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Around the World With Balestra's Melcher

Emma Trincal

Among hedge funds, global macro managers take long and short positions in stocks, bonds, currencies and commodities, based on broad economic bets that may or may not pay off. With a 13% return after fees at Dec. 2, New York based hedge fund Balestra Capital Management is a winner in this often-risky field.

James Melcher, Balestra's founder, spoke to TheStreet.com last week about his investment philosophy. (As always, any hedge fund's positions are subject to change without notice.)

What makes you different from other macro hedge funds?

Some define global macro managers as just players of themes in interest rates, commodities or currencies, but not as stock-pickers. We are also stock-pickers. We invest in groups of equities and of course we use ETFs, futures, and even mutual funds if we want. We go anywhere in the world to implement strategies. Our only limited factor is risk.

Does it mean that you are running a low-volatility strategy?

Not necessarily. Sometimes if you accept higher volatility, you can actually get a better risk/return ratio. To rely heavily on volatility, I think, is a mistake. Take Long Term Capital in 1998. There was nothing in their volatility figures that would have predicted a risk of that sort. We look at volatility without relying on it. We have at times plunged into very high volatility situations while actually controlling risk.

Give us an example.

In 1999 and 2000, we entered into two groups of equities with extremely high volatility. We went long some small and large high-technology stocks. The volatility was high on the upside and we knew that when the bubble burst, they'd drop very sharply, maybe 50% to 80%. We sold short small Internet stocks, which also had extremely high volatility. If the bubble burst, we thought our shorts would drop 90% to 100%. So we went to a well-hedged position. We did have very high volatility, but during that period of time, we were hedged. In 1999, despite being long and short -- roughly market neutral -- we were up about 100% after fees. In the first quarter of 2000 we were also up very much. When the bubble burst we gave back some of our gains, but over the entire year, we were still up 25%, because the system of long and shorts worked. We were in a hedged position that produced 150% gains for a portfolio in two years and yet we were condemned because we dared commit the cardinal sin of having volatility in any given month. Institutional investors are trapped by their own restrictions.

What's your take on energy?

We've been long energy for three years, but primarily concentrated in oil field services. Currently, for instance, we own Halliburton(HAL Quote), Lone Star(LSS Quote) and Maverick Tube(MVK Quote). We are offsetting that by being short oil futures. And here again, we have high volatility on both sides but we're comfortable with our positions. In fact, in the past weeks and months, it's worked well as oil field services have outperformed the actual price of oil because there is a shortage of oil field services and there is very limited supply. If oil goes higher -- we short oil so we lose money on that -- but the services stocks will also go even higher, so it will be offset. On the other hand, if oil drops substantially, the earnings of the oil field services companies will still be the same, there will not drop and the stock will drop temporarily maybe but in a limited way.

What sectors do you short?

We've been short the automotive industry: General Motors(GM Quote), Ford(F Quote) and also Visteon(VC Quote). We shorted the homebuilders and the mortgage companies. For instance, we were short Hovnanian Enterprises(HOV Quote) and Toll Brothers(TOL Quote). We covered those several weeks ago, fortunately, right around the bottom. We did very well with that.

What about gold?

We have a heavy position in gold and it does two things for us. It offsets what we believe is a trend toward rapidly depreciating paper currencies in the world, including the dollar. We see paper currencies being debased. And secondly, it gives us a form of insurance against financial distress, not limited to inflation. Gold did very well in the 1930s. We continue to hold significant amount of gold.

Any thoughts on the dollar rally?

We're long the dollar right now. The dollar is the least of evils relative to other currencies. There is only one country in the world that absorbs vast amounts of liquidity and that's the U.S. market. OPEC got $350 billion more in revenues in the past 18 months. It's not going to build new hospitals in Algeria. It's going to buy U.S. Treasuries, U.S. agencies and U.S. corporate bonds. They get dollars and recycle it. If you have a 4% interest rate in the U.S. with a rising dollar versus a 1% rate in Japan with a falling yen, it's a no-brainer.

Tell us of sectors that you like.

We like agriculture. We have long-term confidence because people are insisting on eating every day and the population of the world is growing. As the populous countries of India and China are moving rapidly up the standard-of-living ladder, they'll demand more expansive agricultural products, beef and pork as opposed to rice and wheat. We own Bunge(BG Quote). They're in Brazil; they do agriculture products and fertilizers so they cover a lot of areas. It's a well managed company and the stock is attractive. It came down from $65 to $53 and we bought more. We like emerging markets because if the U.S. does OK, the emerging markets will outperform.

We're heavy in Russia. We began to invest just after the crash of 1998, when the Russian market was down 92%. Russia is probably the greatest story in natural resources. We like India. We think it will be the best performing economy for the next 20 years. China will continue to be a great growth story. But we do not trust their securities market because of the lack of regulation. We are in Japan. We're in-and-out short the yen. We have held Japanese equities for several months and it has worked very well for us.

And sectors you don't like?

We're short housing. We are also increasingly short the financial sector. That's because the flattening yield curve squeezes the opportunity for profit and also because of banks' heavy reliance on residential mortgages. The banks currently hold 62% of their assets in residential mortgages compared to roughly a third 25 years ago. And the quality of these mortgages have been dropping very fast because lending standards have been dropping in what has become a competitive lending frenzy.

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