The Long and
Short of Things
Why we remain flexible
by Dale Wettlaufer (TMF Ralegh)
ALEXANDRIA, VA (Nov. 2, 1998) -- Adding to what Alex wrote about on Friday, one of the reasons we short stocks is because we regularly look at entire industries and believe we get a pretty good feel for value in a specific sector. We're not talking about hot growth companies with tiny floats, which we believe are insane to short. We're talking about what are many times very mature industries where we see the relative value of something as totally out of whack with its competitors.
This can happen for a number of reasons, such as short-term events at the company making the long term appear rosier than it is. Revlon (NYSE: REV) is a recent example of this. I think perhaps the appetite for global brand-name companies drove the company's stock as high as it went, but we saw flaws in both the stewardship of the company and in the quality of results it was generating. That's one sort of situation where we'll short something.
We'll also short "thematic" sorts of companies. In 1993, brand-name companies took a big hit because brands were supposedly going out of fashion and marketers were talking about "the brand of one," which drove companies like Drypers or Cott Corp. to pretty high valuations that discounted results that were nearly impossible to achieve and that certainly overvalued what the companies had achieved to date. Since value investors are often contrarians by nature, or at least by practice, we could have either paired off a buy of a beaten-down global brand with a short of the zeitgeist stock, or we could have just gone short the zeitgeist and used those funds to plug into another company that we felt offered very good value.
One could rightfully call this "asset arbitrage" or "valuation arbitrage," and it's something that investors who are quantitative in their assessments of things are naturally drawn to. After all, quantitative assessments of things get you past fuzzy-thinking concepts such a "great management" and "great brands" and drill down to answering the question of "what's the financial performance of these great managements or great brands." I attended a talk by Peter Lynch recently and he made an absolutely 100% right-on comment about supporting an argument for an investment with "they're a great management." He said, "How do you know?"
Some people think that a management team is great because the CEO was a swell guy on the golf course and has a hell of a golf game or tennis game or whatever. Lynch asked, "What about the opportunities the company has passed up?" Most investors aren't going to know about that, but it's an important point. Management teams have to weigh options, and we get to assess the decisions the company makes -- but only the people inside the company know about the decisions that we rightfully and astutely passed on. Of course, if a company missed a decision to acquire a small competitor that eventually destroys the original company's business, then that's an observable non-decision. But most of the decisions that are passed on are not observable by us.
All of that is a long-winded way of saying we like to see results. We want to see good returns on capital and the right capital allocation decisions being made over the long term. That is what determines a great management team, in our opinion. Wall Street can fall in love with concepts that just don't generate value for shareholders, and we want to be in the position to take advantage of the greed cycle, just as much as we want to take advantage of the fear cycle.
To that end, we'll go short some stocks once in a while. And we'll take some slight advantage of the equity that we have in our portfolio to do so. Typically, a business operates with more assets than owners' equity. That's because managements believe they can generate more value from the return on assets than the cost of the liabilities. Many investment portfolios don't operate with any leverage whatsoever. The equity in the portfolio matches the assets in the portfolio. When someone shorts something or uses margin, that's leverage. And typically, when someone shorts something, they want the shorted stock to go down to generate the return. We like that as well, but we also don't really mind if the short doesn't go down that much, as long as it doesn't go up. Minus the transaction costs and any charges for carrying the short, it generates cash for us to use.
If the short declines 20% over the course of a year and the charges for the borrowed shares amount to 7%, then the cost of that float was negative 13% for the year. Had we invested that in a company that showed an 11% return over the year, the return on the transaction is the difference between the cost of the float and the return on investment -- in this case 24%. If the stock doesn't go up or down, then the cost of the float is going to be 7%, around the same as margin debt. The positive performance will be lower, but it's still positive. In shorting something and using the cash to buy something else, the downside is unknown but the upside is that the float will cost nothing or less than nothing. In using margin debt, the cost of the capital (the debt) is known, but there is no chance that the capital will cost nothing or less than nothing. So there are tradeoffs that have to be considered.
Any leverage that we use will be very, very mild. I don't think the assets to equity in this portfolio will ever surpass 1.1 to 1. Looking at in another way, the equity in the portfolio will always be about 91% of assets. So we might short or use margin debt when we feel the odds are in our favor, but we will not get in a position where the liabilities are uncontrollable. This won't be a regular feature of the portfolio at all. We're way too preoccupied with finding things we want to invest in. But in the course of doing lots of research you run into these things, and we want to take advantage of them when we find them.
Stock Change Bid ANDW + 5/8 17.00 CGO +1 11/16 36.19 BGP +2 1/4 27.63 CSL + 3/16 38.81 CSCO +1 11/16 64.69 FCH + 3/8 23.94 PNR + 9/16 38.19 TBY - 1/16 7.00
Day Month Year History BORING +3.13% 3.13% -5.66% 18.70% S&P: +1.18% 1.18% 14.55% 78.82% NASDAQ: +1.67% 1.67% 14.68% 73.00% Rec'd # Security In At Now Change 6/26/96 225 Cisco Syst 23.96 64.69 170.03% 2/28/96 400 Borders Gr 11.26 27.63 145.42% 3/5/97 150 Atlas Air 23.06 36.19 56.94% 8/13/96 200 Carlisle C 26.32 38.81 47.44% 4/14/98 100 Pentair 43.74 38.19 -12.70% 5/20/98 400 TCBY Enter 10.05 7.00 -30.31% 1/21/98 200 Andrew Cor 26.09 17.00 -34.84% 11/6/97 200 FelCor Sui 37.59 23.94 -36.32% Rec'd # Security In At Value Change 6/26/96 225 Cisco Syst 5389.99 14554.69 $9164.70 2/28/96 400 Borders Gr 4502.49 11050.00 $6547.51 8/13/96 200 Carlisle C 5264.99 7762.50 $2497.51 3/5/97 150 Atlas Air 3458.74 5428.13 $1969.39 4/14/98 100 Pentair 4374.25 3818.75 -$555.50 5/20/98 400 TCBY Enter 4018.00 2800.00 -$1218.00 1/21/98 200 Andrew Cor 5218.00 3400.00 -$1818.00 11/6/97 200 FelCor Sui 7518.00 4787.50 -$2730.50 CASH $5750.59 TOTAL $59352.15