The Prudent Bear Smells More Honey

David Tice's short-selling fund scoffs at the Street's recent rallies. Stocks remain overvalued, he says, so further declines are certain

While many investors hunt for bargains amid the market rubble, David Tice is betting that stocks will keep dropping. His $300-million Prudent Bear Fund (BEARX ) is designed to go up when the market is going down, and things have been going his way for more than two years.

Tice's specialty is selling stocks short, meaning that he borrows shares, sells the shares at a high price, and buys them back more cheaply when they fall. Tice also buys put options, which are contracts giving the right to sell a stock at a certain price in the future. Investors who own put options pay a premium for the right, expecting that stock prices will fall. While Tice does take some long positions, the fund has much more short exposure.

The fund's performance has earned it a 5-STARS S&P overall rank. Through July 30, the fund returned 55.2% this year, while the Standard & Poor's 500 Index lost 21.4%. Prudent Bear topped the index in each of the last two years as well, returning 7.4% in 2001 and 30.5% in 2000. The market index lost 11.9% and 9.1%, respectively, in those years.

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

Q: Given the nature of the fund, what was your reaction to the market's surge yesterday? (on July 26)


That was a short-squeeze rally. There are intense rallies inside bear markets, and so it didn't surprise me. It doesn't change my view.

Q: I take it you don't think stocks are out of the woods yet?


Not at all. This has been a stock-market and economic bubble, and a ramification of a stock market bubble that breaks is a bear market that will last a long period of time. The market is still selling at 30 times earnings, and many Nasdaq stocks are still selling at seven times sales.

In addition, we have an economy that is dramatically over-leveraged on the consumer and on the business side. We've had a small recession and, unfortunately, we're going to have a much worse recession.

Q: Why will it worsen?


There's overcapacity throughout businesses and we have a falling dollar that we think is going to continue to fall.

Q: Have we seen the last of the corporate accounting and governance scandals that have hurt stocks?


They're going to be around for a long time. That's consistent with our view that what we had was an environment where the most reckless, aggressive executives were promoted, and they pulled out all the stops to meet earnings-per-share expectations so that momentum stock investors could continue to buy their stocks.

Q: What do you think the price-to-earnings ratio for the market should be?


Generally, about 15. That's been the long-term average multiple of stocks over the last 100 years or so.

Q: Can you summarize how the fund works?


We were set up to make money in a down market. We primarily sell stocks short and we own put options. We have a team of analysts that help us analyze balance sheets, income statements, cash flow statements, and real estate investment trust footnotes.

Q: What size companies do you buy?


On long positions, we typically buy companies with market caps of under $300 million. On the short side, we're all over the map. We have about 150 short positions right now, and about 50 long. That's typical. That number of stocks gives us diversification. I can't talk about the largest holdings, however.

Q: How are the fund's assets allocated right now?


We're at about 50% in short positions. That's a little lighter than normal, because we had been expecting this rally. Put options account for about 7% of the fund. These wind up creating a synthetic short position of about 30%. We're at about 15% long and about 25% in cash.

Q: What's the breakdown for your short positions?


That varies based on the market environment. We are heavily short financial stocks (banks, credit card companies, brokerage houses). We're also short a number of technology companies that we believe are still dramatically overvalued. Even though there's been quite a correction, we have a long way to go in that area.

Q: What helped your performance in the second quarter?


Obviously, the fact that we were short when the market was going down. That helped the most. Gold stocks also helped. Being short technology and telecommunications stocks at the right time helped, too. Financial stocks have also helped us a lot in the last month.

Q: What do you like about gold stocks?


Gold normally does very well at the tail end of a pierced bubble. And we think gold will do very well in either an inflationary or a deflationary environment.

Q: Where do you see tech and telecom stocks heading in the short term?


Lower still. Stocks are still too expensive across the board and expectations are too high.

Q: What about spending on information technology?


It will be lower with corporate profits going down and, technologically, companies don't need to buy new PCs.

Q: What do you do to boost the fund's performance when the market's going up?


We buy some call options. We reduce our short exposure. Our long positions don't necessarily work when the market's going up, so we don't necessarily increase them.

Q: Who is a fund like yours suitable for -- what kind of investor?


Really anybody. The fund lets people reduce their exposure to the market, and by cutting risk and being less long -- by having short exposure -- you essentially set yourself up to make less money if the market goes up, but to lose less money if the market goes down.

Q: How do you feel personally when stocks drop?


We're sad for our friends and family and naive people that are being hurt by this market decline, so we are never gleeful about it.

    Before it's here, it's on the Bloomberg Terminal.