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Mason Hawkins Adds Leverage by Swapping Dell Shares for Options

Money manager Mason Hawkins increased his stake in Dell Inc. by selling company shares and buying more than twice as many options on the computer manufacturer.

The $8.75 billion Longleaf Partners Fund, managed by Hawkins through his Southeastern Asset Management Inc., sold about 10.5 million Dell shares during the fourth quarter, according to a report filed Feb. 17 with the U.S. Securities and Exchange Commission. Longleaf bought call options that entitle the Memphis, Tennessee-based fund to buy 25 million Dell shares through 2015.

The move permitted Longleaf to increase its bet on Dell, the third-largest personal-computer maker, even as the fund was investing in other stocks and had cash reserves equaling just 3.4 percent of net assets. Because interest rates help determine the price of option contracts, the fourth quarter decline in yields on five-year U.S. Treasuries to 1.03 percent presented investors such as Longleaf with an opportunity to boost potential returns at minimal expense.

“For the man on the street, the attractive points are that you are locking in a financing rate,” said Michael McCarty, managing partner at Differential Research LLC, an Austin, Texas, firm that advises institutions on derivatives.

Longleaf paid $213 million for the options, or about $8.52 a share. By contrast, buying 25 million Dell shares at the stock’s average fourth-quarter trading price of $13.86 would have required a cash outlay of almost $347 million.

‘In the Money’

The fund’s options are known as “in the money,” because they permit Longleaf to buy Dell shares for $7 each, about half their average trading price during the quarter. The premiums for “deeply” in-the-money options, such as Longleaf’s, are determined primarily by prevailing interest rates, McCarty said, whereas options that can be exercised at or above market prices are affected more by a stock’s implied volatility.

Dell shares rose 4.6 percent to $15.83 in New York Stock Exchange composite trading yesterday. The stock has gained 16.8 percent this year and 16.7 percent over the last three months.

By selling Dell stock during the fourth quarter, Longleaf cut its direct stake in the company to 33.8 million shares at Dec. 31 from 44.3 million shares at Sept. 30, according to data compiled by Bloomberg. The purchase of private option contracts, from Morgan Stanley and Deutsche Bank AG, raised its total investment to the equivalent of almost 59 million shares.

7.5% Stake

Southeastern reported a 7.5 percent stake in the Round Rock, Texas, computer company at the end of last year, second only to founder Michael Dell in the number of shares held. That total includes the holdings of the Longleaf mutual funds as well as other accounts managed by Southeastern.

Dell’s free cash flow yield, a ratio of excess cash earned by the company to its market capitalization, exceeded 20 percent last year, making the stock undervalued, according to the Longleaf report. The company has delivered “strong” profit margins and earnings in recent quarters thanks to reduced component costs and renewed corporate spending on computers, Longleaf said.

“By selling a portion of the underlying equity position to pay for very in-the-money options with extended maturities, we secured significant additional exposure to the stock at very low long-term interest rates,” Longleaf said in its report.

Lee Harper, a spokeswoman for Southeastern, declined to comment. Longleaf Partners, which invests primarily in stocks it deems significantly undervalued, has produced average annual returns of 2.6 percent during the past five years, better than 61 percent of funds that follow a comparable strategy, according to data compiled by Bloomberg data.

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