Steve Brase and his colleagues don't like everything they see. But unlike most fund managers, they try to make money from losers as well as winners.
Manager: Steven Brase
Fund: AIM Large Cap Opportunities*
Assets: $572 million
2000 Return/Rank vs. Peers: 30.9%/Beat 99% of Peers
YTD Return/Rank vs. Peers: -11/4%/Beats 95% of Peers
Top Three Holdings:
*Closed to new investors, co-manages the fund with four other managers.
Mid Cap and
Small Cap Opportunities funds, Brase and four other managers buy stocks of companies they think will grow earnings faster than their peers, but they can also use as much as a quarter of each fund's assets to sell stocks short. To short a stock, you essentially borrow shares of a stock you think will tumble and sell them, hoping to buy them back at a cheaper price down the road. Shorting can be risky because you can lose a lot of money when you short a stock that subsequently rises.
Brase says the three funds essentially use their short stakes as "shock absorbers." That was an apt description last year as each managed to trounce more than 80% of its peers. The funds are all shuttered to new investors now because their gains made them popular, but their style can be burdened by fat in-flows. Still, it makes sense to ask how they pick out leaders and laggards; Brase likes energy stocks but is shorting the alternative-energy area, for instance. After all, correctly separating winners from losers with some consistency is pretty much what successful investing is all about.
1. Would you detail your funds' strategy? It's a little different from most offerings you come across.
They're long/short funds that typically range from 10%-25% short. We also can employ leverage up to 33% of the assets.
These days, people focus so much quarter to quarter, and things have gotten much more volatile. In many cases we have to revisit names much sooner than we would like to and than we otherwise would have. We have to go back through the portfolio and comb it for names that may have appreciated significantly. Or, we'll find that things have changed either on the competitive landscape or within the company itself and might really warrant re-evaluating our position in the company.
The main metrics in the model that we've incorporated to do the initial screen are a valuation metric that focuses on relative price to sales -- valuation currently with what it has traded at historically. And then, we check the earnings revisions that have occurred on the Street whether we think that things have bottomed out. If the numbers have been coming down, we are looking for the first sign of an uptick in earnings from analysts on the Street.
Source: Morningstar. Returns through May 5.
2. What sectors are looking good to you folks these days, given your time frame and approach?
Technology has been beaten up for almost a year, and we're able to find quite a few good quality growth companies that are still reasonably valued.
We have had a recent run here in the technology sector. But there are quite a few companies that remain reasonably valued that have a lot of upsides to their earnings going forward once visibility returns to the tech sector as a whole, and that they're very leveraged to the rebounding economy.
If the economy rebounds, and if we are correct about the earnings growth of these companies, there's also quite a bit of multiple expansion remaining in a lot of technology stocks.
There are some that are very expensive right now as well. We own some of those. We're waiting cautiously to see if visibility does return before stepping into some of the more highly valued companies.
With technology, what people have been trying to figure out is how much of what has gone on in the first quarter has been the economy slowing, and how much of it has been due to inventory buildup in their products? The recent
GDP data might suggest that more of the slowing was due to inventory buildup. That would be very good for tech stocks in general.
An inventory buildup is a one- to two-quarter phenomenon. It can be worked off rather rapidly, and we can return to the more normalized growth rate fairly quickly.
If it's an economic slowdown and weakening demand, then that is something that is much more tenuous and it may require three or more quarters to really allow that visibility that people are so wanting to return to the technology sector.
Source: Morningstar. Returns through May 5.
3. Since tech is sliced into so many sleeves, what are the subsectors that offer the most stable and reliable earnings growth going forward?
We are focusing on semiconductors and semiconductor-capital equipment. They both tended to be the first ones to see the weakening economy and the inventory buildup. We think also that they'll be the first ones to lead us out, to have that visibility return to those sectors.
One of our other big favorite sectors then would be the energy sector. The fundamentals within the energy group are still very strong, and it's really a matter of what people are willing to pay for that earnings growth.
A lot of investors had been burned back in the late 1997-98 time frame with the Asian crisis. They are wary of stocks now that have been up fairly significantly. Earnings growth looks very positive, but a lot of people say you can burn me once, but I'm not going to get burned twice.
Fundamentals are strong there; they are sustainable as exhibited by the oil and gas prices being at fairly high levels relative to history. And the need there is really to keep your thumb on the pulse of what's going on in the macro oil environment, in OPEC and with demand for both oil and gas domestically.
4. What leads you to consider a stock for shorting?
Shorting is not as easy as many might think it is. It's a very difficult process. No. 1: Your mistakes get magnified, and rather than getting smaller as they do when stocks go down and you're buying them on the long side.
You're always having to monitor the shorts and making sure that the fundamentals that you believe exist in a company are actually going to be recognized by Wall Street in the near term. If they aren't recognized in the near term, you could be hurt.
There are two main categories of shorts. There are companies that have poor fundamentals that are somewhat the mirror image of what we try to do on the long side. We're trying to find that opposite inflection point where earnings are just starting to turn down. And a lot of times, we try to be early because once earnings have turned down, the stock in many cases has already accounted for that downturn.
So we try to be ahead of that curve. The way to get ahead of that curve is through looking at stocks, stock-by-stock fundamentals. We have certain systems we have in place here that do that for us, or help us identify, again, a shopping list of names that we do perform further fundamental analysis on. We really focus on accounting, primarily, and how companies account for their earnings and the trends in the way they report earnings.
The two main tools we use that have developed internally here and are both proprietary to AIM, one focuses on the quality of the earnings, really more so than the quantity of earnings. We do that in all of our companies. We want to make sure that the quality of earnings is up to par with the rest of companies in their group and that they're reporting as others do, so that everything is on an apples-to-apples basis. And the other tool focuses really on the nuances within a report. And it's amazing the differences that you will find in a press release or a conference call vs. what you find in reading the
I guess the difference is what you have to disclose. When you're on the conference call, or in a press release, you can dress it up a little bit.
Right. They can dress it up a lot. And generally accepted accounting allows companies quite a bit of discretion in the way they report earnings.
We're looking at all of their financial statements, line by line, to determine the trends over several quarters in earnings to see if things are changing and when you look at those ratios. There are a lot of things that can pop up that are unusual, and we'll call analysts or we'll call the company to really discuss and find out why these trends are occurring. And try to determine if that's something that will come to roost in the company's stock price in the near term.
5. You folks have a fellow who combs through filings for a living. I found it interesting that there are certain keywords or phrases he routinely searches for. What are some of the keywords, and what do they tell you about the company?
Well, it's a proprietary tool and a proprietary database of words that we've developed. I can give you a general example: a change of auditors. You can search for any phrase reflecting that, or you can even just look at the financial statements themselves and see who signed them.
Keyword searches like that are very helpful in determining -- once you see one company have a problem with a certain issue, you apply that to all companies and you can do searches and really determine who's doing what and who else might have the same problem that company XYZ just had and is down significantly because of it.
Great and Small
Source: Morningstar. Returns through May 5.
6. Are also specific catchphrases for certain sectors? Say, for example, the practice of vendor financing in telecom, where a big firm would loan money to its customers.
Definitely. During the hype of the Internet last year another phrase that came up fairly often -- this is an example that I can give you because it's not so applicable any more now that most of these stocks are $1 or $2 stocks -- the Internet companies were doing barter transactions. That was an easy one to search for, and that's not, as it turned out, the reason that they all went to $1 or $2, but it was something that really helped us focus in on who's got real revenues and who is buying revenues. There was a lot of that going, and now that stocks are down, they can no longer buy revenues.
I imagine if you see a company where sales might be dipping but it continues to meet numbers thanks to cost-cutting, you must worry that there's only a certain amount of time you can kind of keep that going.
Right. That's a very good example. A very simple ratio to look at is the cash flow the company generates relative to its net income. If net income continues to rise while its cash flow is declining, that can only occur for a short point of time where, this is the example you gave, it will eventually come out in the price of the stock. They'll need to do something to generate positive cash. They can't continue to forever put up numbers without generating the cash in the cash-flow statement.
7. Within your short position, what sectors are playing a big role there? Where are you finding most of your opportunities on the downside?
On average right now, we're short about 15%. We have cash in the range of 7% and the balance -- 78% -- long, and we're not leveraged or anything. Our short portfolio can and has made money and the large cap opportunity fund; as an example, last year, the short portfolio was up 130%.
Our short positions are fairly diverse. One sector would be the alternative-energy sector. That sector is exhibiting a lot of the same characteristics as the Internet sector had been exhibiting about a year ago.
These companies, many of them have no revenues, negative cash flow. Their cash is decreasing at a pretty rapid rate. It varies by company, but there will be a cash crunch fairly soon, and that these companies will run out of cash. We've seen a lot of hype, we hope, in this sector without really any evidence
of the economically viable, full-scale production solutions to the problem that they're addressing.
Another area might be in the health care-services area. Again, like I mentioned earlier, GAAP accounting does allow companies certain discretion in the way they report...
But within the health care-services area, there is even more leeway. Technology is beginning to rebound, we think, and some of the money will come out of that, and they will go back to more historical and more normal valuations.
8. With rate cuts, easier earnings comparisons, a potential tax cut and the like, do you see your short position getting smaller?
We've already seen it begin to shrink, and it probably will continue to shrink. Typically, our short portfolio builds just prior to earnings season. There's a lot of short-term catalysts on the downside
that can be prevalent throughout the earnings season.
Then after earnings season, there's much less in the way of catalysts, so it tends to increase. But in general, I think we are getting more positive. Whether Q2 will be the bottom or not is still debatable in many areas. But I think people are saying they don't want to miss it, because it's probably, if Q2's not the bottom, then Q3 probably is.
And they're willing to put their money to work now, and so that's what I think has caused a lot of this recent run. We have been involved in that as well and we've been getting more bullish. I think in the near term, things may have run a bit too much, and there may be some consolidation at these levels. But overall, in technology at least, the trend is probably up. But it will probably be a trader's market this year.
9. If you had to pick three areas you are most comfortable with for the next five years, what would they be and why?
Telecommunications would be one area where the buildout of the networks will really need to occur over the next five years because of the growth in data traffic.
The voice traffic is growing, as it always has, at its 2% or 3% annual growth rate, but data -- much more voluminous -- are necessitating the buildout. That's significant for a lot of technology players that supply equipment into the buildout of that network.
Telecom equipment is the first area that companies within that space that supply the key components, have a dominant market share and have the characteristics that we're looking for in the long side -- those are the ones we're really trying to focus on now.
In addition, I think over a five-year period, semiconductor-capital equipment is probably a good investment. Production has really yet to begin in 300mm fabs, but pilot lines are up and running and the feasibility studies are done and volume type orders, I think, will occur over the next several years and that will be a boon to the capital equipment group.
The 300mm equipment cycle is an upgrade from 200mm -- the diameter of the wafers used. So if 8 inches is 200mm, and they're making the process change over to 300mm or 12 inch wafers and that change necessitates a whole new set of equipment, so when you build a new fab, you can't just retrofit your 8-inch equipment, you need to go to the new 12-inch equipment, which requires a whole new order, basically, from all of the capital equipment guys from start to finish. And that's going to drive that group for the next five-plus years.
And then a third sector, I would have to say, energy, actually. The number of rigs drilling for natural gas domestically is up over 40% in the last year, yet the amount of supply we are generating from those rigs has not increased. Even though there's 40% more rigs, we're still getting the same amount of gas, and that's why gas prices are very high.
It's just hard for us, the decline in the existing wells has increased so much over the last few years, in part, due to technology. Technology has allowed us to drill and make economical, much smaller pockets of gas. But when we drill these smaller pockets, they're depleted much more rapidly. And therefore, in the past, when you drill for a well and you hit something, it lasts seven to10 years. Well, now, they're lasting two to three years because they're much smaller to begin with. That's exacerbating the problem.
I think there's a lot companies within energy to benefit from the need for more drilling rigs, the need to drill more holes in the ground and the need to get that natural gas. In particular, exacerbating this problem is the whole California energy crisis and the need for more natural gas-fired power plants to generate electricity. We're just going to need more and more gas, which will necessitate more and more equipment from the energy service sector.
10. What would you say is some of the biggest mistakes somebody can make in this market?
I think we saw a lot of people get too excited about the market a year ago, and they probably ended up losing money. Now, you don't want to get over pessimistic. You want to keep your money in the market, and be patient and know that over time these things do go up and down. There will be volatility, but it's not the time to pull out and go to bonds and go to money markets.
The time to do that was awhile ago.
Right. And that's in part why we think these long/short funds again are great investments, because they really provide better risk-adjusted returns, so that on the downside you have some protection.
Fund Junkie runs every Monday and Wednesday, as well as occasional dispatches. Ian McDonald writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to
email@example.com, but he cannot give specific financial advice.