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Hedger with a Cause

When it comes to picking stocks, John Hussman, manager of Hussman Strategic Growth Fund (HSGFX), looks mainly for increasing cash flow. But when market volatility strikes, Hussman, who considers himself a quantitative investor, will hedge to lessen the potential downside.

Hussman currently favors reasonably priced, steadily growing stocks, and in particular likes consumer discretionary, consumer staples, and health-care companies. He offsets his buys by shorting the S&P 100 and the Russell 2000 indexes. He believes his hedging strategy will bring the fund's beta (a measure of volatility) close to zero.

Hussman's approach has paid off despite difficult market conditions. The fund rose 11.7% for the first half of the year, while the average small-cap blend fund fell 6.8%. Last year, the fund gained 14.7%, vs. a loss of 3.2% for its peers. His fund isn't ranked by Standard & Poor's since it has less than three years of operating history.

Bill Gerdes of Standard & Poor's Fund Advisor recently spoke with Hussman about his investing strategy, top holdings, and portfolio moves. Edited excerpts from their conversation follow:

Q: What is your investment philosophy?

A: Our basic objective is long-term capital appreciation with an emphasis on capital preservation during unfavorable market conditions. To determine whether market conditions are unfavorable, we look at valuations and market action.

We look at valuations in relation to the expected stream of free cash flow. We also look at such measures as price-to-book and price-to-revenue, but we're ultimately interested in the cash flows available for distribution to shareholders over time.

With market action, we focus on the divergence of market subsectors from their prevailing trends. We believe that this conveys information. Instead of forecasting the future, we try to position ourselves to be in line with the prevailing market climate.

Q: What's your view of current valuations?

A: Stocks are not cheap by any means. Overall, valuations are near 18 times peak earnings, while the historic norm for price-to-peak earnings is about 14. On average, bear markets have ended at about 8.9 times peak earnings.

Q: How have you structured the portfolio, given that you feel valuations are high?

A: Currently we are fully hedged. We have 100% invested in stocks with an offsetting short position in the S&P 100 and the Russell 2000. We've shorted the indexes to remove the effect of market fluctuations on our stock positions. We're trying to bring our beta close to zero.

Q: What's behind the fund's recent strong performance?

A: The portfolio is up 50% over the last two years, and we've been mostly hedged over that period. Without hedges, our returns would have been about 19% over the past two years. Since inception, the fund's biggest pullback has been less than 6%. So, the vehicles we use to hedge -- basically the Russell 2000 and the S&P 500 -- have worked very well given the day-to-day volatility of our stock holdings.

Q: The fund has had good returns in a difficult environment. How do you think you would do in a rising market?

A: Over the past decade, the stocks I've managed for individual accounts have outperformed every major index, including the Nasdaq. I've also tested our measures of market action for our hedging strategies back to the 1940s, and they have accurately reflected most bull markets.

Q: What kinds of stocks do you currently hold?

A: They are relatively stable with favorable valuations and slower rates of growth. We look more like a blend fund now than a growth or value offering because we focus on stock prices in relation to long-term cash flow.

Q: What are the largest sectors in the fund?

A: About one-third of the fund is in consumer discretionary, including apparel, restaurants, appliances, and shoes. About 10% is consumer staples, such as food and grocers. Our third largest sector -- currently 8.6% -- is health care, to which we're gradually adding. Our largest holdings there are PacifiCare Health Systems (PHSY) and Renal Care Group (RCI) -- two companies that are attractively priced in relation to their expected streams of free cash flows.

Q: What's your view of current market conditions?

A: Right now, widening credit spreads suggest more defaults ahead and slower economic activity than many investors expect.

Q: What's your long-term outlook for the market?

A: For the long-term, stocks are priced for very disappointing returns, less than 7.5% annually for buy-and-hold investors. I think the market will go nowhere in very exciting ways with big declines and big rallies.

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