Cramer on the Perils of Hedge Fund Logic

By James Cramer

Hedge fund managers play hunches. We can't wait until everybody knows the news to make money. By then it's too late.

Our job is to project, to predict and to extrapolate pieces of data to anticipate how money will be made. Sometimes it's easy. Let's say Ford comes on the tape and announces that business has slowed. The guy who can short Ford's top three suppliers the fastest will go home mighty happy that day. Or if Procter & Gamble announces across-the-board price cuts for all soap and toothpaste products, you can bet that the shark that gets the most Colgate puts before P&G's biggest rival starts tumbling, will be buying at Morton's a few hours after the closing bell.

But it's not always that easy. Sometimes it is downright treacherous. Take yesterday. In the span of one hour we received inputs that could have led to large losses had we tried to capitalize on what we read. Yet we would have been playing the game in its highest form.

Take the health maintenance organizations. On Tuesday, Aetna reported disappointing earnings and tanked 15 points. On Wednesday Oxford reported okay earnings and still got toasted, with Aetna tumbling again.

Now I know United Health Care, the other large HMO was due to report Thursday, so I figured, what the heck, got to short that one. That's what the game's about. But when I made my calls to brokers and analysts everybody told me I would be nuts to extrapolate Aetna's problems or Oxford's weakness to United. In fact, they all wanted me to buy the darn stock. So I stayed away from the short figuring I would get squeezed on a good number.

But the extrapolation game would have been perfect. UNH showed real weakness and issued several downbeat statements and subsequently tanked 10% yesterday. Lotsa big downgrades. I missed a great trade. So when Heilig Myers, a downscale furniture company announced before the opening Thursday that it saw pricing pressure in the home furnishings business, the synapses in my mind whirred and next thing you know I was trying to borrow some Ethan Allen, a furniture pure play, so I could short it. This time I wasn't going to let any apologist analysts talk me out of betting against Ethan Allen. This extrapolation of furniture retailers was too good to check out. I was going to lay out 50,000 shares of Ethan Allen short and just wait until they confirmed what Heilig Myers said about the business.

But before I could even get a "locate" -- meaning before I could find whether I could borrow Ethan Allen's stock -- the fine furniture maker announced sharply better than expected earnings. And management issued an extremely robust outlook for home furnishings going forward. People were willing to buy it up seven points from where it went out the night before. I would have been annihilated. No doubt others, who, had extrapolated the day before, were humbled.

Yet, it seemed like an intelligent trade.

What conclusions can be drawn? Two things readily pop to mind. The first is that the element of management can never be fully quantified. HMY's management may have botched the execution. Ethan Allen's management may have positioned the company in a higher end that is protected from some sort of industry downturn. One may simply be better at running a company than the other.

But the larger conclusion is that it's very hard to run money in the style we hedge funds have adopted. One minute we look like geniuses as we link disparate economic events to each other; the next we look like fools when the data fail to support our Jerry-built theses. Remember, though, all we have to do is get it right more times than you get it wrong. Then, it's worth every minute of the angst it produces....

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Random musings: the old Abby Joseph Cohen's going bearish argument clubbed the market late in the day Thursday. It must be so tiring for her to have to reit enthusiasm endlessly. Do they try to track her down on that bus to Queens each night when these rumors occur?

... Shocking: but I am not doing this column to try to find people to run money for or to hire. So those inquiring about the hedge fund I run, either as an employer or a manager, should forget it. I won't be rude, more like curt.