Subprime woes a prescription to hedge

Date: Monday, October 22, 2007
Author: Shirley Won, Globe and Mail

Hedge fund manager Allan Brown has become more cautious on North American stock markets despite the recent rallies, saying he doesn't believe the credit woes in the United States are over.

"This credit crunch has been probably more severe than we expected," said Mr. Brown, a portfolio manager with Burlington Capital Management Ltd. "We think there is more fallout to come."

There is a chance that the United States could head into a recession because the "housing downturn is severe, and it's going to last longer than people think," he suggested.

The fund manager does not believe the recent move by the U.S. Federal Reserve Board to cut its interest rates by 0.5 percentage points last month will turn around a deep housing slump triggered by the meltdown in the mortgage market.

The weakness in the housing market plus rising oil prices could slow down consumer spending and, ultimately, the economy, Mr. Brown added.

Expectations by Wall Street analysts for earnings of S&P 500 companies to snap back in the fourth quarter after ratcheting them down in the third quarter is also "a little bit optimistic," he added.

Mr. Brown co-manages Burlington Partners I LP, which has posted a 11.9-per-cent annualized return at the end of September since its inception in January, 2005, and the newer BluMont Core Hedge Fund. The funds, which have $44-million in assets, are invested equally in Canada and the United States.

His funds are primarily driven by a pairs trading strategy for two-thirds of the assets. That strategy consists of buying one undervalued stock in an industry, and selling short another stock - believed to be overvalued or not growing as fast - in the same industry.

"In a bull market, paired investing may not be the most exciting thing," Mr. Brown conceded. "We [funds] are not going to up and down based on what the market does. We are going to go up and down based on what our pairs do."

That was evident when the market tumbled from July 20 to Aug. 15. The TSX/S&P composite index and S&P 500 composite index, respectively, fell 12.3 and 9.8 per cent. His funds were off 1 per cent. "Those hedges are in place for that environment," he said.

Because he is more cautious on the U.S. market, all his long positions are hedged with short positions. The funds, however, are net long the Canadian market by 15 per cent. "We are not as negative on Canada," Mr. Brown said.

Beyond pair trades, his investment strategy also includes making thematic calls - like investing in energy or gold stocks based on a view of the market or industry - and buying income-oriented securities.

Solar power

Long: Suntech Power Holdings Co. Ltd. (STP-NYSE).

The Chinese maker of photovoltaic cells used in solar panels is a major global solar play and is "growing rapidly," he said. Suntech's revenue is expected to grow by almost 100 per cent this year and 40 per cent in 2008, and yet only trades at about 26 times next year's earnings, he said. "It is not a very high multiple for this kind of growth."

Short: First Solar Inc.

(FSLR-Nasdaq).

The stock of the Phoenix-based solar-cell maker, which closed Friday at $133.24 (U.S.), is a "very expensive stock" trading at almost 100 times analysts' expectations of $1.42 a share for next year, he said. "We think investors are overvaluing the technology."

semiconductors

Long: SanDisk Corp.

(SNDK-Nasdaq).

The Milpitas, Calif.-based producer of NAND flash-memory chips used in cellphones, digital cameras and music players is expected to be in a "really good cycle over the next six to 18 months" because of demand from products like the iPhone, he said. "We think there is a good chance that SanDisk could earn $3.50 to $4 a share next year, while the Street is estimating $2.47 a share next year."

Short: Semiconductor HOLDRs (SMH-A).

The exchange-traded fund tracks the major semiconductor players like Intel, Texas Instruments and Applied Materials. "We are not particularly bullish on the semiconductor sector over all," he said. "We are long on SanDisk and short on SMH to hedge out any negative moves that semiconductors might have."