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   Interview

    Guest Interview:

   Monetary Mgt. Corporation

    One Embarcadero Center Ste 4100
    San Francisco,CA 94111

    Telephone: (415) 981-9212
    Fax: 415-981-9211
    E-mail: stevenson@mmcsfo.com

 

    Interview Quarter: 3Q1995

 Stevenson Browne

 President

 

Q: Stevenson, how would you describe your method of managing money?

A: I would describe my method of managing money as "market neutral". This term applies to techniques that seek to reduce or eliminate the effects of unfavorable market fluctuations on the value of a portfolio. We achieve this objective by maintaining equal amounts of long and short positions in a portfolio. The net result is that the profits are equal to the amount that the long positions outperform the short positions-about 30% per year on average, with surprising consistency.

Q: Could you please tell us what some of the benefits are of hedging the market?

A: The benefits of the market neutral approach are both the reduction or elimination of loss during periods of market decline and also the reduction of risk associated with fluctuation in market value. The more that the value of an investment fluctuates on a monthly or quarterly basis, the higher the degree of risk is indicated. Our portfolio shows about the same amount of risk as the overall market on this basis.

Q: Does this technique work if you were to only buy stock but not hedge the market?

A: One could achieve highly satisfactory results during bull markets merely by buying the stocks recommended by my program, which have outperformed the averages by 20-30% per annum. However, this strategy would be subject to substantial losses during bear markets when security prices sometimes decline by as much as 50%. No investor individual or institutional should be unhedged in the market unless he is able to sustain a loss of this extent. Therefore, hedging by the addition of short positions to our portfolio, which requires no additional capital, con reduce the maximum loss to 10% or so. Since reduction of risk is a significant factor in portfolio evaluation, we prefer to be fully hedged at all times.

Q: If this is the case, could you be more specific about what makes a stock outperform the averages?

A: There are two main reasons that stocks outperform the market: Significant improvements in earnings, and takeover targets-the latter being highly difficult to predict without engaging in some highly questionable practices. A dramatic increase in earnings is the most likely factor to cause an increase in the price of a stock. My formula is designed to identify the 5% of stocks in the universe most likely to out perform the market, the "universe" being 3000 or so most actively traded stocks. Most of the stocks we buy fall into two main categories: growth stocks and turnaround situations. A growth stock with accelerating earnings is likely to enjoy a multiplier effect of higher price earnings ratio time higher earnings, which can produce an impressive gain in price. One the other and, a turnaround situation can also produce substantial profits since stocks of companies operating at a lost or in poor financial condition may be substantially under-priced until internal conditions such as management changes or external conditions such as changes in prices of supplies or product, return the firm to profitability. We have also noticed that cyclical issues tend to outperform the market while earnings are rising faster than average. Curiously, secondary issues often make better trading vehicles than the larger high grade stocks due to their higher degree of leverage. Thus, as long as there are fundamental security analysts among both individual and institutional investors, stocks with rising earnings will tend to increase in price as earning expectations are raised.

Q: Conversely, what are the characteristics of a stock that underperforms a market?

A: Stocks that under perform the market are usually the victims of deteriorating finances as indicated by increasingly dismal earning reports. As the financial condition of a company weakens, its stock price will tend to decline and in extreme cases, many lose its value altogether. How important are the earnings fundamentals of the issues you are buying and selling? The earnings fundamentals are the single most important factor in determining the relative price action of a stock. Over time the price of every stock tends to gravitate toward its ideal valuation-the earnings per share multiplied by an appropriate price earnings ratio. Although we cannot predict the random factors that also influence stock prices, such as merger activity, investment fads and fashions that temporarily distort valuations, and other unexpected business developments, we shall continue to rely on the underlying earnings fundamentals as the predominant influence on stock prices.

Q: Where do you get your research?

A: Research is derived only from company news releases to news services such as Dow Jones and Reuters. Rarely are companies contacted directly, although it is sometimes necessary to clarify the effect of extraordinary charges and credits. It seems that some companies are actually trying to conceal the actual amount of their operating earnings by including them with other items of a non-recurring nature.

Q: If your technique is earnings-driven, how is it that you can take advantage of earnings reports before the market has a chance to react?

A: Usually the market does react to earnings report, which does present a problem, as often we are attempting to buy or sell, or sell short at the same time as everyone else on the street. We believe that positive or negative earning reports continue to be reflected in the stocks price performance over a period of time. Also, there seems to be a tendency for good earnings reports to be followed by subsequently better reports, and similarly with bad reports. If believers in the random walk theory were correct, it would then be impossible for us to make any money in the market.

Q: What is the relationship between market swings either up or down and your historical returns?

A: It seems that we have historically done the best during periods of slowly rising stock prices. The worst periods have been the first week or two weeks when a bull market has corrected, as those issues showing the largest gains are usually the first to be sold. However, we have usually made money during both up and down markets and avoided significant loses during periods of our worst performance.

Q: Why is it that your holding period is only 3-6 months?

A: Our holding period is generally only 3-6 months because the market usually recognizes a change in earnings power within this time period. Only when a dramatic earnings increase or decrease occurs over an extended period of time do we hold an issue longer, although sometimes with impressive results. Our average profit in a stock may be only 5-10%, but some long held issues have shown returns of 300, 400 or 500%! On the short side, some companies with steadily deteriorating earnings eventually declare bankruptcy, which is a bright spot in our day.

Q: What do you do to minimize risk?

A: Two main factors which minimize risk are the maintenance of equal amounts of long and short positions and the representation of a large number of issues in our portfolio. The significance of short positions has been explained previously. It reduces loses during periods of market declines. A large number of issues minimize loss in the case that any single stock or a group of stocks shows an unfavorable return. At any time our total portfolios exhibit more than 100 issues on both the long and the short side. Portfolio analysts measure risk by standard deviation this is the average amount that the value of the portfolio tends to fluctuate over any given period of time. It is important to note that the level of risk is not determined by the rate of return. An investment returning 30% per annum could have a lower degree of risk than another investment returning 10%. Another factor in risk evaluation is the maximum potential for loss. Although the stock market as a whole has shown declines as much as 50-90% during bear markets, our overall portfolios have never declined more than 10% in value.

Q: Do you ever concentrate your position in just a few industries?

A: Although we do not concentrate unduly in any single industry or industry group, certain industries may be represented heavily in the long or short side due to secular charges in the economy. Therefore, we are above average risk as far as balance by industry groups is concerned and an unexpected change in fundamentals can have an negative impact on damaging total returns. However, we have found the long term profit potential greater in spite of the possible draw backs of this strategy.

Q: How many positions do you normally hold in an average account?

A: Although our total holdings in all portfolios generally exceed 100 long and 100 short positions, individual accounts may exhibit a considerably smaller number of issues and a greater degree of variation in return from the average of all portfolios.

Q: Where did you first discover that you had an approach that might beat the averages?

A: In 1975, I studied the best market performers of previous years and found two major factors in their performance-takeovers and substantial increases in earnings. Eliminating takeovers as a predictable factor, I developed a formula with earnings as its main component and began keeping track of stocks that fit the ideal "buy". After 30 days these issues had outperformed the market overages by 3% - not conclusive at that point - but the ideal portfolio kept out performing the market at the rate of 30% per annum - a significant amount.

Q: How did the idea of hedging occur to you?

A: It was not long after I began keeping tabs on the performance of the long positions that it became apparent that the performance was not profitable during periods of market decline, and that on a short term basis their performance was sometimes worse than the market averages. Thus the addition of short positions happened to be the only solution to maintain consistent profitability during all kinds of market environments. The best allocation appeared to be the holding of equal amounts of long and short positions at all times, without trying to predict future market fluctuations. The creation of a formula to indicate the best short sale candidates was a little more difficult than the formula to select long positions, but in most respects it was a mirror image.

Q: How long have you been using this approach and how come you don't manage more money after this time?

A: I have been testing the theoretical returns from the program since 1976. the theoretical results are as follows: Actual accounts have been managed since the beginning of 1989. However, the returns of actual investments have been somewhat less than theoretical due to the cost of commissions and the inability to buy or sell at the last traded price. Some stocks are unable to be borrowed for purposes of selling short and others are forced to be bought in if they can no longer be borrowed. By comparative standards we have a small number of clients and a small amount of money under management. However, we have been growing at over 50% per annum and I have been very comfortable with the rate of growth and the ability to maintain superior results. Until 1993 I worked exclusively with one firm, so I did not begin adding to the client base until after that time.

Q: Do all your accounts hold the same positions and if not, why not?

A: There are actually no two accounts which hold the same positions, and no single account holds all the positions recommended. Stocks are purchased for each new account as recommended, so two accounts opened at different times would have entirely different portfolios. Due to commission costs it would not be practical to buy a small enough amount of each stock to represent all or even a majority of stock selections in a single portfolio. Isn't your heavy turnover detrimental to your return because of high commissions costs? Even with discount brokerage services commissions can run as high as 5-6% per annum. However, in some cases we have been able to negotiate wrap fees which allow unlimited trading for significantly lower commission rates. Thus, the effect of commission expenses is not as detrimental as it could be.

Q: How do you keep track of so many positions and their high turnover?

A: It is a full time job following over 3000 stocks and keeping track of the positions in a growing number of accounts. Therefore, it is probably a good idea to keep assets under management increasing at a moderate rate, not too fast so as to avoid a back office backlog. So far we have been highly successful in managing the number of positions and the high trading volume.

Q: Do you think your performance will suffer if you grow significantly in size?

A: We are already find a few stocks which have thin enough floats that we are limited in the amount that we can buy. However, that is a relatively small number and I believe that we can manage a significantly larger amount of assets without running into liquidity problems or any other factors that would curtail our performance.

Q: What kind of fee structure do you usually charge in your accounts?

A: We usually charge a management fee of 20% of the profit that we generate. Although it must be stated that similar services are available elsewhere at a lower price, we do not believe that similar services exist that produce as consistently profitable returns, and consider our management fee justified by the results that we achieve. We have found that most clients actually prefer a fee structure that rewards the manager for performance as opposed to a flat fee regardless of profits or satisfactory returns.

Q: Why haven't other managers used your approach?

A: Actually, other mangers do use our approach. Usually for the management of hedge funds or market neutral funds. Also the employment of short selling techniques has a reputation of being high risk, although in actuality it reduces the overall risk of a portfolio. Nevertheless, the charters of many mutual funds prohibit short selling and we suspect that many managers avoid the practice after experiencing losses.

Q: Do you think there is danger in using a strategy of shorting stocks when there is no limit to the upside loss?

A: The risk of loss shorting an individual stock is theoretically infinite, although so far no stock has gone to infinity. We temper this risk by representing a large number of issues in our portfolios so that the risk of extraordinary loss is substantially reduced. Our biggest losses on the short side have been the result of mergers which are announced without warning and allow no opportunity to cover a position, usually at a substantial loss.

Q: Is your technique appropriate for retirement accounts?

A: Yes, as long as the client is comfortable with the degree of risk represented by the holding of an average portfolio of stocks, we feel that we can achieve consistency better than average returns regardless of the type of market environment. During the last 5 or 6 years, steadily rising stock prices have helped to boost the returns of most management firms and many of them have produced impressive results. However, in order to evaluate them fairly, it is necessary to compare their performance relative to the market on a risk adjusted basis. In all modesty, we stand up quite well when these measures of comparison are applied. We would therefore conclude that our technique is quite appropriate for retirement accounts as well as a variety of other types of individual and institutional accounts.

 
 
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