One of the most frustrating things about working as a private equity investor is being structurally committed to a “long-only” outlook. To be successful in any market, it is equally important to understand both the trends that will make you money and those that will lose you money. However, investors working in private equity – and most mutual funds – can only profit from the former. In my opinion, this is one of the larger challenges to the long-term success for each of these industries.
Restrictions on capital flexibility limit intelligent investors’ ability to generate profit (and preserve capital). For example, even if a great investor like Bill Miller had been prescient enough to foresee the entire financial crisis ahead of time, the best strategy he could implement would be to sell off his entire portfolio and move into cash equivalents. His returns would be market-beating, but they wouldn’t even exceed those of his checking account.
While empirical data and luminaries like David Einhorn of Greenlight Capital support a net-long investment strategy, today’s markets require a rethinking of this practice. Global growth is slowing to a crawl and the dominance of the United States is shrinking with the evolution of the BRIC countries and others. At this point, it is equally risky to assume a situation with continued growth of the stock market as one in which it oscillates upwards and downwards with the prevailing economic environment.
For these reasons, I have attempted to keep my portfolio close to market neutral. It has served me well, particularly over the past year, as many net-long portfolios were destroyed. Additionally, many of my positions are “pair trades” that seek to profit from relative valuation disconnects between companies in similar industries.
For example, say you were a fan of Google (NASDAQ:GOOG) 6 months ago at $560.90 (don’t be embarrassed, many people were). If you had simply bought shares in the open market, you would be sitting on a 54.1% loss. If you had instead hedged your long with a short position of equal size in Yahoo (NASDAQ:YHOO) at $27.00 on the same day, the net position would be up 8.1%. Clearly, the upside of the pair trade is more limited than a simple long position, but as you can see, the downside is quite significantly protected.
In the oscillating market that we are now in, relative value and market neutral investment strategies offer investors a way to continue to profit without exposing themselves to extreme volatility, sector-specific weakness, and the macroeconomic winds of change.
Below is a list of 5 long/short pair trades, 3 longs and 3 shorts that I recommend to begin building a better-protected, market neutral technology portfolio. I hope to write in detail about each, but I’ve included my basic thoughts to get your brains whirring. I’ve tried to pick pairs from a diverse array of technology industries to not become over-focused on any.
- Why: Nascent search monopoly; secular shift to online advertising; market expansion; strength in mobile; valuation; growth
- Why: Lack of direction and innovation; fading search share; weak online display market; overstated M&A potential
- Long: Google
Long: Priceline (NASDAQ:PCLN)
- Why: Counter-cyclical should benefit from consumer bargain hunting; strong free cash flow; valuation; competitive positioning; relatively lower U.S. exposure
Short: Orbitz Worldwide (NYSE:OWW)
- Why: Highly levered; losing share to Priceline and Expedia; high exposure to U.S. market
- Long: Priceline (NASDAQ:PCLN)
- Pair 3:
Long: Research in Motion (RIMM)
- Why: New product cycle not fully appreciated – particularly the Blackberry Storm; valuation; strength in enterprise; international expansion
Short: Palm (PALM)
- Why: Weak product cycle – particularly weak Centro momentum and limited new Treo uptake; difficult financing environment; poor fundamentals; competition
- Long: Research in Motion (RIMM)
Long: Citrix Systems (NASDAQ:CTXS)
- Why: Prime beneficiary of secular shift to distributed computing; clear ROI; well-positioned product lines; valuation; acquisition target; growth
Short: SuccessFactors (NYSE:SFSF)
- Why: High churn masked by customer acquisition; poor operating expense management; competition; soft end-market
- Long: Citrix Systems (NASDAQ:CTXS)
Long: EchoStar (NASDAQ:SATS)
- Why: Technology leadership in DVRs; market discounts value of STB and IP; high free cash flow; strong balance sheet; strong management team
Long: Omniture (OMTR)
- Why: Limited competition; large technology leadership; high product ROI; strong management team; market growth; valuation; M&A candidate
Long: Microsoft (NASDAQ:MSFT)
- Near monopoly in many core businesses; high ROIC; strong balance sheet; favorable product cycles; finally beginning to embrace SaaS
Short: Nortel (NT)
- Why: Potential bankruptcy; high burn rate; soft end-markets; poor management
Short: Intuit (NASDAQ:INTU)
- Competition in SMB accounting software; freeware competition in consumer tax software; poor on-demand strategy
Short: Overstock.com (NASDAQ:OSTK)
- Why: Potential fraud; poor management team; weak economy; deteriorating fundamentals; hedge for eBay ecommerce exposure
- Long: EchoStar (NASDAQ:SATS)
Disclosure: Author holds long positions in GOOG, RIMM, EMC, SATS, CTXS and short positions in YHOO, SFSF, PALM, VMW, OSTK