How to Make Bigger Profits with Less Risk (Doug Casey)

Originally Published by Casey Research

Editor’s Note: Happy holidays from everyone at Casey Research. Today, in place of our regular market commentary, we’re sharing a classic essay by Casey Research founder Doug Casey. This essay originally appeared in Doug Casey’s hit book, Crisis Investing for the Rest of the 90s.

In observance of Christmas, we will not publish a Daily Dispatch tomorrow. We’ll be back on Monday.

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Hedging for More Profit and Less Risk

By Doug Casey

It’s impossible to be sure, at any given moment, whether any market is going up or down. No matter how overpriced a market may be, there are always bulls with good-sounding arguments why it could go twice as high: No matter how “cheap” a market may be, there are always convincing bearish arguments for it to go lower. After all, for every buyer there’s a seller (and vice-versa). The same is true for the economy, where a case can be made for both good times and bad times at almost any juncture.

How can you hedge yourself against being on the wrong side of the market? By using “hedge” strategies which are surprisingly little known, though they’re almost always lower risk and higher potential than pure long or short positions.

A “hedge” is a position where you buy X dollars worth of one stock or commodity, and simultaneously short sell (bet against) an equal dollar amount of a different stock or commodity. Since you’re both “long” and “short” the market, you don’t really care which way it goes. By choosing your positions intelligently, you can be right on both sides of your trade, regardless of overall market conditions.

As fashions change, the first tend to become last and the last tend to become first. This was recognized in biblical times, and it’s equally certain in the investment markets. Regardless of the overall direction of the market, relatively overpriced stocks tend to decline, and underpriced securities tend to rise. Indeed, both movements often happen at once. By being both long one investment and simultaneously short another, you can escape the need to second-guess the direction of the overall market and still profit in either a bull or bear market. The keys to profitable hedging are patience and consistency: Patience because it doesn’t make sense to be in any market all the time; consistency, because your plan won’t work if you don’t follow it.

Most of the time, it’s a 50/50 bet whether something is going up or down, and you need better than 50/50 odds to make money. The idea is to be in a given investment only when the odds of its going up appear to be 90% or better, and to be short when the odds of its going down are equally strong. It is fortunate that odds that strong usually identify investments that are getting ready to move 10-for-1 or more as well.

Suppose, for instance, you like the prospects of Stock X; you’re sure the underlying company will do well. But you’re afraid of the market as a whole, which could take Stock X down, despite the company prospering. How do you solve the dilemma of whether to buy or to wait?

A hedge might be the answer. Find another company in the same industry, Stock Z, which you feel has terrible prospects and perhaps will lose business because of Company X’s very success, and whose stock looks to be overpriced. Then buy Stock X and short an equal dollar amount of Stock Z.

If your assessment is correct, it will not make any difference how the market in general, or the industry in particular, does. You’ll make money as long as X does better than Z, whether they both go up or they both go down. And, if their prices move in opposite directions, you can make money on both and double your profits, even while you’ve reduced your risk.

Value is relative, not absolute. In other words, you want a position not only because of what it is, but because of what price it is. For instance, in February 1993, gold is a good buy at $335 and the Nikkei 225 at 16,500 is not; so I suggest owning gold and short-selling Japanese stocks. Several years from now, if gold is at $1,000 and/or the Nikkei is at 5,000, I’ll almost certainly be inclined to say the exact opposite: Buy the Nikkei index and sell gold.

It’s never a question of how many dollars you can get for something you want to sell. The real question is how many shares, or contracts, or acres you can exchange it for. It might, for instance, be hard to say whether corn is cheap or dear at, say, $4 a bushel, unless you know what to compare it with. But we know that wheat usually sells for about twice the price of corn, and soybeans for about triple - because of factors like production costs and protein content. If soybeans sell for $6 while corn is at $4, you can be pretty sure corn is dear, at least relative to beans. By selling corn and buying beans, you’re likely to make money.

The idea is to pick out very cheap stocks or commodities to buy, and very dear ones to sell simultaneously, with the intention of protecting yourself from general market moves. Buy and sell respectively equal dollar amounts of each and wait for the inevitable, without caring whether the market in general booms or busts.

EXAMPLE ONE

In 1991, I recommended such a hedge in the thrift industry. It provides an ideal illustration of the principle.

Continental Federal, an S&L based close to Washington, D.C., was selling for $5, less than a fourth of its $22 book value, and about a fifth of its previous high of $27. An analysis of its balance sheet showed it could even then have been liquidated for $15. It exceeded all regulatory capital requirements by at least two-to-one. All but a few of its loans were in the relatively low-risk residential market, and it had already charged off most of its bad loans.

Although management had been competent in making good loans, their overhead expenses were very high at 320 basis points of their $1.1 billion of assets (i.e., about $35 million, or 3.2% of assets). Typically for a public company, management was treating themselves quite well at shareholders’ expense. Why not? They owned only 100,000 of the 2.9 million shares outstanding. Overhead should be no more than 250 basis points (2.5% of assets), and a difference of 70 points on $1.1 billion is about $8 million per year. If management were forced to tighten their belts by only that much, the stock could easily sell for at least $12 per share.

A group of shareholders, including myself, joined together to make it happen. Still, because of my misgivings about the economy at large, I did not want to be long on Continental Federal without being short an equal dollar amount of something likely to join the choir invisible. GlenFed, the third largest thrift in the United States, with most of its assets in California, seemed like a good choice in that category.

GlenFed had about $16.5 billion in assets and $950 million in stated capital, which was satisfactory on the surface. But about 80% of their capital was debt, on which the interest clock continued to run. At the same time, almost any portfolio losses could quickly wipe out shareholders’ equity since non-performing assets were already over $700 million, and in California’s depressed real estate market, it was clear they could easily suffer large losses. In addition, GlenFed owned numerous hotels, shopping centers, and business parks through a subsidiary, the very worst things to be in at the time. It was all for sale, but there were no bidders, because it seemed likely that the Resolution Trust was going to wind up with GlenFed’s properties, and potential buyers could get them more cheaply later.

The hedge worked out well. GlenFed crashed 80%, from $5 to $1, while ConFed rose to $22, where it was bought out by Crestar Bank. I wound up making more money using a hedge than I would have simply being right about Continental - and I took much less risk, to boot.

EXAMPLE TWO

All mutual funds are run by management companies, who are responsible for sales, administration, and portfolio decisions. Of several hundred management companies, only about a dozen are themselves public companies, not counting subsidiaries of much larger public firms, like Merrill Lynch. They are all very leveraged as to the amount of money they control. And when stocks and bonds start “heading south” from today’s manic levels, half of them could disappear. It is fairly analogous to a gold mining company, in which costs are fixed and profits fluctuate radically with the metal’s price.

Fund management companies, like brokerage houses, are an excellent proxy for the kinds of securities in their portfolios. When the value of assets rises, their earnings skyrocket. When the market drops, the whole process goes into reverse.

An effective hedge within this industry might be a fund group specializing in that most-neglected and abused group, the gold stocks. Of the 34 gold funds, all but one, United Services Group, are either a tiny part of conventional groups, or are run by privately owned managers. United Services (USVSP, Nasdaq, $3.25) is going up for a number of reasons:

1. The company has just been acquired by new management, but the stock remains bombed out from disastrous decisions of the previous managers. USVSP has 4,382,000 shares outstanding, selling at $3.25, for a market cap of about $15 million. Management companies typically sell for between 3% and 5% of the assets they have under their control. For example, the Templeton Group was just acquired by Franklin Resources for about 4.5% of assets. Based on the $650 million USVSP now has under management, its stock is selling for about half of what it should be.

1. United Services manages $650 million at present. Its assets are growing at about $3 million daily, mostly in its government money market and bond funds. A rule of thumb for United Services is that every $10 million gain in assets yields $57,000 (or just under $.013 per share) to the bottom line. When United Services hits $1 billion in assets, that should yield an additional $2 million in operating income, or $.46 a share. At the $5 billion level, that sum should equal about $2 per share in earnings, for a realistic share price of around $20.

1. United Services manages 14 funds at the moment, but over half their assets lie in its two gold funds. When a gold bull market gets underway, not only will the number of accounts multiply but so will the value of the assets, offering double leverage. During a gold bull market, $50-$100 million could flow into these funds per week. And the management fee on gold stocks is a multiple of that for more general funds.

1. United Services’ largest and fastest growing funds, after the two gold funds, consist of government securities. These funds should be big beneficiaries in a financial crisis, since billions will desert garden-variety income funds, which invest mostly in CDs and Eurodollars to maximize yield, and will flow into the safety provided by the very limited number of government-only funds available.

While most fund management groups are way overpriced, United Services should do well because of its concentration in governments and gold.

Which management group might do worst, based on that same reasoning? As the short in the hedge, you should consider Franklin Resources (BEN, $40), the group mentioned above that just bought out Templeton. Several facts about them scare me.

First is a $500 million debt burden, taken on for the acquisition; that will be difficult to bear in a down market, when their asset base starts shrinking.

Second, most of their asset base is in bonds, and most of that base is in California municipals. As chapter 15 spells out, both are candidates for a meltdown.

Third, John Templeton sold his fund group to Franklin Resources. Do you really want to buy something the master is selling? I suspect Templeton got rid of his fund group because he sees the business much the way I describe it in chapter 13.

It’s impossible to tell whether this hedge will work out as well as the hedge described in Example One. But I expect profits will accrue on both the long and the short side of the ledger.

I think United Services is a buy in and of itself; Franklin is an excellent short by itself. But you can both reduce your risk, and increase your profits by making both trades at once.

OTHER HEDGES

The market is rife with hedge strategy candidates, if you keep your eyes open. I discuss another, centering on the prospects of the ecology movement, in chapter 32. Also look at commodities. Think about going long a contract of silver, versus short an equal dollar amount of platinum. Or long palladium versus short copper. The rationale for these hedges is laid out in chapter 21.

Hedges play a big part in my personal investing. The combinations you come up with are limited only by your personal experience and imagination. But the key is to reduce risk, and simultaneously increase profits, whether the markets head up or down.

At a minimum, it would be prudent to take a look at your present holdings and to hedge them. Identify those positions in the most inflated industries and those most likely to be damaged by tough times. Sell off the most overpriced half of these, then take that cash and use it to short issues that are over promoted, or buried in debt, or run by people of bad character.

Editor’s Note: Doug Casey believes we’re in the early stages of a currency collapse that will affect all major currencies, including the U.S. dollar. Casey Research has put together a free video to show you how to prepare. In this video, you’ll learn how to protect and grow your money when paper currencies crash…using the same strategies that Doug Casey is using today. Click here to watch the video.

The article How to Make Bigger Profits with Less Risk was originally published at caseyresearch.com.

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How to Make Bigger Profits with Less Risk (Doug Casey)