Jerry Paul doesn't buy the ideas that the economy is poised to boom and stocks are cheap. But he's starting a fund anyway.

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Despite a less than rosy view of the markets, Paul's new hedge fund, Quixote Capital, will start trading next month. Prior to that, Paul ran the ( FHYPX) Invesco High-Yield from 1994 through last September. In the last two years of his tenure, Paul's fund fell victim to the high-yield sector's tech flu as upstarts overspent and folded, failing to pay off their bondholders. Before that, however, he'd routinely trounced his peers, earning Morningstar's bond fund manager of the year award in 1999.

What's next for high-yield bonds and the battered telecom sector? Where does he see value and what low-hanging fruit is wormy?

1. What's your strategy with the new fund?

We're going to be doing what's known as event-driven investing. We're looking for special situations, and that could be equity arbitrage or equity breakup value plays. It could involve distressed debt or capital structure arbitrages, that might be where we own a company's bonds and short its stock. We'll be employing leverage to increase the returns.

Basically looking for stocks or bonds that you think are mispriced -- owning what looks cheap and shorting whatever looks expensive?

Yeah.

Using both equity and fixed-income instruments?

Yeah.

2. Given that approach, what are you focusing on now?

We think Price Communications ( PR) is a pretty interesting situation, where it's being acquired by Verizon ( VZN), and those bonds are callable here shortly. They've got some high-coupon bonds out there. From an equity point of view, we think Security Capital ( SCC), which is being acquired by General Electric ( GE) is a relatively safe, interesting arbitrage.

3. Is there a stock being sold off due to accounting questions that you don't think is justified?

Tyco International ( TYC) has probably been overdone. They've done some things that can be called into question, but it's not going to turn out to be an Enron situation where they go broke. We wouldn't put that bet on. The equity's gotten to a valuation that might be kind of interesting. If you buy the stock at $29 today, the breakup value can be $40 or $45. The problem with that is that it's gotten riskier as the stock has dropped in a certain sense in that it may undermine the breakup process. That's one that we've just kind of avoided in general. We can't get our hands around that, but we get the sense that it's been overdone.

Talking With:
Jerry Paul
Hedge Fund:
Quixote Capital
Launch: March 2002
Former fund: (FHYPX)
Invesco High Yield
Tenure: May 1994 to September 2001
Sources: Morningstar

4. As a high-yield investor, obviously you spent a lot of time looking at telecom, which might be furthest from the sweet spot right now. From where you sit today, what went wrong with telecom, and what can we expect this year and next year?

Capital was just too readily available. Too many marginal competitors got funded. That created a competitive environment that got a little silly, but it also forced and enabled the better managed stronger guys to probably reach too far. Clark McLeod chairman and co-chief executive of McLeod USA , for example, is a very good telecom manager and has a very good team, but they expanded their business plan one bridge too far. A number of them, not just McLeod but folks at XO Communications ( XOXO) and others, went beyond the original business plan, which itself was probably reasonable and wasn't going to stress their balance sheet or management talent. The availability of capital hurt the industry on both of those fronts.

5. What do you see now? Is the wash-out over?

A lot of this restructuring is already underway, and that gives them a chance to retrench and reduce the capital demands on their business plans. I would hope that we can wind up with some survivors out of this that can provide some competition to the local carriers.

Who are some survivors?

There's some of them that will never come back -- the Winstars and the Teligents were marginal to begin with. Somebody like McCloud or XO will come out with a responsible, restructured balance sheet. You've got the guys that are hanging in there -- Allegiance and Time Warner Telecom -- that are probably survivors and may actually be survivors without having to go through restructuring.

Do you see telecom stocks starting to gain ground this year?

I don't know about that. Ultimately there's got to be consolidation, but there's so much stress in that industry right now, I think we're a ways from that.


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6. Do you see anything worth owning in the telecom area?

I think AT&T ( T) and AT&T Wireless ( AWE) have gotten down to interesting valuations, down around the $10 mark. So things of that sort could be interesting. Some of the distressed stuff at the right level might be interesting. McCloudUSA debt at the distressed levels it trades at right now could be an interesting value. We're kind of picking over some of the carcasses out there, but to just do a long lonely bet on one of the telecom names, I'd be a little uneasy about that right now. Qwest Communications ( Q) is interesting, but certainly under severe siege right now. The problem is that a lot of guys have gotten hammered trying to catch falling knives. I like Qwest management and I think a lot of that company, but to buy the stock right now you've got to have ice water running in the veins. But if I was going to pick a single one to make a speculative stock play, I'd pick Qwest.

7. Let's talk about some telecom giants that are under pressure, starting with Lucent Technologies (LU) and Nortel Networks (NT)?

Most of their customers are under siege, and it's going to be hard for them to do well. We haven't spent a lot of time on those companies specifically. But when your customers aren't doing well, it's kind of hard for you to do well. I would be a fence sitter on those.

How about Nextel (NXTL) or Level3 Communications (LVLT)?

Level 3 at some point is an interesting play. It may be better to play it through its bonds. The same for Nextel. Nextel is really under a lot of siege too. We may not be nuts about the equity, but we might play something via the debt.

8. What about the high-yield market?

I'm a little more skeptical about the returns from high yield than a lot of other people out there seem to be. If I was running a high-yield portfolio right now, I'd be running it with more defensiveness than the soothsayers would have you do.

I think people's expectations are too high. I keep hearing this stuff about economic turnaround and bailing out the high-yield market. I'm not real convinced. I'm a little more skeptical of the idea that the economy can bail out bad business plans. We don't spend a lot of time looking at macro stuff like economic forecasting and that, but we think for the most part that people are too optimistic about the economy. Generally it's going to be soft for a lot longer than people expect.


Ragged Glory
Paul faltered a bit in his last two years running the Invesco High-Yield fund
Sources: Morningstar. Returns through Dec. 31, 2001.

The Invesco High Yield fund held up OK in 2000, but was crushed in 2001. What did you miss?

Stayed too long with the telecom stuff. Stayed way too long. It killed me. I let my confidence in the management teams get the best of me.

9. What are investors underestimating?

We've become a little more complacent about the continuing terrorist risks than maybe we should. It's still a dangerous world. If we get any kind of a significant terrorism event, I don't think the markets are priced to reflect that. That's an ongoing risk. Osama Bin Laden isn't the only bad guy out there. I think there's a risk that the consensus is probably a little more positive on the economy and the turnaround than I would be comfortable with. We just think it's going to be slower, not that it's not going to happen. If you're paying high multiples on something on a different premise, time value is a killer. So, in general, stocks look like they're still pretty fully priced.

10. So would you say this market is cheap, or is it fairly valued?

I don't think the market is cheap. Cheap has to go down a lot further than what we have.
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 imcdonald@thestreet.com, but he cannot give specific financial advice.

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