Outwitting the bear

“I think that we’re in for another five to 10 years of low growth,” says John Schmitz, president and chief investment officer at SciVest Capital in Toronto. “Debt levels are still at historical highs. As a result, I think what we’re looking at is a cultural change, and cultural changes don’t happen in six months or 12 months or three years.”

Schmitz was speaking at the third in a series of debates, called “Under the Hood of Hedge Funds,” sponsored by the Canadian chapter of the Alternative Investment Managers Association in Toronto yesterday.

He manages market-neutral as well as long/short funds. Schmitz says that with his 7% return last year, “you probably wouldn’t have known what was going on in the market,” which is the goal of being market neutral.

Yet, unexpected market movements do have an impact, and January and February were tough sledding. That’s when many investors were liquidating at just about any price. In turn, that forced Schmitz to modify his model. While he uses quantitative techniques to hedge out the market — beta — as well as industries and investment styles, the model was in dangerous territory in the first part of the year. It would have indicated shorting stocks that had already fallen 90%, yet jump 105% in a “junk rally.”

In a market-neutral strategy, the manager selects good stocks to buy and bad stocks to short, to “generate a spread return,” Schmitz explains. But, “the definition of ‘bad’ is key.”

For a good stock picker, market movements shouldn’t matter. But good stock pickers can’t help observing what is going on in the market — or in the lives of consumers.

Stuart Kovensky, co-chief investment officer at Onex Credit Partners, recalls being in New York as the private equity boom went bust in the late 1980s. People pledged to get off the credit treadmill, saying “let’s downsize our lifestyle.” Yet, “the second things started to turn up, everyone went crazy.”

That fits with the distressed debt cycle Kovensky follows. Onex recently bought senior debt issued by the Las Vegas Sands Corporation at 38 cents on the dollar. The company owns premium properties in casino land. He figured that buying at four times cash flow would allow for a profit. But lesser-quality casino properties were being bought at six times cash flow. And, at the height of the financing boom, “people lost money because they thought those properties were worth 15 times cash flow.”

Historic overvaluations also come to the mind of newsletter publisher Denis Gartman. His generation, 58-year-old to 63-year-old boomers, have all the money, compared to Gen-Xers and Gen-Yers. And now they’re experiencing a “tectonic plate shift,” as he calls it.

“The dumbest thing that happened in the U.S. over the past 20 years is that people thought their house was an investment.”

For his part, Gartman plays his cards close – ever since 1984, when he made the wrong trade in the U.S. Treasuries market against what was then a small shop named PIMCO, which now runs the world’s largest bond funds. As a result, he says, “I”m always looking for ways to hedge out or allay the risks there.

“I understand the terror involved with losing all your money.”

His strategy, when trades are going against him, is to get smaller. Despite using futures contracts to exposure to commodities, he says he is not leveraged, since he trades with the notional amount of the contract in mind, not capital on margin.

“I own as if I paid full cash,” he says.

Still, debt has been profitable for Onex, after coming off a disappointing 2008. It had mark-to-market losses of 26%. It has since returned 48%. While debt investors had to reduce or eliminate leverage, Onex had none to start with. So after the December debacle, it was able to buy when others were selling at deep discounts.

Will it be as good in the future? Kovensky thinks not. “That time has come and gone.”

All the same, so many companies have borrowed so much money from 2003 to 2008, that there are still opportunities as they deal with their debt, which may lead to restructurings that take out the junior debt holders in return for equity, thus boosting the credit outlook on the senior debt that Onex specializes in.

While Onex has seen a rally in corporate credit that is unlikely to be matched again, equity markets are suffering through a “junk rally,” Schmitz suggests. Sorting the S&P 500 into quintiles, the 100 stocks with the highest price/earnings ratios have returned over 200% since March 9. The highest-quality stocks, the top quintile, have returned 48%.

A quantitative model would have suggested shorting the lowest quintile and buying up the top quintile.

Or as Schmitz puts it, when he was younger, he was 100% quant. If his model told him to jump out the window, he would have.

Now he modifies the models.