Mike Shinnick on Finding the Best Valuations

by: Benjamin Shepherd

Although this newsletter focuses primarily on long investment ideas, short positions can boost profits in both bull and bear markets. And after last year’s market rally more investors are looking for short ideas. For this month’s interview we sat down with Mike Shinnick, portfolio manager of Wasatch-1st Source Long/Short (FMLSX), whose adept management of long and short positions ranks the fund in the top 7 percent of Morningstar’s Long-Short category.

You take a value-approach when constructing the fund’s long portfolio. In which sectors are you finding the best valuations?

Health care is somewhat of a contrarian play. Although these companies are executing well, multiples have contracted because of concerns about health care reimbursements and legislative change.

But demand for health care remains strong--it was just a question of which business models would be able to maintain prices or at least benefit from increased volumes. Our strategy targeted companies with strong businesses whose stocks traded at a discount and niche names that would grow regardless of developments at the macro level.

We took advantage of opportunities to buy some of the more established names that resemble consumer staples.

Along these lines, we’ve owned Johnson & Johnson (NYSE: JNJ) for a few years and bought shares of Medtronic (NYSE: MDT) in the third quarter of 2009. Medtronic is a high-quality company with a strong balance sheet and good business model. Its growth rate has slowed, but it’s a great buy whenever it trades at less than a market multiple. And both stocks offer decent dividend yields.

That’s also the story with St. Jude Medical (NYSE: STJ), which we bought after the stock got roughed up because the top line was off a bit. That didn’t faze us--there’s real demand for the company’s cardiovascular products.

One niche health care name that we like is ZOLL Medical Corp (NSDQ: ZOLL). The stock has doubled since we bought it last year. The company operates three business lines, one of which is a bit of a staple--the other two provide a growth kicker. ZOLL manufactures defibrillators for hospitals, emergency vehicles and public spaces such as schools, airports and malls. These products serve an important, lifesaving function and have a finite life span because the batteries lose their charge over time. When we picked up the stock, concerns about constrained spending at hospitals caused a selloff. But we noted that demand was simply deferred--not disappearing.

And the company’s other two businesses offer attractive growth prospects. One is the LifeVest, an external device that functions like a pacemaker. Patients who suffer a heart attack are at the highest risk in the subsequent two months, but that’s also the riskiest time to perform surgery. LifeVest isn’t intrusive, giving the patient time to stabilize before a pacemaker is installed. Auto-Pulse, on the other hand, delivers regular, consistent compressions automatically--far preferable to manual CPR. Evidence suggests that this technology increases survival rates when transporting patients to the hospital.

The fund also has an overweight position in the energy sector. What are some of the stories you’re tracking in that space?

Offshore drilling was a theme that worked last year, and we expect this play to gain momentum in 2010. If you’re looking for value in this market, many of these companies have price-to-earnings ratios under 10 and solid balance sheets.

Some of my favorite names are Noble Corp (NYSE: NE), Ensco International (NYSE: ESV), Transocean (NYSE: RIG) and Diamond Offshore Drilling (NYSE: DO), which we own through a position in Loews Corp (NYSE: L).

The investment thesis behind offshore drillers is simple: A third of the planet is covered with land, and the remainder is water. When it comes to the debate about peak oil, I take the middle case: Oil is out there but we’re running out of the cheap stuff. On land, oil producers are sinking ever-deeper wells and drilling horizontally. Today’s oil finds are complex to produce. Technology has extended the search for oil into deeper waters--oftentimes four to five miles beneath the surface and seafloor. National oil companies and the industry’s major players need to go offshore to find oil, and these massive, long-term projects don’t shut down based on variations in the price of crude. Deepwater drilling activity even held up in fall 2008.

Pipeline operators are another group we like in the energy space. Our position in Loews Corp provides exposure to Boardwalk Pipeline Partners (NYSE: BWP), and we also own Plains All American Pipeline LP (NYSE: PAA) and Spectra Energy Corp (NYSE: SE). Relative to other businesses in this area, energy infrastructure is somewhat boring; pipeline operators collect recurring fees that are independent of natural gas prices. But these stocks offer impressive dividend yields.

What’s your take on financial stocks? I notice your fund has both long and short positions in this sector.

I’ve been relatively bearish on the financials; the sector accounts for the fund’s largest short component.

Loews Corp, the holding company that owns stakes in Diamond Offshore and Boardwalk Pipeline Partners, is our largest long position in the financial sector. It also controls roughly 90 percent of CNA Financial Corp (NYSE: CNA), a property and casualty (P&C) insurance firm whose shares trade at two-thirds of its book value. We find the firm does a much better job of asset and liability matching than a bank. This value proposition prompted us to add a position in the company itself. CNA’s investment portfolio was under pressure in late 2008 and early 2009, which prompted the firm to issue 1.25 billion worth of preferred shares that it sold to Loews at a 10 percent coupon. The insurer raised capital in the fall at 7.35 percent, and the firm used some of the proceeds to redeem the aforementioned preferred shares. The company’s investment portfolio has also appreciated over the last two quarters because of the recovery in credit markets.

The Allstate Corp (NYSE: ALL), which specializes in P&C insurance for consumers, is the fund’s second-largest position in the financial sector. Allstate doesn’t necessarily offer extraordinary growth prospects, but demand for auto and homeowners insurance should continue independent of macroeconomic developments. Management has worked hard to reduce its exposure to mortgage-related assets, and the company appears well-positioned to take market share from financially strained competitors and mom-and-pop operations.

How do you identify opportunities on the short side?

Identifying profitable short positions doesn’t involve looking for accounting fraud or companies that could go bust; rather, I look for companies whose share prices are overvalued and likely to decline. These bets are a way to make money--it’s not a judgment on the underlying company. You don’t have to be negative on a company to profit from a short position.

For example, last year one of the fund’s largest short positions was in ExxonMobil Corp (NYSE: XOM)--a great business with a healthy balance sheet. That being said, the company wasn’t replacing its reserves aggressively, choosing instead to pull back the throttle on exploration and allocate more capital toward share buybacks. These investments made me question why the stock commanded a premium to the energy group and its subgroup--size and perceived safety only go so far. Although the price of oil doubled last year, shares of ExxonMobil were down 13 to 14 percent while we were short.

In the financial sector, we’re shorting companies whose business models are under deflationary pressure. Real estate investment trusts (REIT) are a capital structure play with favorable tax advantages. But real estate prices are flat or declining across various asset classes, and REITs’ debt levels are inherently high. Add occupancy pressures and falling rents to that equation.

I was short these companies in 2008, and they cracked hard in the first quarter of 2009. I reloaded in the second half after harvesting profits. Some of these names have headed higher than I had anticipated based on perceived strength. Although I applaud these companies’ efforts to issue debt and equity, these moves have solidified the position of bondholders and diluted future equity returns. REITs will be under pressure until there’s a case for rising commercial real estate asset prices.

It’s almost become cliché, but we’re short consumer discretionary names. Even though the economy is in recovery, higher levels of unemployment and underemployment don’t bode well for consumer spending. And US households need to allocate more money to servicing their debts. Income growth has also stagnated. I expect consumers to focus on needs as opposed to wants. In general, we’re shorting specialty retailers that sell items that Middle America doesn’t need--for example, towels or bedspread covers.

Disclosure: No Positions