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By Yearend, "Investing Long Will Pay Off"

The stock market is on the upswing -- the best evidence of which is that mutual funds are buying again. And it's time to go back to an aggressive growth strategy. Those are among the observations of Pat O'Neil, president of Loring Investment and manager of the Loring Hedge Fund.

O'Neil expects a 33% increase in profits for the technology sector in this quarter, vs. a 30% decrease in the last quarter. And profitability is what he looks for in selecting stocks. The names that have done best for his fund in the downturn include auction Web site eBay and discount retailer Dollar Tree Stores. But he also likes Southwest Airlines, pharmaceutical giant Johnson & Johnson, and a Los Angeles bank, UCBH, that caters largely to immigrants from China -- who have a very low loan default rate.

These were some of the points O'Neil made in a chat presented May 16 by BusinessWeek Online on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff and Karyn McCormack. Edited excerpts from this chat follow. A full transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: Pat, dare we hope that the up days of the market are a harbinger of a better tone?

A: I do think so. It took eight months for the market to recover from 9/11, and the volume we see this week indicates mutual-fund buying.

I expect the next 6 to 10 weeks to continue this upward trend -- three of five days up every week.

Q: Can you give us your definition of a hedge fund, Pat?

A: Typical hedge funds are "shoot 'em up," Wild West-style investing. Being a grandfather, I'm more on the side of "find a good stock, buy it, and if I have to hedge, I will sell part of the position and go to cash." Hedge funds might typically do things like trade currencies, futures, commodities, and options with the idea of making a lot of money in a hurry. That's probably a better example of a typical hedge fund.

Q: What lessons can the average investor take from the strategies you use in managing a hedge fund?

A: My No. 1 qualifier is profitability. Unless the company is making money for the last year, it doesn't get on the desk to be researched. We look at groups of stocks that are showing the most profit growth, and the highest profit growth is in technology. Despite this last year of trouble, technology profits are going to make a 33% gain this quarter. That's above a 30% loss last quarter. And stock prices always follow earnings.

Q: Which groups in tech interest you the most?

A: I like e-commerce, such as eBay (EBAY). The other group that's strong coming out of a bear market is financial stocks. Bear Stearns (BSC) and Citigroup (C) are two of the best in that area.

Q: What stocks have done the best for your fund through the downturn?

A: eBay and Dollar Tree Stores (DLTR), a discounter, have held up the best in the last six months. I like Southwest Airlines (LUV) -- it's the only air carrier to make money for the last 30 years, and so many airline stocks are down that I think this is a good buy.

Q: What are the criteria for investing in a hedge fund? It's beyond the reach of the small investor, isn't it?

A: Yes. Hedge funds are closed to the general public. They're kind of like a private golf club, where rich people throw their money in the pot, and somebody -- in this case, me -- tries to invest it and share in the profits. People can do their own hedge-fund-type investing -- that is, investing for six months or so -- if they just do some homework and look for profitable companies.

Q: You started a new service in January called StockList. Can you tell us about it?

A: StockList is a three-stock real-money portfolio that I opened in my own name. It's actually what I plan to do once I retire -- manage a small three-stock portfolio. My StockList service at my Web site ( lets people look over my shoulder as I manage three stocks at a time. They, of course, can do the same in their own account. I demonstrate for people why I'm buying a stock and why I'm selling it, and then I follow the rules week to week. It has been very successful. In the last four months, we have closed nine trades, winning seven and losing two. We are up 18% or so this year.

Q: What three stocks are you managing now in this fund?

A: The three stocks are open only to the subscribers. But I will tell you three of the trades that we just closed. One was Abercrombie & Fitch (ANF), which we paid $22 for and closed at $29. We also bought Hotel Reservation Network (ROOM), in at $42, out at $51. On the downside, I bought a stock called CGI Group (GIB), which was profitable and everything looked great, but we got in at $7.50, out at $6.50, and it's lower now. So you never know!

Q: Have you had any other big losers recently? In the hedge fund?

A : I've not had any big losers, because we establish the selling rule when we buy the stock -- and stick to it. There was a stock called Craftmade (CRFT) that we bought at $18.10, and at the time of purchase I raised my right hand and said, "If the stock ever hits $15.50, we're out." And sure enough, it went to $15.50, and we took the loss. The key to successful short-term trading is deciding when you're going to sell at the time of the purchase. Then there's no wondering what to do later on. You just have to sell when the stop line is hit.

Q: Does the quality of earnings -- and of the accounting that produces the numbers -- concern you? Didn't Enron scare a lot of companies to stop creative accounting and depress earnings this year?

A: First of all, fake numbers are a grave concern to those of us who invest professionally and to everyone's 401(k). There's no way to assure that the company numbers are right. This is when I go back to investing in the management and not betting on the company. I like Cisco's (CSCO) boss, John Chambers, as a person. And if you read or listen to his reports to shareholders online, I think you'll agree that he makes sense and sounds legitimate.

This doesn't guarantee anything, but it makes me more confident if I believe in the person running the company. I feel the same way about the eBay president, Meg Whitman. I don't think it's the case that creative accounting has hurt the latest earnings reports up and down the line. It was a hangover from the bear market triggered by 9/11 that stopped our economy cold.

Q: With WorldCom (WCOM) being one of the leaders in telecom and having cash to weather the sector's drought, do you see it as a good long-term investment?

A: Yes, I do. If you consider buying WorldCom today for $1.30 a share, this stock only has to go to $2.60 for a 100% return. I don't think it's unreasonable that WorldCom and the telecom group will begin to move in the next six months.

Q: My hedge fund isn't doing too well this year. Is reduced performance widespread this year? What about your fund?

A: Yes, it's widespread -- including mine! Depending on the hedge fund's strategy, I would say, "Was this an environment that my manager should have been successful in?" For instance, if he were selling stocks short, he or she should have had a good year. In my case, we only go long, so I'm not surprised that we have not made any money. I do expect that by the end of the year, investing long will pay off.

Q: What's a fair hedge-fund management fee?

A: They vary, depending on the success record of the fund. But an average fee would be 3% per year, plus 15% of the yearend net profits.

Q: What do you think about using an aggressive growth strategy in this market?

A: I think that right now is the time to turn up the dial on mutual-fund allocation to growth and aggressive growth. These stocks are now getting earnings that exceed expectations, and the number I mentioned before in technology (going from -30% profits last quarter to +33% this quarter) is typical of how quickly the market can change.

Ninety-nine of 100 people are so sick of losing money that they are reluctant to put money in aggressive investments now. However, I think now is the time. I think we've run out of sellers in the market, and we've seen the worst on the Nasdaq index, where the aggressive stocks are located.

Q: You've told us you like the tech and financial groups -- and at least one discount retailer. Any others -- health care and pharmas, for example?

A: Well, I like Johnson & Johnson (JNJ), as they continue to grow their business 15% per year and have made money for the last 17 quarters, right through the bear market and 9/11. There's a small bank in California that I like called UCBH Holdings (UCBH) that specializes in serving the Chinese immigrant market. The people entering the U.S. from China settle and mostly stay in Los Angeles. This bank is Chinese-owned and has a steady stream of new customers. This may be cultural, but they have the smallest loan-default rate in the U.S. I like the stock for about a 25% move in the next year, from $40 to $50.

Another medical company is Quest Diagnostics (DGX). Quest is in a very boring business -- they make and execute medical and lab tests. However, it's very steady, and their profits are growing at 40% per year, and sales are growing at 13% per year. I try to follow the stocks that are attracting mutual-fund money. Most funds will buy profitable, growing companies and hold on as long as the quarterly reports continue to show growth.

Consumer stocks such as Best Buy (BBY) will continue to do well as we come out of the recession and begin a new bull market. If you noticed last week after Sears (S) offered to buy Lands' End (LE), the mutual-fund money rushed into Sears stock, and it's up $5 in the last few days. I think retail stocks will continue to do well.

Q: With corporate spending still not picking up, will the market soon start a downward slide? Do you see revived earnings reviving capital spending, which is something tech really needs?

A: I agree -- tech needs the spending. And instead of my opinion, we're looking at the actual earnings reports, and they are, as a group, exceeding expectations. Cisco exceeded last week, which was the catalyst for this spark in the market. I think if you watch technology earnings reports for the next three months, you will see more upside surprises than we have had in the last year. Again, it boils down to what the real numbers are saying.

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