Keith Long and Jeffrey Racenstein are the principals of Otter Creek Partners, a small Palm Beach-based hedge of a rather unusual sort: It actually hedges. And it boasts an entirely respectable portfolio record, even though it has hewed to its discipline ever since its 1991 founding. I dropped in on Keith and Jeff during a recent swing through the partly cloudy Sunshine State, just to see what they’re long and short.
KMW
Keith, you’ve never had much to apologize for to your investors—and you certainly can’t be embarrassed to send out your recent results.
Keith: Actually, it’s been a struggle for the last five or six years. But the change has been amazing. I can remember sitting in my office a year ago and showing our track record—we’ve consistently compounded at 16%-17% a year since 1991—and just getting an unenthusiastic pat on the back. “Oh that’s great.”
But why didn’t you do 90%? Last month?
Exactly. What they really wanted to know was, “What happened? How come you guys kind of lagged?
Jeff: Last year was a disappointment, but not to us—
Keith: Or to the people who invest with us and who understand what we’re trying to do.
Jeff: Especially after our 33% return in 2000!
Keith: We are being a little facetious, but the whole partnership is built around our original objective: to consistently produce absolute “market rate” returns, while taking significantly less than market risk. Consider that I started the partnership back in 1991. I had come out of Wall Street, specifically Morgan Stanley’s fixed-income trading desk, where I accumulated a little wealth. But remember, things looked reasonably dicey in early ’91. So my attitude was, “Well, if I can just compound in the high teens and not lose money, I’ll be very happy.” And a number of people that I had worked with basically had the same attitude. Their personal income streams were highly volatile. They were Wall Street
transactors, traders. They were looking to put money into a low-vol [volatility] vehicle where they could compound at what we defined as “market rates,” or in the high teens at the time. So our goal was to generate market returns with significantly less than market risk, defined as “no rolling 12-month
drawdown.” We did not want to have a year in which we lost money. We stated from the beginning that we were an absolute return business. I have to eat off this—and you can’t eat relative return.
Not even a burger at MickeyD’s. So you set yourself apart from most of the business from the word go.
Keith: Well, what we do goes back to the ’70s and the classic hedge funds set up to run long and short— actually hedged.
You are different.
Part of it stems from my personal background. I mean, I vividly remember the Nifty Fifty days and ’73-’74. I started in the business in November of ’72, started reading about all of the hot portfolio managers of the day. Then just as I really got involved, I remember going through two years in which everything we did was wrong. We lost money on every transaction we made. I remember thinking at the time, “Boy, wouldn’t it be great to be able to short? Be long
and short? So if the market went down, we’d make money on the short side.” The classic hedge fund format. So that’s really what we were trying to do when we set this thing up. And as we went through the ’90s, we were pretty consistent. Jeff got involved two years ago, in January ’98. We define our playing field as “U.S. equities.”
Jeff: We work as a team pretty much. I came on here from a small research firm that does both longs and shorts. We thought there would be a good fit between what Keith was doing and what I was doing. So I rode some of those technology horses in 1999. Since then, my style has gravitated a little more towards Keith’s, but I’d say over the last six months, we’ve become more opportunistic. We’ve traded a little more. Taken advantage of the opportunities. We’ve hit on some great shorts.
Keith: We just got back from a tech conference, though, where we felt more like kids in a candy store on the long side.
Jeff: We’re able to buy some of the companies now that we only looked at before. Now they are trading at just slight premiums to cash, or we can buy profitable companies trading at 12-14 times. You can buy something like that and feel there’s something
there. You’re not just buying a concept, like at this time last year, with a billion-dollar valuation.
Keith: At literally the same conference, last Spring, I remember looking at these companies and saying, “Boy, I’d like to own these. These are good companies.” But at the same time, looking at the prices. “God, I can’t do that. I can’t pay up.” But all of a sudden, we’re seeing some very attractive smaller caps—and our longs tend to be smaller caps—tech-related companies that were trading at extremely high prices a year ago, at very reasonable prices. One of the areas we’ve focused on is flat screen technology.
I don’t see any in your office.
Jeff: We don’t have one!
Keith: We can’t afford one yet. But I actually just bought my first, a small flat screen for my house.
Jeff: Gave himself a treat.
Keith: It’s phenomenal. I love it. One of the companies that I’m really attracted to Photon Dynamics
(PHTN). I first saw the company last May. The stock was at 65 on its way down to 16 and a fraction from 95. But we got ourselves in around the low last week. The numbers are there. I like the concept. The problem last year was price, not just the stock’s but the displays’. People are working madly to get the retail price of these things down and as the price comes down...If you can get the price of a flat screen down to within a multiple of say two or three times the price of a CRT, then cathode ray tubes are gone. They’re history.
Jeff: Plus, Photon also makes testing equipment for the flat panels. It’s almost like an Applied Materials for the flat panels. They also have a chip packaging business. The earnings—
Keith: are rolling along.
Jeff: The stock got hit lately because Merrill Lynch downgraded it on the basis of some talk about weaker orders. But they did a secondary a few months back at 45.
Keith: There’s a whole bunch of little tech companies out there that did secondaries last Spring at significantly higher prices. Put a bunch of cash on the balance sheet. Photon’s balance sheet is pristine. There’s a ton of cash. It’s generating cash, and it’s right in the technology we want to be in. And all of a sudden I can buy this thing in the low 20s.
At 20-25 times. Now, the stock could go to $10 in a flash. So you’ve got to position yourself where, if it does go to 10, you can buy more.
Another lesson of the ’70s? When the good stocks didn’t just fall to reasonable valuations, but to levels where they were ridiculously cheap. And totally unwanted?
Keith: At the bottom in ’74, every stock sold between $3 and $5.
Jeff: Is that right? I wasn’t around then.
And every other story across the Dow Jones wire was about a bankruptcy or a force
majeur.
Keith: Right. Like I said, this stock traded at 16 a week ago. It traded at 23 today and who knows, it could trade at 10 next week. We do trade around these things. We have an attitude. We want to be long it, but if it runs up, there will be others, cheaper—
Jeff: We’ll sell it. We’d have no problem selling most of it, maintaining only a small core position. In this environment, you’re almost forced to do that, given what we’re trying to do. When individual stocks move 20% in a day, that gives you opportunities to both buy and sell. Listen, in perfect world, we’d build our portfolio and just let it grind out at 15%-20% a year. But this market isn’t working that way.
Isn’t liquidity in those kinds of names a mirage?
Keith: That’s all part and parcel of this environment. But it also creates opportunity for investors like us. We’re a reasonably small hedge fund at $60 million. We’re onshore and offshore, and it looks like we’ll be at $100 million shortly. But I look at what we do, to a certain extent, as providing liquidity. I mean, we will provide liquidity down 30% in a stock. I’ll stand there and buy it down and I’ll also provide liquidity up 30-40%.
And you feel you’re being generous in doing so!
We are performing a valuable function. There are no more market makers.
Except Weeden, of course.
This is not original. If you look at some of the more successful equity hedge funds, that’s exactly what they are doing. Look at Jeff
Vinik. I mean, he’s folded up his shop. I’m not privy to what his activities have been over the last three or four years. But I’m convinced that he stood there and provided liquidity with an attitude in certain securities, both ways. When you get this unbelievable volatility, that can be very lucrative
Jeff: We want to know our stories and we want to know where we’re comfortable. That’s how we’ve been successful. By saying, “Look at this name. It’s down from where we wanted to buy it only two weeks ago or a month ago. So that makes it easy to get involved. Because we know the stories. So we just try to follow as many names as possible. The portfolio runs the gamut. We’re in all industries, all sectors. Opportunistically.
Sounds like a lot of work.
Hey, that’s how we make money.
Keith: It’s a high intensity business. The analogy I make is to compare what’s going on in U.S. equities, specifically NASDAQ, right now to the fixed-income capital markets of the early/mid-’80s. I look at these screens all day and it feels to me like I’m looking at bond screens, circa 1984-1985. I mean, all the risk capital in the world is funneled into this market right now, while 15 years ago all the risk capital in the world was funneled into trading fixed-income securities. Back then, I was a bond trader, and a random opening move in the 30-year Treasury was a point, while 2-point moves were the norm. There was a tremendous amount of noise, a tremendous amount of activity. But the securities tended to revert to the mean to a certain extent around a tremendous amount of volatility. Now, with all the risk capital in the world funneled into over-the-counter stocks, it feels the same. The price action and the way things move.
Interesting. And in neither market is the market-making function centralized.
Right. Back in the ’80s, you had a tremendous ramp-up of the participation of institutions in the Treasury market. You had 20-odd primary dealers, of which really only 5 were true market makers. So the 5 primary dealers that were true market makers really were somewhat overwhelmed by the massive influx of new market participants.
And hot money.
Retirement funds coming in and moving $300-$400-$500 million of long bonds around at a clip. It was very similar. You know, everybody complains about the volatility at times. But the bottom line is that it doesn’t get any better in terms of the environment for what we’re doing. It’s reflected in our performance. The volatility that we had last year and the shift from a momentum-driven market to a ranging market with a lot of volatility is ideal for a classic long/short strategy. We’re the antithesis of momentum investors. We’re essentially trying to buy low, sell high—and to short, higher. In this kind of environment, it works.
But you had to catch that shift. When momentum held sway, no amount of trying to buy low and sell high was going to generate much performance. Especially of the relative variety.
Our track record reflects that. The one blemish on our record is that we flat-lined ’97. Essentially, our shorts went up more than our longs. Funny how that works. You know, in ’96, you could still short junk and make money. So I shorted and made money on things like Presstek and Diana, and so forth.
Sterling stocks.
Well, they’d ramp. They’d spike. You could short them and they’d come back. But towards the end of ’96 and into ’97, the dynamics changed. I could feel it every morning as I came in and turned on my machines. You just felt 10,000 new market participants joining you in the fray every morning.
Jeff: I don’t think there are as many coming in today.
Keith: Well, no. Things have changed again. But as those new participants came in, they tended to be very short-term oriented and very momentum-driven. That really is not good for a classic long/short style. So there’s no question, all of a sudden shorting junk at high prices didn’t work. What saved us was that I figured that out towards the end of ’97 (after not making any money when everybody else was making a ton of money). But essentially because we still wanted to keep the hedges, we shifted probably 90% of our short positions into put options in late ’97 and early ’98, strictly for risk control.
Shorts who didn’t do things like that went out of business.
Right. That basically saved our bacon. Then a few well-selected shorts—puts, really—as we moved into ’98 helped, too. Even with the market rolling along, we caught the meltdowns in a few roll-up, financial engineering disasters that had been hot. We’re always looking. Jeff’s background includes a stint at Price Waterhouse as a CPA. I’m accounting-sensitive. So we caught
Accustaff, which was a roll-up temporary help story; bogus accounting, and made good money. Then in early/mid-’99 we were making money in our longs, but we were leaking premium—until we caught the e-Toys situation. Jeff came up with that one in late ’99.
Jeff: My buddy worked in the toy business. You try to pick the minds of people who are in the same business themselves. He just told me there was really not much there at all. Some warehouses with toys in them. They had negative gross margins.But at the peak, they had about a $10 billion valuation. The stock got to over 100. You had to go back and scratch your head and ask why. So we had a good-sized short position in that one.
Keith: Obviously, there were a ton of dot.coms floating around at that point—
Jeff: You could have picked any of them.
Keith: We could have. But there was a catalyst in eToys. In October, 1999, it the end of the year was fast approaching and
eToys’ revenue run rate was about $1 million or $1.25 million a day. They were looking for a $100 million top line in the fourth quarter. But you knew that come Dec. 22, switch out the lights. The run rate was going to plunge to $100,000, or maybe to just $50 grand or $20 grand a day. So we got short. And it worked.
LONG
And how.
In my opinion, during the last year, the average person invested in the stock market just didn’t think twice about it, when it started to come down. No one really felt that this market
could come down. People were such believers. That’s why you hear of people who lost so much money, because they never sold. They didn’t hedge themselves. They kept buying into “Technology is the way.” But that was too easy.
Buying the dips, you mean.
Jeff: They never stopped. But now everyone’s learned.
Keith: There was one event in late February, which we caught, that I’d say was the equivalent of the UAL breakup circa ’89: the Micro Strategy blow-up. That said (to people who were paying attention) some very interesting things about liquidity in the market. It was clearly a wake-up call and almost coincided to the day with the top in the
Nasdaq.
Since then, a lot of the risk capital that you had seen pouring into the Naz has been vaporized.
And there’s no question now, in the hedge fund business, that long/short, low exposure managers are the prime choices
du jour.
The few of you left who actually hedge.
Exactly. The guys who were putting up 90% returns, they couldn’t have been hedged. They couldn’t have been short. There’s no way they would have done those numbers. So there’s literally a bit of a shortage of capacity for what we do. The funds of funds have been coming around, looking for classic long/short, low drawdown programs and we’re clearly getting more money coming in. The only problem is putting it to work, because you don’t want to damage your performance record. So we’re trying to do it in a measured fashion.
A nice problem to have.
Jeff: So now we have a lot of cash. We don’t want to make a lot of mistakes. We’re taking our time in picking up stocks. And shorting them.
What sorts of stocks?
Keith: It’s interesting. Our short exposure has shifted in the last 3-6 months. We are no longer heavily short in high-tech, high-volatility names. We may have a few, but for the most part our shorts now are in some of the “safe havens” that have been ramped in the last few months. Essentially what’s driving it is that the “cash is trash” rule is
still in effect in most mutual funds. It’s just ridiculous as far as I’m concerned. We clearly are not in the “cash is trash” camp. We will carry a
ton of cash if we feel that is appropriate. The concept that we have to put all our money to work in stocks is just bogus.
What? Haven’t consultants warned you that it’s a terrible drag on your performance? And told you that you’re not doing what your clients pay you to do?
I’ve seen all the mutual fund ads. “Your funds will not be held back by our cash. We do not carry cash. We will not. We promise you.”
No one, evidently, has ever stopped to consider what that could mean if the herd ever starts to redeem
en masse. Payment in kind, anyone?
Well, 80-90% of market participants have never been in that sort of environment. But what the funds’ abhorance of cash means is that when they liquidate positions, they have do something with the money. So they look around for “safe havens” and all tend to pile into the same ones, ramping them to ridiculous prices.
Such as?
One of my shorts is Walgreen Co. (WAG). It reported somewhat disappointing December numbers. Same-store sales up 9%, lower holiday merchandise sales, but pharmacy sales were up, and total sales increased 12.3%. The thing is, front-end sales were down 1.9%. The front end is where they make all their money. That is where the margins are, not in prescription sales. These are not the sort of numbers that justify a 50 P/E. I’m not saying it’s a horrible company. It’s very well-run. But there’s every possibility of a Home Depot-type decline, as the market reaches saturation.
It’s hard to get too excited about any retailing business in a
disinflationary/recessionary environment.
Another of our large, meaningful shorts is Northern Trust (NTRS), which also just reported. Again, it’s a bit of a valuation story. But our basic reason is that the largest part of its revenue base is trust fees, fee-related income. And in the fiscal third quarter that they just reported, these revenues were down, sequentially, for the first time in this cycle. Notice, this revenue tracks very much with the stock market. Essentially, Northern Trust is a good bank. They’ve compounded net income in the high teens for the last 5 years. But when your revenues are tied to equity valuations and equity activity, it doesn’t require a unique business model to generate reasonably attractive returns.
Nor is it an especially difficult analytical insight, although it’s uncommon these days, to realize that those returns
might be cyclical.
Jeff: Let’s talk about Northern Trust’s valuation in relation to somewhat similar bank. Wilmington Trust
(WL), I was looking at today. It trades at half of Northern Trust’s valuation, literally. At about 2-3 times book vs. 6 times for Northern; At 13 times earnings, while the other trades at 35-40 times. We don’t own Wilmington, but the comparison is startling.
Isn’t Wilmington a lot smaller?
Jeff: It is smaller; and it’s only moving into the trust business. It’s not quite there. But the valuation disparity is enormous.
Keith: What I don’t understand is, how the analysts—the Wall Street Guidance Community—cannot notice the flat-lining and actual decline in Northern Trust’s fee-based revenue. I guess, if you project that the market’s going to ramp right back up, you can project that the trust fees will start to accelerate again. But the bottom line is that they also have a $16-$17 billion loan portfolio that I’d guess is reasonably heavily oriented towards high net worth real estate loans. I know they make jumbo mortgage loans. That’s their clientele. So there’s some risk in the loan portfolio. The bank is not a bad bank, but their performance in the context of the environment that they’ve been in has been just okay, and I think the environment is changing. I cannot believe that the valuation of the stock is where it is.
Jeff: The stock is down, from 85—
Keith: to 70. And bottom line EPS is 54 cents. So it is trading around 35 times. You know, it’s just that Northern Trust isn’t the sort of stock I’d want to be long in the environment we envision, which is not a disaster this year, but highly volatile. We might end this year essentially in the same place we started it—even though the market may trade up and down 40% from that starting point.
Jeff: Does that mean we make no money, or does that mean we make a lot? What I know is that it means we can’t just sit here and pray that we’re in the right places.
Keith: It’ll depend on how we do as stock pickers.
So pick another long or short.
The other bank stock that we have focused on from the short side—even though we’ve strictly used puts with this one, because it’s a smaller cap, is Southwest Bancorp of Texas
(SWBT). This is a new momentum bank stock. A small-cap Houston bank. Probably $1.2 billion. This is a bank that trades at tech-like multiples.
Jeff: We started following it at 28. It last traded around 45.
What’s the growth story?
Jeff: I don’t quite get it. They have grown the earnings, but it trades at a monster multiple of book and a monster multiple of earnings.
Keith: I’ve heard people talk about Houston, energy loans. But the bottom line is energy loans are about 10% of the loan portfolio. The quarterly run rate of net interest income is respectable, but average. Return on assets, at 1.3% is okay. They’ve got a reasonable capitalization. Not bad. Return on equity has been good, 18%-19%, but it has a large construction and development loan exposure. And it trades around 45 off of a tangible book of $8. That’s more than 6 times tangible book. Besides, in addition to the possibility of asset quality problems, there’s a fellow on the board, Michael Willis, who was involved in the founding of
Corestaff, which was a temp roll-up firm, and who has demonstrated an uncanny knack for using an H. Wayne
Huizenga-like ability to sell at the proper time. If you look at insider sales in
SWBT—
SHORT
He’s been bailing?
Keith: It’s shocking. This company’s list of recent insider sales goes on for pages. You’ve got to be careful, but a big chunk of them were sold buy Willis. You never know about insider sales. They aren’t necessarily bad, but as far as I’m concerned, they’re never a good sign, either.
They are always suggestive.
Keith: Yes. Especially when you see insiders lining up to check out, like you’ve got here. I’ve served on boards. I’ve seen people. If the stock is truly undervalued, insiders don’t sell.
Let’s talk about something you’re long.
Keith: Photon Dynamics is one we’ve mentioned already—and a similar company we like is Applied Films Corp.
(AFCO) which makes the actual equipment that makes the glass for flat panel displays and also makes the thin coated glass.
Didn’t Applied Films recently run into trouble with a financing?
Jeff: Yes, they screwed up in a recent deal. They just bought another company, trying to really expand into all the markets for coated glass. But some financing fell through at the last minute, so they used up their cash, then had to sell a $10 million convertible preferred. They’re a little company. There are something like 8 million shares outstanding after the convert, and the stock is trading at 13-14. A small cap.
Keith: The revenue run rate is something over $100 million, around there.
Jeff: But this should earn something like $1.25 in this June year, and some of the numbers I’ve seen are in excess of $2 for next fiscal year. So this stock is trading at what, 7 times forward numbers. And this is going to be a really big market. They have come out and preannounced a fourth quarter that’s a little weak, but their base business is doing about $10 million a quarter and this new business is doing in excess of that. Next quarter they’re supposed to do around $36 million in revenues. So we’re talking about one times sales. It’s just that because of the acquisition financing, instead of carrying like $52 million in cash on the balance sheet, now they’re going to have about $10 million in debt. But they’ve doubled the size of their business.
Keith: In a very interesting market. I heard the CEO of Photon Dynamics, Vincent
Sollitto, say at a recent conference that “If you were to convert every CRT, every cathode ray tube screen in the State of California to a flat screen, you could shut down two electrical generating plants.”
They’re that much more efficient?
They use a third of the electricity, I think. It’s a fascinating quote. As people become more aware of the amount of energy that’s consumed by these cathode ray tubes, and the potential energy savings, you begin to justify paying up for a flat screen.
First you have to get people past the notion that everything that comes through a computer screen is free, including the energy to run it.
Oh absolutely. But that idea is going to be driven home, with the situation in California. I wonder, basically, how many screens have been added in California over the last decade, and how much incremental power they consume. It’s got to be a tremendous amount. Yet they haven’t added any generating capacity in the state over that time. That’s the problem.
So much for the “new economy.” What else has caught your eye?
Jeff: We like the EDA space (electronic design automation), though don’t always want to pay up for companies like
Synopsys, Cadence Design or Mentor Graphics. But there’s a smaller, niche player in that area, Innoveda Inc.
(INOV), a very tiny cap. A roughly $60 million revenue company. But they’ve got a $1 in book value. Their growth is starting to kick in again after a product transition that took 6-9 months. The management team seems like they know what they’re doing. And the stock is trading under $4. It was actually a $2 stock when we first heard about it. But they are profitable. They’re supposed to earn in excess of 30 cents this year. So it’s trading at around 10 times earnings and revenues are growing. This is a way to be in this EDA space, which really can make semiconductor companies more efficient in coming up with new chip designs, with a name that no one else really knows about. A bombed out stock that can compete with Synopsys and Cadence in their space. There are risks, of course, but the stock trades okay. It could easily be a $5-$6 stock, in my view.
There’s another small company we like, too, a stock that’s been all over the place.
MetaSolv. The symbol is MSLV. They make OSS software, which stands for operational system support. It is basically the software that big telecommunications companies (the
RBOCs, the CLECs) are using to manage and integrate their systems like payroll and billing into their networks. Basically it allows them to automate and run their businesses. It’s a necessity type product. And it’s not a low-end purchase. The software can range from $225,000 to $1.5 million. But this is a very illiquid stock. Within the last few weeks, the stock traded as low as 7. They’ve got $4.50 share in cash. And we were owners then. But it has run back up to over 20. We’ve poured through the numbers. They generated $4 million in operating cash in the last quarter.
Keith: It has a pristine balance sheet.
Jeff: A good management team. They’re out of Texas, not Silicon Valley. Very
unpromotional.
Do they collect real cash for their software?
Jeff: Yes. Real money. This is, I think, a prime takeover candidate. If you put it up against Micromuse (MUSE), which basically makes a product called “Net Cool,” a performance measurement software program that the telcos also use, and compare their
valuations—Micromuse has several billion dollars in market cap and MetaSolv has a market cap of around $500 million. It’s in basically the same space. When the Nasdaq was flying, Micromuse got up to about a $6 billion cap, while
Metasolv, at its peak, was maybe $1 billion. Just an idea. From a financial perspective the companies are quite comparable. I could actually see a takeover of MetaSolv by
Micromuse; it could work well.
Let’s move on—
Keith: We’ve been involved in natural gas on the long side for the last year and a half, which has helped us, obviously. We’ve used a bit of a barbell approach, in terms of owning a very small cap company, Petrocorp
(PEX), which is Amex-listed.
An endangered species.
But an interesting story. A very small exploration and production company, which has languished. It was an energy partnership in the ’80s, set up by USF&G, the insurance company. It went through the various transformations. Came public in the early ’90s and still languished. There are just shy of 9 million shares outstanding, which were trading at $4-$5 a share back a year and a half or so ago. The thing that caught my eye was that about three years ago a fellow out in Tulsa, George Kaiser, who is a private E&P guy—Kaiser-Francis Oil Co.—
A name to be reckoned with—
A great value guy. Creates value. Kaiser acquired 49% of the outstanding shares of
Petrocorp. He paid $7-$8 a share, probably circa ’96. He didn’t make any money. Essentially what’s happened is that Kaiser-Francis has taken over the management of
Petrocorp. They’ve basically jettisoned all the overhead. They’re running PEX
pari passu with the private E&P activities of Kaiser-Francis. I’ve been out there. I’ve gotten to know Gary Christopher, the CEO. Also the CFO. They are absolutely top-quality finders of natural gas. I mean, what we’re looking for is somebody who can create value through the drill bit; find the stuff. Still, it’s tough to buy a
Petrocorp, it’s such a small cap. But they’re really sensitive. They’d like to create a little more shareholder friendly environment, create a little more liquidity. So they announced the acquisition of another Houston-based micro E&P operation, Southern Minerals
(SMOP). The timing was interesting: the Friday before Christmas at like 4:00 in the afternoon, when nobody was around. Why? Because they didn’t want anyone else coming in and bidding against them. This deal basically doubles PEX’s gas reserves. He’s buying gas in the ground at a little over $1 an
mcf. Good reserves. It’s contiguous to their Canadian reserves. Adjusted cash flow should be a little over $3 a share, so it’s trading at a little over 3 times cash flow at 10. But a cheap way in is through
SMOP. The deal is at $4.71 a share, split roughly 50-50 between stock and cash. You can buy SMOP right now at $4.17 or so. I’m sure the deal closes. It’s friendly-friendly. After the deal closes, you’ll have almost 13 million shares of PEX outstanding, at 10, or a $130 million market cap.
And Kaiser will still own how much?
Kaiser’s stake will be down to around 35%. You’ve still got to want to invest alongside George Kaiser. And I want to. Given his track record, I can’t think of a better way to participate in natural gas.
What’s the other end of your barbell?
Burlington Resources (BR), just because of its great reserves—
And despite its management?
You got it. They’ve managed to snatch defeat from the jaws of victory repeatedly. But the reserves
are there and I don’t think the market reflects the value of those reserves. I believe gas at $4 or $5 is here to stay. (You know, it trades in the spot market at $8-$9, but that’s not sustainable.) Still, the current price of the stock, at 44-45, does not in any way reflect the value of Burlington’s reserves if gas is going to stay at $4-$5. Maybe they will get their act together, but it’s an asset play. I mean, Burlington traded in the low 50s 8 years ago as a natural gas play. But $4-$5 does not in any way reflect the value of its reserves.
Assuming they don’t hedge away their profits forever.
Sell low, buy high! But hopefully the hedges run off. Then I suspect we’ll see some of these independent electricity generators acquiring natural gas reserves. Sooner or later, they are going to realize that they’re paying $5 in the marketplace for stuff they could buy in the ground at $2 and lift for another $1, so that would work. And I just look for good E&Ps in natural gas.
Keith, your portfolio seems weighted towards small caps—
We’re all over the map. Clearly, on the long side there’s a small-cap bias. That’s where we can find inefficiencies and mispricings. We’ll carry maybe 100 positions, but only 15-20 drive the performance. We are not clean freaks. When we liquidate a position, we often keep a few shares because that focuses you on the company. If nothing else, in the morning, when I look at the daily sheet, I’m looking at a lot of names and I see price changes, press releases, SEC filings. I’ve made a lot of money over the years just by virtue of seeing some small piece of information cross my desk on a security in which I held a meaningless position. It was a catalyst. And I already had the necessary base of knowledge. Didn’t have to climb the learning curve. Shorts are a little different. Shorting small caps is dangerous to your health.
Not to mention wealth.
Exactly. So a Southwest Bancorp of Texas is at the lower end of what we’ll do. I mean, its market cap is around $1.2 billion, and total assets of the bank are $3.2 billion. That’s a huge valuation for a banking business. I don’t get it, except that it’s a darling of some institutional investors.
Are you still opting for puts mostly, on the short side of your portfolio?
We have shifted most hedges back to outright shorts, as the types of stocks we’re shorting have changed. You can short a Walgreen or a Northern Trust and not worry about walking in the next day and seeing it double in your face. But we still use puts fairly heavily. We’ve been a beneficiary of the ramp-up in volatility. And our move to puts was for risk control. Now, it feels to me like you can tippy-toe back in the water on the short side. The dynamics are not what they were a year ago. I don’t think the market’s going to take off on a ramp.
A lot of folks are still wishin’ and hopin’
A lot of people own a lot of underwater stock. To digress a bit, my own non-official estimate is that somewhere between $500 billion and a trillion dollars worth of middle America’s savings was transferred into investments which have gone up in smoke over the last 2-3 years.
Perhaps more. Nasdaq alone lost $3 trillion of market cap.
Well, that’s everyone and I was focusing on middle America. All the mutual funds basically flat-lined at $7 trillion and you had $350 billion come in, so mutual funds alone lost $350 billion last year. Then there were all the IPOs and secondaries, the losses in individuals’ portfolios. Yet, I sit here and I watch Wall Street’s favorite economist, Larry Kudlow, on CNBC as he grovels and begs for free money, and condemns the Fed—and anybody else that doesn’t agree with his viewpoint that interest rates should be zero.
The Japanese Central Bank tried that. It didn’t work.
I think that is what is going to happen here essentially. We’re right now in a pushing on a string sort of situation. But Wall Street’s mentality was summed up a week or two ago by one of the Kudlow lookalikes on TV who said, “If you don’t agree with free money, you should be the first one in the unemployment line.” My contention is that the individuals who underwrote a lot of the securities Wall Street sold in 1999 and 2000 are the ones who should be first in line. I mean, Bear, Stearns did a couple of deals for a little stock I was short a year ago, Interworld (INTW). An IPO and a secondary. I would imagine that they offloaded somewhere around $300-$500 million worth of securities between those deals. The stock traded at 75 a year ago. I have on my desk a Bear, Stearns “strong buy” research report with a target price of 120. The stock trades at 75 cents as we speak. My contention is the people who orchestrated that transfer of wealth should be at the front of the unemployment line. Look, all Wall Street economists want easy money. Easy money brings back the IPO market. So they can transfer massively more amounts of money out of savings and into their favorite investments—and take a 7% cut on the transfer.
Your problem is you just don’t understand the real role of the Fed—keeping the Street’s money machine well-oiled.
Not to mention supporting real estate values in places like Greenwich, the Hamptons and Silicon Valley. From my perspective, which encompasses 25-30 years in the business, we have a very long way to go before we flush out the excesses of the past 3-5 years. But at the same time, this ripping volatility in the markets is creating attractive valuations for certain companies. So it’s a great time to be a true long/short hedge fund. We are in a market where if you do your homework, you get rewarded both ways. And that’s good.
For you, anyway. Thanks, Keith—Jeff, too. |
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