Surviving with a defensive game

Date: Friday, December 12, 2008
Author: Shirley Won, GlobeAdvisor.com

Hedge fund manager Eric Sprott heaps praise on his "defensive team" for helping him survive this bear market.

While some of his peers have cratered amid this year's stock market crash, his short positions have kept him well ahead of his benchmark index.

For the first 11 months of this year, the returns of Sprott Bull/Bear RSP and Sprott Hedge LP I and II range from an 8.5-per-cent gain to a 4.5-per-cent loss compared with the S&P/TSX composite's sharp 33-per-cent slide.

"The reason we started our first Canadian hedge fund in 2000 was because we foresaw this very, very difficult market," recalls Mr. Sprott, also chief executive officer of Toronto-based Sprott Inc.

"I think we came upon being a hedge fund honestly," said the 64-year-old manager, whose firm runs hedge and mutual funds. "It was to protect people. If things got really ugly, we might be able to survive and/or prosper."

The problem with hedge funds is that the term "defines a thousand methodologies," and many don't emphasize protection, he said, referring to bets that a stock would fall. "You have to have your defensive team on the field all the time. Generally, we have been 50-50, long and short."

WHY WERE YOU SO BEARISH BACK IN 2000? You could see the end of the dot-com mania. The valuations were ridiculous. You'd have to think that we would go into a very long bear market. I probably said then it would be 10 to 15 years. Some people would argue that we got into a bull market that started in 2003 and peaked in 2007. I might argue that we really were still in a secular bear market, and the reason we were able to have this cyclical bull is because the authorities - the U.S. Treasury and the Fed - forced rates down, and allowed a lending mania to happen.

YOU HAVE BEEN BEARISH ON U.S. FINANCIAL STOCKS. WHAT ABOUT CANADIAN ONES?

I am pretty bearish today on them, but I wasn't two months ago. Our bank stocks were one of the only banking groups in the world to have their share prices stay up. That seemed unusual to us. All banks are in the banking business. Our guys are as international as anybody is. So why were we exempt? Then, of course it fell apart. They have taken some charges now and, one might argue, have been undercapitalized. A lot of them have done [stock] issues. I am short Canadian banks, insurance companies and the stock exchange.

WHAT DO YOU THINK ABOUT GOVERNMENT BAILOUTS?

We have spent so much time, effort and money trying to protect the banking system that the economic system is today in freefall. I'm talking about the real economy- not the pretend, paper economy. I believe the real economy is in a depression. U.S. housing and automobile sales are down 66 per cent and 50 per cent from their peak. Everyday you read about plant layoffs. It's laughable that there is resistance to help Ford and GM, which is the real economy.

WHAT IS YOUR OUTLOOK FOR THE CANADIAN HEDGE FUND INDUSTRY?

It is going to shrink dramatically. I know some of the guys who are down those kinds of numbers, and I kind of hope they keep their funds going and fight their way through it. They have been good managers before, but the bear market has caught them offside.

WHAT ARE YOUR HEDGE FUNDS INVESTED IN RIGHT NOW?

We have 25 per cent in bullion, 40 per cent in cash and 35 per cent in various stock groups, with the biggest in energy and precious metals. I like the Utica shale gas play, and have been a buyer of some of those stocks like Gastem, Junex and Questerre.

We have been picking around some gold names and oil stocks.

WHAT HAVE YOU SOLD?

We have been selling base metals like molybdenum and copper stocks because demand has fallen off the table. We have sold some stocks at year end to take the losses.

The loss you can recover for your hedge fund holders can be worth more than your share price in instances. But we have maintained by far the bulk of our position in Timminco [maker of solar-grade silicon]. It's in one of the few industries that might be the subject to a lot of [U.S.] government investment. I bet a big part goes to alternative energy.

YOUR FLAGSHIP FUND, SPROTT CANADIAN EQUITY, LOST 46 PER CENT FOR THE FIRST 11 MONTHS. WHAT'S HAPPENING?

We need gold to go up. Gold and silver bullion is 39 per cent of the fund. Historically, gold has been the go-to investment in very difficult times. It hasn't done it this time because of the anomalous move of the U.S. dollar.

I think the dollar move will abate at these levels so we will see other currencies and gold start to rally.

WHAT ADVICE CAN YOU GIVE INVESTORS IN THIS MARKET?

They have to tread very warily. There are still only certain things that are going to survive this - government bonds, cash, gold and hedge funds that are hedged.