 million
|One-Year Return: 37.67%
|Five-Year Return: -3.31%
|Maximum Sales Charge: none
|Top Holdings: not available
|Source: Morningstar, April 30, 2002.
Plus, individual companies are still overvalued. The Nasdaq
might be down more than 60%, but the companies in the Nasdaq 100 are still trading at eight to 10 times sales, and their sales are declining. Juniper Networks (JNPR)
is selling at five times sales, and their customers are going away. Everyone thought Cisco (CSCO)
was cheap at $20; now it's at $14. There's competition and customers are not spending anymore money, but it's still selling at 70 times earnings. That's not right.
3. So at what levels would you say the markets would be fairly valued?
It'll scare the jeepers out of us on the downside. Alan Greenspan called it irrational exuberance when the Dow was at 6,300 in 1996, and he was right. This is the aftermath of a problem that's been with us since 1996. We just papered over the problem, creating more debt to keep the party going. It's like a group of partygoers who are drunk at 11 p.m. You can give them more tequila, and they'll be really
drunk at 4 a.m., but that doesn't mean they weren't still drunk at 11.
I think it could be Dow 3,000 or below, and the Nasdaq below 500. People think it can't happen, but it can. That's the way markets work; that's the way economic history works; that's the way companies work.
4. You've often said that the dollar is overvalued. Do you still think that's the case? What part do credit issues play?
Yes. We have a dysfunctional global currency and economic system, in which the whole world is set up to sell to the American consumer. Essentially, the rest of the world is working for the U.S. consumer, who is spending far more than they earn, sending paper to the rest of the world for their goods. That's been able to occur because the dollar has been so strong. In other words, the rest of the world wants to buy our paper.
But the dollar is weakening, and the price of gold is increasing. Gold is the antithesis of the dollar; it's the asset for uncertain times. When gold prices go up, it indicates a problem -- some discomfort or uncertainty -- in the system. The price of gold is close to $310; it had been below $300 for a long, long time.
5. What will trigger the dramatic downturn you're expecting?
It could be a number of things: the dollar continuing to decline, interest rates go back up, gold prices going higher, a resistance to buying asset-backed securities, continued lowered corporate earnings and uncertainty in corporate bonds. All these factors in the background could cause some incremental selling in the margin, prompting a slide past September's lows. If interest rates start rising at the same time the stock market goes lower than it did in September, corporate earnings won't come back and we could see another round of layoffs -- and the U.S. consumer will start to panic.
The U.S. consumer has been sold a bill of goods that the Fed
will create permanent prosperity for us. But in a postbubble economy, there's not a lot that can be done except take the pain and correct the imbalances. That means lower and lower profits and lower and lower stock prices and a more disconsolate consumer. And it gets ugly. We're moving from the virtuous circle of the past five years to a vicious cycle. I wish Alan Greenspan could snap his fingers and make it go away, but he can't.
6. How do these macroeconomic issues influence your strategy? Short-selling, after all, is generally considered a "bottom-up" exercise.
We're looking at financial companies, for instance. We think that consumers are overleveraged and will scale back dramatically. Most financial companies' reserves have been understated because there's this misunderstanding of the economic picture. So defaults are going to increase surprisingly, and companies in that arena are going to disappoint. Homebuilders are another category we're looking at, for similar macroeconomic reasons.
7. What specifics do you consider when looking at individual stocks?
We look for companies that generate either very high returns on capital (ROC) or very low returns. Companies that generate very high returns on capital, especially those in niche businesses, attract competition. And competition breaks down those returns. That kind of company is a great short candidate.
Companies with low returns on capital that are growing quickly can sometimes be sources of hype. Wall Street wants nothing more than to find small, fast-growing companies that generate low return on capital. Those companies' need for capital becomes a regular source of income for the Wall Street firm. We also look for euphoric expectations: when everyone on Wall Street thinks the company's going to go to the sky.
8. Are you telling us you follow analyst ratings?
Oh yeah. But we look at them as a contrary indicator. If there are 20 recommendations and they're all buys, and the stock is close to its high, we'll put it on alert. We'll allocate research to it.
9. Some 65% of your fund is in short positions. What's the other 35%?
We own some special situations stocks, which make up about 15% of the portfolio, and we own some gold and silver mining companies, which make up another 15%. We own put options as well. [Put options give the holder the right to sell a stock at a certain price. If the share price drops, the holder can still sell at the higher option price.]
We only have micro-cap companies on the long side because that's where we think there's value. Usually, long positions are in companies with less than a $200 million market cap
. For instance, we like Cardima (CRDM)
, which makes a device that maps and removes cardiac arrhythmias. We also like InSite Vision (ISV)
, which makes tools to manage glaucoma and other ophthalmic pharmaceutical products.
10. Your fund has a $2,000 minimum investment. Most other bear funds have minimum investments closer to $10,000. Why the lower requirement?
We set up this fund for the little guy. Hedge funds have been around for rich investors for a long time. Short-selling has a bad reputation, but we think there needs to be a vehicle to provide a mechanism for individual investors to make money in a slide.