Paul Stuka's small fund reaffirms his reputation for trend-spotting
By SANDRA WARD
Barron's Online
Monday, March 3, 2003
Revived at Osiris
An Interview With Paul Stuka -- If you weren't a believer in the afterlife, the man behind Boston-based Osiris Partners might make you rethink the concept: One of the most successful and celebrated small-cap managers in the land in the mid-'Eighties as steward of the Fidelity OTC Fund, Stuka's back in the game in a big way after starting the long-short fund in 2000.
Applying a mixture of macroeconomic and theme-driven analysis with a value bent to pick stocks and structure his portfolio, Stuka's little fund -- with only $27 million -- delivered 103% in 2002 after fees. In 2001, Osiris gained 12.9%. The small asset base exaggerates performance, of course, but there's no denying Stuka's savviness in spotting trends and sizing up Mr. Market. He's also honed his risk-management skills, after getting burned in late 1991 by a surprise interest-rate cut that managed to spoil a stellar record in his first foray into running hedge funds. For why he's built his cash position and for a glimmer of his days as a health-care analyst at Fidelity, listen to Stuka for yourself.
Barron's: You had a lot of cash when we last spoke. How is your portfolio structured now?
Stuka: We are 34% long and 21% short, so looking at it that way we have 45% cash. Or, if you look at it as 100% minus our 34% long position, cash accounts for 66% of the portfolio.
Q: That is huge. Have you been building it all during the year or is this a recent development?
A: It was partly because of new money coming in at the beginning of the year. But partly, too, it was a conscious decision to hold a lot of cash, especially when some of the macro, technical and fundamental indicators we look at started going in different ways. We were afraid in late December of a reaction rally in the market when we started to hear rumors that Saddam could end up in Syria, or Libya, or Moscow, or even wake up dead some morning. You can argue whether it would be 500 points or 1,000 points, but there would be some kind of a positive reaction. I don't want to be heavily short in that environment. On the other hand, my macro view is that we are in a secular bear market, and the action on the tape is so negative, I can't justify being heavily long. I'm caught.
Stuka made "a conscious decision to hold a lot of cash" when some indicators started going in different directions.
Q: How much of this malaise in the market is Iraq-related and how much is it related to the economy?
A: It is a huge and complex question. Even if a war with Iraq goes very, very smoothly at the onset, the question becomes what do you we do with it once we have it? How much it is going to cost to reconstruct Iraq and put in a stable government? How long will troops be tied up there? It is an open-ended question, and the market could react positively initially although the longer-term outcome would be totally different. On top of that concern is the fact we're in a secular bear market in which major economic drivers have been changing during the past couple of years.
Q: Such as?
A: The consumer. Two years ago, we thought consumers would have to pull back and increase their savings. That is taking longer to occur, largely because of the mortgage-refinancing activity. There is still heavy refinancing activity. Consumer-debt levels are scary, but the percentage of income that it takes to service the debt is no higher than it was in the past. Of course, the Federal Reserve is doing what it can to cushion the downturn by keeping rates low, and the federal government is doing what it can by running big deficits.
Q: Aren't we now seeing a pickup in spending?
A: Well, the first wave of baby boomers turn 65 years old in 2010, and they are hoping to retire. There have been a number of studies showing they haven't been saving enough, and what they have saved has been savaged in the downturn. If the baby boomers do turn from being big spenders into savers, that will really screw everything up. Some of that is showing up in the monthly credit numbers, as repayments overtake borrowing. Increasing the savings rate is a good thing longer term. It's a question of how fast it happens. If the savings rate goes to 10% over seven years, it isn't going to be that bad; but if it goes to 10% over two years, there will be a real problem because the consumer is 70% of the economy.
Q: Do you still own a lot of gold stocks?
A: Yes. But gold stocks certainly haven't been perfect. Gold and metals have done OK this year, but gold stocks are down. It's been a very frustrating environment, because even if you've been right on energy or gold or a lot of commodities, the stocks haven't appreciated.
Q: What is that telling you?
A: That the market isn't convinced the upward move in commodities is anything more than temporary. If the outcome in Iraq is favorable, that would negatively effect gold and oil.
The bond market bewilders me in that rates continue to drop. The 10-year is at 3.8% despite the bad PPI [producer-price index] number released recently. The bond market also suggests the spike in commodities is temporary or is simply a flight to safety. Nobody is concerned about inflation right now. In 2002, the long bond returned 13% to 14% and the commodity indexes were up 20% to 25%. I don't know of any other year where that happened. It just doesn't fit. Now, the numbers are starting to come through on the PPI, but they haven't really shown up in the CPI [consumer-price index] yet. But the bond market seems to be dismissing it.
There are guys like Gary Shilling who argue there is no way around deflation and recommend buying bonds because the 10-year is going to 3% or less. They may be right, but I don't see that as a great bet right now. You have to believe the economy is going to slow, you have to believe the dollar isn't going to get totally trashed and you have to believe higher deficits won't matter. A bet on the long bond is really a bet on at least three assumptions, and any time you make more than one you are adding complexity to the trade. In a world of low returns maybe you can justify it, but it is hard to see how it is going to be a home run.
Q: What if the consumer doesn't slow down?
A: The issue then is how much the dollar can sustain. The current-account deficit is running more than $500 billion annually, sucking in about 80% of the world's savings. Can we go to 85% to 90%? Theoretically, I guess it is possible. We are getting to the outer limits of what we can expect people to lend. The Chinese have positioned themselves in an interesting way: They fixed their currency against the dollar so they get dollars from their trade surplus, recycle them back into U.S. paper, earn a decent return and don't have a currency risk. In their Central Bank reserves, they own very little in terms of euros or gold, and one would think that they would now start diversifying their assets away from the dollar. The dollar has reacted to the trade-deficit numbers by going down. But the dollar decline hasn't been a disaster. The dollar has been declining primarily against the euro. The choice of owning dollars and owning yen is a tough one, because both Japan and the U.S. are trying to devalue their currencies.
Table: Stuka's Picks...1
Q: So how does this shake out?
A: Over time the consumer pulls back slowly. We become a nation that increases our savings. The currency goes down and the stock market just kind of treads water, because against the rest of the world we may lose purchasing power, but in terms of the dollar, purchasing power holds steady. That is the best case for a benign outcome.
Q: Do we often have benign outcomes? Is there an example of a time when this was the outcome?
A: Not that I know of. But now we're getting into the subject of what it means to be an empire. If you consider other financial empires, once you become king, a lot can happen. Citizens demand more. Politicians are willing to give them more. There is also an element of taking responsibility for protecting the world, and you spread yourself all around the globe. That has always been the burden of empires. Once that happens you usually see the currency start to decline, and unfortunately the standard of living starts to decline. That has to be translated to the consumer.
Q: Are you more concerned about deflation or inflation here?
A: The bond market is certainly signaling deflation. And the commodities markets are signaling inflation. One is wrong. We just don't know which one.
The third possibility, and one that's maybe more realistic, is we get some kind of a stagflation. Commodities are rising because of a devaluing dollar and because of growth in Asia. At the same time, U.S. retailers can't pass on price increases, if there are price increases, because the consumer is pulling back. That leads to overcapacity and causes some deflation in the consumer area. At the same time, we have inflation in basic materials because of global demand. That's stagflation. What's masking the true situation is Iraq. Iraq is letting the bulls on bonds say the inflation risk is temporary. Until we get past the Iraq situation, and we might not get past it for a long time, it will be very easy for people on both sides to argue. There is a truth underneath, but it is being buried because of Iraq.
Q: Despite all this and despite your cash, you still have more longs than shorts?
A: I only have more longs than shorts because of my gold stocks.
Q: Haven't you pulled back on gold? Hasn't it become a disappointment?
A: Yes and yes. Last year we took a big bet on gold. It isn't unusual for us to put 20% to 25% of our assets in an industry, and that's what we did with gold. By the middle of last year, gold got up to a third of the portfolio. It was just too high to be sustained. We'd obviously had a great run the first part of the year, the stocks were way overbought, the sentiment was very bullish in terms of the gold stocks, and so we cut the position in half. It was fortuitous, because gold then dropped, with the XAU index losing 40% in about seven weeks. But consider the XAU: It peaked at 89 last June when gold was at $330 [an ounce], and now the index is at 70 and gold is at $350. Gold is up 6% and the XAU is down 20%. That is a real historic anomaly, because the stocks should appreciate about two to three times the rate of the metal itself. There is something really odd going on. There's Iraq. Another possible reason is simply that money is coming out of the stock market and these are stocks like any other. Also, all the major gold companies have issues. They tend to have large hedge books and they've had shortfalls in earnings. With gold prices below $300 for so long, companies stopped doing exploration. There was very little mine construction. They mined their higher-grade veins and are left with low-grade reserves, and that is showing up in the production numbers.
Q: But you still see opportunities?
A: We've continued to own the gold stocks. I own 13 gold names right now. This is an industry where you can't just own two stocks. It's a tough business. You are guessing what you've got underground. You are guessing how much work it is going to take to pull it out. You are guessing whether you are going to get cities and states to approve your project. Of course, now we are finding out the reserves are somewhat questionable in certain cases. So you have to spread the risk around. Then there are the production and hedging issues that the big gold producers have. And the larger companies are faced with little to no growth. There are some great little companies -- Goldcorp, Meridian Gold, Agnico-Eagle Mines -- but they've had huge moves in the last year. I'm not sure you sell them in this environment, but it is really hard to buy them. In the end, you wind up going into the smaller names, and that's where you can still find some decent values. But you have to do the research and you have to own at least a handful of them.
Q: What are some of those?
A: The biggest name I'm still relatively excited about is Hecla Mining. Hecla was actually the best-performing stock on the New York Stock Exchange last year. It has historically been viewed as a silver mining company, and silver is about the only commodity that hasn't gone up. But Hecla has made itself more into a gold company. They had a very questionable balance sheet two years ago, but they just completed an equity deal. The dilution from the deal is already priced in to the shares. The stock peaked at $5.90 and is now at $4, so it has come off a fair amount. One of the issues surrounding Hecla is its exposure to Venezuela. They have significant exploration projects there. The mine itself is doing well, but there's political risk.
There are also some real interesting speculative stories. One is Canyon Resources, which has a mine with wonderful potential in Montana. But Montana passed a law that prohibits the use of cyanide, and if the mine can't use cyanide they can't go into production. Cyanide is used in low-grade deposits to separate the metal from the rock. But, obviously, a lot of localities aren't thrilled about cyanide use. To my knowledge, this is the largest known deposit in the U.S. that isn't being permitted. Unless the law changes, they won't be able to get it into production. That's why it is a spec. It recently traded at about $1.30 a share. If the mine were to go into production, Canyon shares are probably worth $10. If it doesn't, you are going to lose half your money.
Q: Why take the risk?
A: There is a movement afoot to return the question of cyanide use to the ballot. There is also a lawsuit at the state level that is being appealed before the Montana Supreme Court, in which the company argues that its production plans were based on the previous law that allowed cyanide use and therefore it should be compensated for its loss. An appellate court ruled against the company. The question is, how much of that decision was based on politics and how much on legal theory.
Q: Let's move away from gold. What else are you attracted to?
A: Typically, two-thirds of my portfolio on both the long and short side come from my macro view of the world. The other third is dedicated to individual value-oriented situations. These are companies with good projects or a good product, maybe they've made a good acquisition, or spun off a losing division or there's been some favorable regulatory change.
We combine that with what we think is good management and a cheap valuation based on price-to-assets, or price-to-cash- flow or price-to-earnings, or all of the above. They tend to be small companies with market caps of $100 million to $200 million, maybe a little bigger. They are companies that tend to be underfollowed by Wall Street. Right now, we have 17 of those in the portfolio.
Q: Give us an example.
A: One that's really interesting is Lionbridge Technologies. It is extremely small, with a market cap of about $65 million. It translates technology companies' Websites into different languages. It also translates customer-support materials and product and engineering materials. It is a $2 stock and they are just becoming profitable.
Q: Are they a creature of the Internet boom?
A: It's a spinoff from R.R. Donnelley. They should make about 15 cents a share in 2003. This trades at about half of sales. The only negative is that they have some net debt. I typically don't like companies with debt, but they are turning profitable and the debt schedule over the next couple of years is fairly low.
Q: So, what kind of growth rate are you expecting Lionbridge Technologies to have?
A: For the year they showed top-line growth of 15% to 17%. But there'll be leverage to the bottom line because it is beginning to turn a profit, and so profitability should increase faster than revenue.
Q: What else?
A: Axcan Pharma. It's a specialty drug company based in Canada with a market cap of $500 million They basically make drugs to treat gastrointestinal ailments. They have their own products. They make acquisitions. They made two at the end of last year, which should be accretive to earnings. I like management and the fact they are focused on the gastro market. They are niche drugs that aren't big enough for the majors to care about. The company should earn 70 cents for the fiscal year ending September and the stock trades at about $11 a share.
Q: What are the prospects for this? Does it stay independent?
A: It will do well independently. But it could easily fit with another small or midsized specialty-drug company with a similar strategy. I don't own it for the merger possibilities; I just think they've done a good job executing. It should be valued $2 to $3 higher. Is it exciting? No. But in this low-return market, if you can make 15% to 20% in a year, that's pretty good.
Q: Anything else?
A: Omega Protein, another small company with a $110 million market cap. It's a play on fish oil. Fish oil is considered to have big health benefits and it is mixed into different foods and juices. It also is a big supplier of fish meal for animal feed. The company went public in 1998 and traded up to almost $20 a share. It was a big growth story back then. It traded as low as $1.50, and I started buying it around $3 a share. It's now trading around $4.50 a share. That's still below book value of nearly $6 a share. Earnings have been rising the past three quarters -- 11 cents, 12 cents, 14 cents -- and the stock is cheap on a price/earnings basis. I was attracted to it because it was a low P/E situation trading at half of book value, and its competition was going away. Lately, it's been moving up in a lackluster market, so that's kind of intriguing.
Q: What about the short side of your portfolio?
A: Again, because of my macro view, the companies I've shorted have been those selling high-end and home-related consumer items. I've been short Polaris, Toll Brothers, Ethan Allen, Tiffany and Mohawk Industries. They have done really well, and that's one of the reasons the short positions in the portfolio only represent 21%.
Q: How about something different?
A: I'm short Northern Trust. They are a trust bank, and you know what's happening to financial assets. But even that has come down quite a bit. It is now around 31.50, down from 40. They earned $1.97 for the year just ended, but their fourth quarter was down from the year-ago period. I am bearish on the financial markets, so that's the play.
This can be extended to things like the brokerage industry. My No. 1 fear is that the market rallies on any resolution in Iraq. You could lose 10% or 15% in some of these shorts very quickly. If you are a student of economic history, this is an absolutely fascinating time, but it is also a very difficult time to try and make money.
Q: Thanks, Paul.
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