Interview With Douglas A. Kass, President, Seabreeze Partners Management
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By Lawrence C. Strauss | 20 May 2008
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Barron's: Why short, Doug? What got you interested in that line of work?
Kass: Short sellers are an endangered species, like the dodo bird. The dedicated short pool totals about $5.4 billion, according to Knowledge@Wharton, a Website. That's roughly one-seventh the size of the Fidelity Magellan Fund. It's also a tiny sliver of the approximately $1.9 trillion of hedge-fund assets. But it provides a huge business opportunity for Seabreeze. My friend Jim Cramer's mantra is that there is always a bull market somewhere. At Seabreeze we consider ourselves the anti-Cramers; we say there is always a bear market somewhere, and it's our job to find it.
[For Kass' Pans, see Table below] In the past two decades of the bull market, on average about 58% of the issues on the New York Stock Exchange have advanced and roughly 42% have declined every year. The 42% provides us with fertile opportunities for secular, cyclical and thematic shorts. Short selling is the least served and most uncrowded hedge-fund strategy out there.
What makes short selling so difficult to do effectively over a long period?
The objectives of a long buyer and a short seller are similar. Both want to produce uncommon returns by taking common risk— typically by developing a variant view. Many believe short selling is a mug's game, but I don't, and thus far our results at Seabreeze have supported our opinion. But it is essential to maintain a disciplined short-selling strategy because, remember, risk and reward are asymmetric in selling stocks short. An investor can make only 100% if correct— that is, if the stock sold short goes to zero. But you can lose an infinite amount if you're wrong as the stock keeps appreciating. And there is a gravitational pull of stocks higher over longer periods of time. So we use a very conservative approach to shorting.
Explain it, please.
First, we're diversified across company and industry lines. No individual security exceeds 2.5% of our partnership's assets and no industry sector exceeds 20% of the assets. We'll have 35 to 40 holdings at any given time. Second, "Wee Willie" Keeler, a .341 lifetime hitter who played in the early part of the 20th century, liked to say he "tried to hit 'em where they ain't." We try to do the same by being creative in our stock-selection process.
In what ways are you creative?
We strenuously avoid stocks whose short interest is high relative to the float, or companies whose shares have large short positions relative to their average daily trading volumes. Many short sellers have made the mistake of shorting valuation and have blown up during short squeezes. Avoiding them allows us to sleep at night and allows time for our negative fundamental catalysts to develop.
We also mitigate risk by avoiding leverage [borrowing to enhance the size of a position]. Historically, short sellers have taken concentrated positions, often in companies with small to medium capitalizations, and then used— and abused— leverage. That's a recipe for disaster, particularly when they select investments with too many shorts. The average market capitalization of our holdings is more than $10 billion. Shorting large-caps is another way to control risk.
One of the latest trends in asset management is 130-30 funds, in which the manager shorts 30% of the portfolio and uses the proceeds to buy more long positions. What do you make of this idea?
These funds are a silly gimmick and their half-life will be short. Nearly every long/short manager thinks he is equally facile on the short side as the long. Shorting requires a different skill set; you have to have the mindset of an investigative reporter and be a skeptic at the core. Also, many 130-30 funds use exchange-traded funds [ETFs] as a proxy to short. That's a cop-out and a poor way to produce excess returns.
What are your current investment themes?
Right now our emphasis is on the consumer sector. We've found an undiscovered sector that has limited short interest, namely the dental industry. We wouldn't look at traditional retailers like Target [ticker: TGT] or Kohl's [KSS], or short the Retail Holdrs [Merrill Lynch Retail HLDRs [RTH], a retailing ETF. ETFs are the opium of the hedge-fund community because they are an excuse for lazy hedge-fund managers not to go belly to belly with companies and their managements. A dependency on ETFs as a shorting tool is simply an excuse for not doing hard-hitting and creative research.
But why are you so bearish on the U.S. consumer?
The consumer is spent up, not pent up, and more levered than during any period in history. That's one of the structural problems facing the economy. At the same time, job growth is declining and real disposable incomes are pressured as inflation literally is eating away at the consumer's buying power. It is frightening that the consumer has entered this economic downturn with the most levered position in history. On top of that, we're facing four consecutive months of job losses. We've seen the depreciation of the two most important assets, home prices and equities. Consumer confidence is at a 26-year low. The availability of credit continues to be a problem that will plague the economy for a while. Inflation, the cruelest tax of all, is rising as energy and food prices, in particular, are soaring. And the first-quarter GDP report contained a number of ominous signs that the consumer is spent up while the housing depression continues apace.
So, which consumer stocks are you shorting?
Colgate-Palmolive [CL], Kellogg [K] and General Mills [GIS], which are trading at 17 to 18 times earnings, but have secular earnings-growth rates of 7% to 10%. These companies historically are seen as recession-resistant, but we doubt it. All three are aggressively lifting their selling prices in response to huge cost increases, but demand is starting to suffer as private-label companies and generics gain market share. Demand elasticity, or sensitivity to changes in prices, in toothpaste, soaps and other consumer products has begun to surface in the current recession, as consumers trade down to private-label products.
You're short Berkshire Hathaway [BRK.A]. Betting against Warren Buffett in the past was a costly move, as evidenced by Berkshire's stellar performance since the 1960s. Why do so now?
No. 1, there will never be another Warren Buffett. I respect and admire him considerably, but in part because of the lucrative compensation set-up in the hedge-fund industry, the investment landscape now is inhabited by a lot more smart and aggressive managers who comb for value— far more than there were 10, 20 or 30 years ago. Berkshire Hathaway's outperformance versus the market has been narrowing in the last decade, and I expect that will continue. Investors are going to dump the shares if Buffett is no longer at the helm, though I'm not signaling that he plans to step down anytime soon.
What else concerns you about Berkshire?
More than anything, I'm short Berkshire because of Buffett's recent investment-style drift. In the past five years, Buffett frequently called derivatives "financial weapons of mass destruction." Yet, very much out of character, he immersed himself in several large and thus far unprofitable derivative transactions, leading to an unrealized $1.6 billion pretax loss in the first quarter. I'm also short Berkshire because the salad days for insurance, which is the cornerstone of Berkshire's business, are over. Also, Berkshire's premium valuation seemingly has been a byproduct of the credit crisis, and the perception of the company as a safe haven. Berkshire's shares might underperform as some of the deflated financial companies regain their footing. And Buffett is substantially exposed not only to financials— he owns large positions in Wells Fargo [WFC], Bank of America [BAC] and American Express [AXP]— but also to a weakening housing market through his ownership of Clayton Homes.
You mentioned one of your short themes is the dental industry. What's behind that?
We're short three companies in that space: Danaher [DHR], Henry Schein [HSIC] and Patterson Cos. [PDCO]. The sector is exposed to a weakening consumer and it's not heavily shorted, something we look for. My father was a dentist, and through him I know a great many dentists and CPAs whose clientele consists of dentists and doctors. We have made extensive channel checks of practitioners around the country. One thing we have learned is that elective cosmetic dental procedures are starting to tail off dramatically.
What was the bullish case on these stocks?
Dental distributors and original-equipment manufacturers are seen by many as defensive investments with minimal exposure to recessionary pressures and health-care reimbursement risk. The reality is that nearly half of the roughly $96 billion in annual dental spending— which is basic dental care and cosmetic dental surgery in the U.S.— is paid out of pocket. What's more, there are substantive signs that a slowdown in dental care has begun, especially in weak housing markets around the country. And there are signs that third-party financing is becoming generally less available. At the same time, there's evidence dental consumables and dental equipment like chairs and X-ray machines are tailing off as dentists have begun to cut back.
Do you have a favorite dental short?
Yes, it's Danaher, which isn't typically thought of as a dental company. It's actually a diversified industrial company, but dental products account for roughly 25% of revenue. What caught my eye in Danaher's latest quarter was that they reported flat core dental equipment and consumable sales. Danaher has a trailing 12-month price/earnings ratio of about 20. In contrast, the P/E ratio of General Electric [GE], another diversified industrial company, is under 15. This is surprising since GE consistently has had more rapid organic growth overall than Danaher, and organic growth is the key sentiment driver and metric that moves the diversified-stock group.
How about one more short idea?
Fastenal [FAST], whose stock has risen from 33 in late January to around 50. They operate about 2,200 stores in nonmetropolitan areas selling an array of services and industrial supplies, including threaded fasteners. What intrigues me about this company, in looking at the second half of the year, is that their sales growth is going to be increasingly difficult to sustain, and a profit miss will likely follow. Earlier this month, Fastenal announced its daily sales in April dropped by half a percentage point on a sequential basis. That compares to an 11-year average gain of 0.5%. Companywide sales in May could be several percentage points lower than the typical seasonal growth.
Thanks very much, Doug.
Kass' Pans...
Company Ticker Recent Price
Berkshire Hathaway BRK.A $121,510.
Colgate-Palmolive CL 72.30
Kellogg K 51.53
General Mills GIS 62.08
Danaher DHR 80.07
Henry Schein HSIC 56.21
Patterson Cos. PDCO 36.09
Fastenal FAST 51.66
Source: Bloomberg
M O R E. . .
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