Our Updated Focus List and Portfolio Leverage Strategies

by: Stephen Castellano

Last Monday we introduced six long and five short "focus list" ideas generated using the same framework as the Ascendere Long/Short Model Portfolio. These ideas serve as good starting points for in depth research as long-term holdings, but they also tend to work in the short-term as well. This week we update the list of focus ideas and share a few thoughts on applying different leverage strategies to our model portfolio.

Focus long ideas outperform, but focus short ideas do better - but in the wrong direction
Four of six focus long stock ideas generated as of the close on March 5, 2010 outperformed the SPX, averaging for a 1.60% return and ranging from -6.41% (NASDAQ:WCRX) to +6.41% (NYSE:UFS). This compares to the S&P return for the week (excluding dividends) of 0.99%.

Only one out of five of the short focus ideas underperformed the SPX, averaging for a 1.80% return, and ranged -2.88% (SMS) to 4.62% (NYSE:DRE). The rally in higher-risk "low-quality" stocks has been a common theme in the markets in recent weeks. Below we explore potential changes in leverage strategies that could mitigate this recent trend somewhat.

New Long Ideas for the Week

Of these new long ideas, we would focus our attention on Macy's, Inc. (NYSE:M), Dick's Sporting Goods Inc. (NYSE:DKS), Ultrapar Holdings Inc. (NYSE:UGP) and the Bank of Montreal (NYSE:BMO). This is because these stocks look like they can sustain their operating momentum for the next few quarters and they are "new" on our list. Put aside for a moment the idea that retailers "shouldn't" be going up, and that they have gone up "too far" already. These stocks are on this list for a reason -- the numbers still look very good. Granted, maybe you will find something you will not like, but do not let conventional wisdom dismiss these ideas outright. At a glance, DKS looks like it has more short-term potential than M right now.

New Short/Contrarian Long Ideas for the Week

We are hesitant to make this list available. Anyone going short this market has been burned in recent weeks, especially those shorting "low-quality" stocks. Our models indicate that Carnival plc (NYSE:CUK), Central European Distribution Corp. (NASDAQ:CEDC) and Martin Marietta Materials Inc. (NYSE:MLM) should all deserve some focus. Activision Blizzard, Inc. (NASDAQ:ATVI) does not really belong on this list -- it is there because our models do not yet adjust pro forma for acquisitions or significant changes in operating structure and this is what has skewed some metrics so it appears on this list. Just another illustration of the fallibility of some quantitative models. CEDC deserves a closer look -- why is this supposedly "low-quality" stock up 30.59% for the year-to-date? What are our factors missing?

Off the "Buy List"

We recall that a few sell side firms downgraded Netflix, Inc. (NASDAQ:NFLX) this past week due to valuation. Interestingly, our models concurred with this move. All that could mean is that NFLX is moving into growth territory, so the stock could move some more. Ross Stores Inc. (NASDAQ:ROST) has also had a good run, but some factors are relatively better compared to some other stocks in the sector. Just because a stock moves off a list does not mean it is always an automatic sell.

Off the "Sell List"

These stocks just do not look as ugly as they did last week. For example, Prudential plc (NYSE:PUK) has already declined significantly; as a result, its relative value is no longer significantly out of line with other Financials.

An alternative leverage strategy would work better in the current environment
If the overall performance of a portfolio is being hurt by "low quality" short positions in a rising market, it seems to makes more sense to reduce these positions, get rid of them completely or even buy them outright instead. Look at the Materials sector, for example. We explored what would happen to our model portfolio if: 1) in a rising market, we went all-in at 200% with 0% short positions; or 2) in a down market, we went 50% long and 150% short. We found the results fairly interesting. Next week we will explore the "buy low quality" strategy.

Underweighting shorts could increase overall performance at the cost of more severe drawdowns
Our original strategy shows a return of 203.65% since the 12/31/2004 inception, including a drawdown of 13% over 7 months in 2009 -- caused by underweighted short positions that nevertheless still caused an overwhelmingly negative impact. In contrast, this new strategy returned 581.98%. Unfortunately, the approach of this new strategy would not be viable for most people. This is because of the more frequent and significant losses that may occur in any given month. For example, the new strategy suffered a drawdown of 14.3% over June and July of 2007, was down 13.56% in January 2008 and down 14.45% in December 2008.

Model portfolio on 10-to-1 leverage illustrates a familiar story from the summer of 2007
The model portfolio using 10-to-1 leverage would have generated a 4,462.28% return -- even after losing 70.63% of the portfolio during the summer of 2007 and regularly experiencing 40% and 50% draw downs in any given month. This high cumulative return was driven largely by 2005 and 2006 results. A new investor at the beginning of 2008 in a hedge fund portfolio would have only realized a 60% return to date, but only after watching the portfolio swing up and down like a rabid starving monkey hanging from a rubber band.

For a pdf of this report follow this link.

Disclosure: None