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Friday, February 28, 2020

A tale of two hedges: Playing safe and playing for profit

Date: Saturday, October 10, 2009
Author: Globe and Mail

Special to The Globe and Mail

Avner Mandelman is president and chief investment officer of Giraffe Capital Corp. and the author of The Sleuth Investor.



During the decade that I've been involved with hedge funds, I've heard many arguments for and against them; but I also found that many investors still do not fully understand what a hedge fund is, and what hedging is for. Indeed, many so-called hedge funds are little more than levered long-only funds, where customers are really buying risk.

So, what is hedging for? In my experience, it can be done for two main reasons: First, to eliminate risks you don't have a handle on, so you can focus on the ones you do understand (because you have researched them); and second, to actively create a profit opportunity.

Let me give you examples of each, including a current one.

First, eliminating risks: The earliest hedge fund was formed 60 years ago, the brainchild of Alfred Winslow Jones, a journalist who realized that investing both long and short can smooth out market fluctuations - if both longs and shorts have been picked well. So the "hedge" in that proto-hedge fund's name meant hedging out (eliminating) market fluctuations.

But hedging can also be used to eliminate other risks. Say you consider a specific small copper producer a takeover target. You're willing to bet on the takeover, but don't want the risks of the market plunging or copper tanking. To hedge the latter out, you can go long the target stock, while shorting large copper producers as a hedge.

Or another example: Say you own U.S. stocks but live and spend in Canada. How do you eliminate U.S. dollar risk? You short the American dollar in the same amount as your U.S. stock portfolio. There are other risks you can hedge out, such as interest rate risk, or even weather risk, for the ultrasophisticated.

But what of active hedges, where you create an opportunity? These require creativity and research. As a typical example, take an industry where a company is the clear winner at the expense of competitors, but its stock is too expensive and volatile.

Can you still benefit? Yes. In some cases you can go long the winner and short the losers.

To take a concrete, current example, consider the bookselling industry, where in the U.S. Amazon is a clear winner at the expense of bricks-and-mortar bookstores. However, Amazon's stock is expensive, and although over the long term the stock did well, its volatility could've made you lose sleep. But a successful hedge has been (and may continue to be) going long Amazon and short bookstore operator Barnes & Noble.

Why did it work? And why might it continue to?

Well, based on fundamental data, sales of online books have been rising fast, while sales at traditional bookstores have been languishing. And now there's another element: Kindle, the wireless book reader that has transformed the industry. Indeed, you can compare the new book-buying to the start of electronic stock trading: Instead of paying a high commission to your broker and waiting for your purchase confirmation to arrive by mail, you can click, pay a $9.99 commission, and you see the stock in an online account immediately. In other words, like e-trading, book-buying has become an impulse purchase. Up to now, Kindle has been only a U.S. product, but last week it went worldwide nearly everywhere, except Canada (where it seems the government is defending bookstores). But soon the Kindle should come here, too.

How did the Amazon/Barnes & Noble hedge work out?

Over the past two years, going long Amazon and shorting Barnes & Noble made for a fairly stable rising line. (See chart.) As for the return: Over the past two years the ratio rose to about four from two, or 41 per cent per year. However, remember that the amount of capital needed for such a hedge is twice a regular amount - for each $1 long you need $1 for the short - so the real return on the hedged capital was about 20 per cent a year. Still, not bad.

But will this continue? I think it likely will, but there are risks. First, the usual risk of borrowing stock to short, and the risk of Barnes & Noble being taken over. But also, several competing e-readers have been announced by electronic firms, so Amazon's hardware profits could decrease (they don't own any core patents). Yes, Amazon has the content - more than 1.5 million books available, with about 250,000 more added per year, but competition here, too, is coming, from two online giants - Google and Apple.

Still, all in all, the hardware is not the advantage, the content is; and as the price of books comes down, and book-buying become an impulse purchase, sales volume should rise, and so should margins - while bricks-and-mortar competitors could continue to lose market share and margins. Indeed, independent bookstores have been closing in droves.

Why do I mention it now? Because over the next year or so this type of hedge may be particularly interesting, since if markets correct (as I expect them to), levered long funds could become even more vulnerable, but well-researched industry hedges, like the long Amazon/short Barnes & Noble, could still do well.