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Hedging Your Stock Bets

Hedging is a smart strategy to manage the risk in an investment portfolio, but not for speculation. That's the advice of Patrick Adams, CEO of Choice Investment Management, whose Long-Short Fund gives mutual-fund investors the advantages of a hedge fund.

The fund, established in February of last year, is down somewhat but is still ranked sixth in the Lipper Multi-Cap Growth category of funds. However, Adams says Choice's two-year-old private hedge fund has done extremely well. For people in stocks with some downside risk, he recommends shorting similar securities against them, with a loss limit.

Adams generally invests with a growth philosophy, and as the economy recovers, he likes technology, health-care, consumer, and financial stocks -- among them such names as Vitesse Semiconductor, Lowe's, Home Depot, Best Buy, and Household International. He's nervous about biotech -- a sector he sees best for shorting -- but does hold IDEC Pharmaceuticals. Pressed to say what one stock he might buy now, he picks Tyco International, which is proposing to break itself into four parts. He thinks some of the parts could be worth as much as double the current stock price.

These comments from Adams came in a chat presented on Mar. 14 by BusinessWeek Online on America Online, in response to questions from the audience and BW Online's Jack Dierdorff and Karyn McCormack. Following are edited excerpts from the chat. A complete transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: Pat, what's your analysis of this somewhat choppy market? Is it recovering for sure, as we hope the economy is?

A: I believe the market is recovering. It's our opinion that earnings growth will rebound for the next 12 to 24 months and should drive the market higher, but we think it will continue to be a choppy market, as interest rates appear to have bottomed on a long-term basis.

Q: What do you use as criteria to buy or sell stocks?

A: We are growth investors and focus on high-quality companies that are gaining market share within a fast-growing sector of the market. And we also incorporate a valuation discipline to make sure we're buying these securities at a reasonable price.

Q: What are your top or favorite holdings right now?

A: Our top sectors in general are technology, health-care, consumer, and financial stocks. We're taking an approach to being more cyclical, so we're looking at companies that are more sensitive to economic growth. A few of our favorite stocks are Lowe's (LOW), Home Depot (HD), Best Buy (BBY), Household International (HI), and we also like the semiconductor group a whole lot. Our favorite company there is Vitesse Semiconductor (VTSS).

Q: Are your buy/sell criteria any different for the Long-Short Fund? What have been your recent moves there?

A: Our buy/sell criteria are the same on the longs. We tend to have a more active style in this fund, more trading-oriented, and obviously we have shorts in the portfolio, which are companies that we believe have fundamental issues or are extremely overvalued.

Q: Among the retail stocks, what about Target (TGT)?

A: I like Target a lot as a company, and we've owned it in the most recent past. However, we believe the stock is expensive relative to its growth rate, and we would prefer to own other stocks in the retail group. We also believe Wal-Mart (WMT) is very expensive relative to its growth rate. We do like Family Dollar Stores (FDO), Abercrombie & Fitch (ANF), Barnes & Noble (BKS), and we're also starting to take a look at Gap stores (GPS).

Q: If I owned a lot of Target already, would you recommend I sell or hold?

A: I would recommend you possibly trim back some of the position, or what you could do is short-sell Wal-Mart against your Target position on a short-term basis to help hedge out any downside risk in the security. Target is a very well-run company, and we believe it is a long-term holding.

Q: Do you like any Internet stocks? And would you buy eBay (EBAY)?

A: We don't own any Internet stocks at the present time. eBay has definitely been a winner in the group. At some point in time, the group will reemerge, but never to the same extent that it once was.

Q: Some important fund managers still like WorldCom (WCOM). What's your opinion?

A: That's funny -- "still like"! We're starting to buy WorldCom now, given its extreme low valuation. We believe it is clearly a winner in the telecom space, as it is consolidating rapidly. We believe the company is solvent -- therefore there are no balance-sheet issues. They have a great franchise in the data sector of telecommunications, and either the stock will come back on earnings growth or a regional Bell would love to acquire it. We bought some today!

Q: What about biotech stocks?

A: We believe the opportunity is more on the short side of biotechnology, given that when companies miss bringing product to market, most of them eventually go bankrupt. We believe that there has been a lot of funding of biotech companies that will not make it. There are a few that we like. The one biotech company that we own currently is IDEC Pharmaceuticals (IDPH).

Q: How has your hedge fund fared in the turbulence of the markets since the tech stocks peaked out?

A: We have a private fund -- therefore not open to the public -- that started two years ago, and it has done exceptionally well. We were able to take advantage of the big correction we had during the last couple of years. We also opened to the public a Long-Short mutual fund in February, 2001. The first 12 months of operation, the fund was down slightly. However, it was still sixth out of 455 funds in the Lipper Multi-Cap Growth category.

Q: What is your net exposure? What are total assets in your fund, and is it tougher to add "alpha" now?

A: That's a smart investor! Net assets in the fund are currently $44 million. Our long exposure is 44%, and our short exposure is 35% -- therefore we have 9% exposed to the market currently. It is more difficult to add alpha now, given that the market doesn't tend to move in a particular direction for very long -- therefore, you have to be much more nimble and careful in this market.(Alpha is the excess return generated on a security vs. just its normal volatility, so alpha is basically a measurement of how good a stock-picker a portfolio manager is.)

Q: Any thoughts on EMC (EMC) and the storage sector?

A: Yes. I just talked to the company today. The read I got was that the quarter is back-end-loaded. As usual, the management doesn't understand some of the concerns regarding the quarter. I believe the stock is very attractive on a long-term basis. However, regardless of what the management told me today, I think they will have a tough time making the quarter and would look for them to either preannounce over the next couple of weeks or else have a very sloppy quarter when they report it. This would provide a better opportunity to purchase the stock, and we would do so at that time.

Q: If you had to buy a single stock tomorrow, what would it be?

A: That's a tough question! Let's see -- it's a lot easier owning 30 names than it is one. I would say the stock that has the most potential over the next six months is Tyco International (TYC). As you know, it has been in the news a lot regarding accounting issues. We believe there aren't any, and we like many of the businesses that it's in.

Breaking up the company into four pieces, as it discussed, we think will unlock a lot of unrealized value. The stock is selling for only 10 times earnings. We believe some of the parts could be worth as much as double the current stock price.

Q: What's your advice for an average investor wanting to hedge (aside from your fund)?

A: My advice for the average investor is, seek a professional. If you choose not to, I would not do it to speculate but do it to help manage the risk in your portfolio. I'm from Denver and have seen a lot of wealth destruction from companies around town such as Qwest (Q), Level 3 (LVLT), AT&T (T), Lucent (LU), etc. Many of the people who own these stocks, in my opinion, could have shorted a similar security to protect their downside.... I would strongly advise using a loss limit on any shorting you do.

Q: Ford (F) -- would you buy at 15?

A: Yes, I would buy Ford at $15. We have owned the stock recently and would love to buy it back on a dip. I believe that this is a reasonable price to buy it. We think the auto sector is turning like the economy, and thus far I'm very happy with the most recent change in management. If the economy does improve for the next two or three years, the stock could easily double.

Q: What about the the travel/leisure area?

A: Without question, the hotel and leisure sector is coming back very nicely. I was very surprised to see the magnitude of the earnings surprise tonight out of Royal Caribbean Cruises (RCL). I plan to take a closer look at that stock tomorrow morning to see if there's more upside potential in it.

Q: What is your short- and long-term prospect on the health-care industry?

A: Our long-term prospect is that it's a great place to invest. Our near-term prospect is that it's going against the economic trends that we believe will unfold over the next 6 to 24 months of seeing an improving economy. Therefore, earnings growth will likely be more dynamic in other, more cyclical sectors of the stock market. We did mention that we believe the biotech group has many opportunities to short securities. A couple of our favorite long ideas in health care are McKesson (MCK), King Pharmaceuticals (KG), Pfizer (PFE), and IDEC Pharmaceuticals.

Q: Any quick final advice for us, Patrick?

A: Be patient. The stock market will improve. However, we're never going back to the old days, and I would encourage people to both look at the risk in buying a security as well as the potential returns.

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