Although this newsletter focuses primarily on long investment
ideas, short positions can boost profits in both bull and bear
markets. And after last year's market rally more investors are
looking for short ideas. For this month's interview we sat down
with Mike Shinnick, portfolio manager of
Wasatch-1st Source Long/Short
(
FMLSX
), whose adept management of long and short positions ranks the
fund in the top 7 percent of
Morningstar's
Long-Short category.
You take a value-approach when constructing the fund's long
portfolio. In which sectors are you finding the best
valuations?
Health care is somewhat of a contrarian play. Although these
companies are executing well, multiples have contracted because of
concerns about health care reimbursements and legislative
change.
But demand for health care remains strong--it was just a
question of which business models would be able to maintain prices
or at least benefit from increased volumes. Our strategy targeted
companies with strong businesses whose stocks traded at a discount
and niche names that would grow regardless of developments at the
macro level.
We took advantage of opportunities to buy some of the more
established names that resemble consumer staples.
Along these lines, we've owned
Johnson & Johnson
(
JNJ
) for a few years and bought shares of
Medtronic
(
MDT
) in the third quarter of 2009. Medtronic is a high-quality company
with a strong balance sheet and good business model. Its growth
rate has slowed, but it's a great buy whenever it trades at less
than a market multiple. And both stocks offer decent dividend
yields.
That's also the story with
St. Jude Medical
(
STJ
), which we bought after the stock got roughed up because the top
line was off a bit. That didn't faze us--there's real demand for
the company's cardiovascular products.
One niche health care name that we like is
ZOLL Medical Corp
(
ZOLL
). The stock has doubled since we bought it last year. The company
operates three business lines, one of which is a bit of a
staple--the other two provide a growth kicker. ZOLL manufactures
defibrillators for hospitals, emergency vehicles and public spaces
such as schools, airports and malls. These products serve an
important, lifesaving function and have a finite life span because
the batteries lose their charge over time. When we picked up the
stock, concerns about constrained spending at hospitals caused a
selloff. But we noted that demand was simply deferred--not
disappearing.
And the company's other two businesses offer attractive growth
prospects. One is the LifeVest, an external device that functions
like a pacemaker. Patients who suffer a heart attack are at the
highest risk in the subsequent two months, but that's also the
riskiest time to perform surgery. LifeVest isn't intrusive,
giving the patient time to stabilize before a pacemaker is
installed. Auto-Pulse, on the other hand, delivers regular,
consistent compressions automatically--far preferable to manual
CPR. Evidence suggests that this technology increases survival
rates when transporting patients to the hospital.
The fund also has an overweight position in the energy
sector. What are some of the stories you're tracking in that
space?
Offshore drilling was a theme that worked last year, and we
expect this play to gain momentum in 2010. If you're looking for
value in this market, many of these companies have
price-to-earnings ratios under 10 and solid balance sheets.
Some of my favorite names are
Noble Corp
(
NE
),
Ensco International
(
ESV
),
Transocean
(
RIG
) and Diamond Offshore Drilling (
DO
), which we own through a position in
Loews Corp
(
L
).
The investment thesis behind offshore drillers is simple: A
third of the planet is covered with land, and the remainder is
water. When it comes to the debate about peak oil, I take the
middle case: Oil is out there but we're running out of the cheap
stuff. On land, oil producers are sinking ever-deeper wells and
drilling horizontally. Today's oil finds are complex to produce.
Technology has extended the search for oil into deeper
waters--oftentimes four to five miles beneath the surface and
seafloor. National oil companies and the industry's major players
need to go offshore to find oil, and these massive, long-term
projects don't shut down based on variations in the price of crude.
Deepwater drilling activity even held up in fall 2008.
Pipeline operators are another group we like in the energy
space. Our position in Loews Corp provides exposure to Boardwalk
Pipeline Partners (
BWP
), and we also own
Plains All American Pipeline LP
(
PAA
) and
Spectra Energy Corp
(
SE
). Relative to other businesses in this area, energy infrastructure
is somewhat boring; pipeline operators collect recurring fees that
are independent of natural gas prices. But these stocks offer
impressive dividend yields.
What's your take on financial stocks? I notice your fund
has both long and short positions in this sector.
I've been relatively bearish on the financials; the sector
accounts for the fund's largest short component.
Loews Corp, the holding company that owns stakes in Diamond
Offshore and Boardwalk Pipeline Partners, is our largest long
position in the financial sector. It also controls roughly 90
percent of
CNA Financial Corp
(
CNA
), a property and casualty (P&C) insurance firm whose shares
trade at two-thirds of its book value. We find the firm does a much
better job of asset and liability matching than a bank. This value
proposition prompted us to add a position in the company itself.
CNA's investment portfolio was under pressure in late 2008 and
early 2009, which prompted the firm to issue 1.25 billion worth of
preferred shares that it sold to Loews at a 10 percent coupon. The
insurer raised capital in the fall at 7.35 percent, and the firm
used some of the proceeds to redeem the aforementioned preferred
shares. The company's investment portfolio has also appreciated
over the last two quarters because of the recovery in credit
markets.
The Allstate Corp
(
ALL
), which specializes in P&C insurance for consumers, is the
fund's second-largest position in the financial sector. Allstate
doesn't necessarily offer extraordinary growth prospects, but
demand for auto and homeowners insurance should continue
independent of macroeconomic developments. Management has worked
hard to reduce its exposure to mortgage-related assets, and the
company appears well-positioned to take market share from
financially strained competitors and mom-and-pop operations.
How do you identify opportunities on the short side?
Identifying profitable short positions doesn't involve looking
for accounting fraud or companies that could go bust; rather, I
look for companies whose share prices are overvalued and likely to
decline. These bets are a way to make money--it's not a judgment on
the underlying company. You don't have to be negative on a company
to profit from a short position.
For example, last year one of the fund's largest short positions
was in ExxonMobile Corp (
XOM
)--a great business with a healthy balance sheet. That being said,
the company wasn't replacing its reserves aggressively, choosing
instead to pull back the throttle on exploration and allocate more
capital toward share buybacks. These investments made me question
why the stock commanded a premium to the energy group and its
subgroup--size and perceived safety only go so far. Although the
price of oil doubled last year, shares of ExxonMobile were down 13
to 14 percent while we were short.
In the financial sector, we're shorting companies whose business
models are under deflationary pressure. Real estate investment
trusts (
REIT
) are a capital structure play with favorable tax advantages. But
real estate prices are flat or declining across various asset
classes, and REITs' debt levels are inherently high. Add occupancy
pressures and falling rents to that equation.
I was short these companies in 2008, and they cracked hard in
the first quarter of 2009. I reloaded in the second half after
harvesting profits. Some of these names have headed higher than I
had anticipated based on perceived strength. Although I applaud
these companies' efforts to issue debt and equity, these moves have
solidified the position of bondholders and diluted future equity
returns. REITs will be under pressure until there's a case for
rising commercial real estate asset prices.
It's almost become cliché, but we're short consumer
discretionary names. Even though the economy is in recovery, higher
levels of unemployment and underemployment don't bode well for
consumer spending. And US households need to allocate more money to
servicing their debts. Income growth has also stagnated. I expect
consumers to focus on needs as opposed to wants. In general, we're
shorting specialty retailers that sell items that Middle America
doesn't need--for example, towels or bedspread covers.