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Neutrality Pays

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An Interview With Neil Druker ~ Geology inspired the moniker of Boston-based Pangaea, a money-management shop with $200 million. Founded almost seven years ago by Peter Homans, a former research analyst at Zweig Partners and Friess Associates, its market-neutral approach to investing in technology issues is equally rock-solid: Don't lose money. Since inception, Homans and his partner, Neil Druker, have delivered on that promise and more, returning 23% a year, on average, before fees. What's especially impressive is that half of those gains have come from the short side. So far this year, the two have steered clear of the storm that has hit the markets, and they have provided their clients with a gain of 23% through last week, again before fees. That follows 1999's gain of just over 40%. Druker, a former McKinsey & Co. consultant and researcher at Montreal's Pembroke Management, chatted with us last week about how the two "keep the market out of the equation." Please listen in.

-Sandra Ward

Barron's: Yours is a technology fund with a twist. Explain, please.
Druker: By design, we take the market out of everything we do and tend to be very neutral. We've certainly kept up with the market, but have done especially well when the market goes down. In retrospect, not using super huge leverage and going long Nasdaq probably wasn't the smartest choice. Our strategy isn't going to make us the most possible money, but we would never be fully comfortable with a strategy that wasn't going to protect on the downside. A lot of our own money is in the fund and our investors have lots of other opportunities to get long the market. Not a lot of people are offering them an opportunity to make money regardless of what the market does, which is essentially what we promise. We try to keep exposure close to zero. Most of the time we are within 30% of net neutral in total exposure. The sum of our positions don't typically exceed 100%. We might be 60% long and 40% short. Equally typical would be to go 60% short and 40% long, which would get us to 20% net short. When we are short we are very short. We can be as much as 40% net short but that would be an extreme position for us and we tend not to take really big swings on the exposure scale because we don't want to end up making a market bet. So we tend to have about as many longs as shorts, both in number and in total exposure.

Q: How many positions tend to be in the portfolio?
A: Between 25 and 30. On that front, we tend not to take very big positions in any one stock. We limit each position to a maximum of 5% -- and that's only if we really love a stock. There may be an occasional occurrence when we let something rise to 10%. But that would be a rare event. We try not to be in anything that is particularly small-cap. It's important to us to be able to trade our positions. That's another thing we do differently. Not to say we don't have long-term holds, but for lack of a better word, we do dynamic hedging, which means basically that if our positions start to go against us, long or short, we start to get smaller. There is a fairly common short-seller's disease, particularly in technology stocks, in which stocks going against you become more attractive and probably a better short because, the thinking goes, there is all that extra potential energy built up. That makes us uncomfortable. We get smaller, and that tends to keep us out of trouble -- especially shorting technology stocks, because they can go crazy and shoot straight up. If you can't get out of the way, you can get carried out. It's very important to overlay everything we do with this trading strategy because it keeps us out of trouble. We describe it as going where the pain is and trying to minimize it.

Q: Sounds like a reverse momentum strategy.
A: In the trading sense it is. We are never so arrogant as to believe we know the reason why a stock went down. If the market is trying to tell us something, we listen to the cues. That has been one of our key success factors. We don't just look at the fundamentals of companies, but whether or not the market is paying attention to them. In the two periods in the last few years when the market has gone straight down, we have gotten an early warning that it was likely to happen by the way our "good news" stocks were behaving. Which is to say they weren't behaving very well in the face of good news. Just recently, in March, we had what we call "canaries in the coal mine": individual stocks we look at every day that reported great numbers yet didn't behave right afterwards. That told us something was amiss in the market. And that's when we tend to be very cautious.

Q: What's your approach to picking stocks?
A: We are very fundamentally driven. We tend to look for surprises. Particularly in tech stocks, surprises allow us to get paid quickly because the stocks move violently. Assuming the market is benign when companies report good numbers, the stocks get moving because small changes in revenues -- especially in software stocks, where we spend a lot of our time -- translate into very large changes in operating earnings. If we can focus on those cases where we have particularly good information and insight into how a company is likely to do, and it's materially different from what the consensus thinks, we can get reasonably sized-up for that event and then get out, having been paid nicely.

Q: And on the short side?
A: What we do on the short side is very different from most short-sellers. Valuation alone isn't enough for us to get involved in a short. So we don't spend all our time looking for really expensive stocks -- in the past five years that has proven to be a recipe for going out of business quickly. What we look for is a stock that is going to disappoint and hopefully is also overvalued. So it's the catalyst we look for first, and that is much more important than valuation.

Q: Some say it's become a lot tougher to ferret out surprises because the market is so much more efficient. What's your thought on that?
A: What we do is marry classic investment research, talking to the companies, going to the conferences and the trade shows, talking to suppliers and competitors and employees and former employees and doing all the legwork that needs to get done for good due diligence, to what we consider to be proprietary sources of information. This is not a scattered approach. We try and stay focused on the areas where we have informational advantage. In the aggregate it may be true that it has gotten harder to get information ahead of others, but in our areas, thankfully, that hasn't been the case.

Q: In what areas do you have an informational advantage?
A: We tend to do pretty well in the subsector of semiconductors having to do with memory. We do well in telecom equipment and enterprise software. We expand our circle beyond that to make sure we are aware of greater trends going on in the industry. A lot of people we talk to aren't even in the U.S.

Q: Are there areas you won't participate in?
A: We haven't been able to add much value to what would be called classic business-to-consumer Internet plays.

Q: Such as?
A: The Amazon.com s, eBay s, CNet s, AOL s. That kind of stuff hasn't allowed us to get any information advantage. We are aware of the trends because they affect so many of the places we're in, but we haven't played them very aggressively.

Q: So, how's your portfolio structured now?
A: We have 12 longs for about a 35% gross long exposure. We trade fairly actively, so this can change pretty quickly. We have 13 positions on the short side, for about 40% gross short. We are about 5% net short. We are 25% in cash because the market is very murky right now and we don't feel the need to make any strong bets here. We are happy to be less than fully invested if we don't have anything extremely pressing from a fundamental point of view.

Q: Do you care about the macro environment at all?
A: Only to the extent that it affects the fundamentals. Otherwise it just becomes interesting intellectually because it isn't likely to affect the portfolio. One of the reasons we were small on the long side in the summer of '98 was because the fundamentals had deteriorated pretty dramatically for most of the companies we looked at.

Q: We're in a period of rising interest rates. Doesn't that affect your technology holdings?
A: That's where we get back to the canaries in the coal mines. To the extent that companies were reporting great quarters -- Vignette reports a great quarter and goes down, Ariba reports a great quarter and goes down, two software companies doing fantastically well but their stocks didn't get going -- that tells us the macro environment is causing people to behave differently than what we would have anticipated. That is when we tighten up on the long side. We do not sit around and say, "Hey, another 50 basis-point move means we have to shave this much exposure out of the portfolio."

Q: What's in store for the rest of the year?
A: Because we're not making a long-term bet on any of our names, but rather catalytic kind of bets, we care how companies will do relative to expectations and whether people will care how they do. While the macro picture tends to affect the "will people care?" part in the short term, in the long term we do our due diligence so constantly on our companies that hopefully we will be on top of any changes to business fundamentals regardless of our macro point of view. It's much better for us to react than to predict. That said, we have told our clients that March felt as if we were on the Concorde flying from New York to Paris when one of the engines got knocked out and we got thrown around the plane and hit our heads on the overhead bins. It was rough and we lost a lot of altitude very quickly, but the plane stabilized and now we are flying along on a lower level. But it is clear that we are never going to be flying as fast or as high as we were when we had two engines working. The fundamentals are still good for a lot of the companies we look at and, in many cases, it has never been better. But we still have only one engine and I would be reluctant to get real bullish. You could probably get a bull market going again when one of two irritants is out of the way: the Fed or accelerating inflation. Right now, we are seeing such a drying up of liquidity, everybody's job is a little bit tougher.

Q: Still, you do well in bear markets and declines.
A: In any kind of major drop in the indexes we have made good money. In the summer of 1998, from June to August, we were up 15% and the market was down 15%. From December to February of this year, we were up 17% when the market was down about 7%. That is not to say we are great short-sellers or we are not going to participate when the market goes up, because clearly we can. It is to say we are going to try to be uncorrelated. We actually don't care. For all we care, this could be the Zimbabwe stock market.

Q: I think you might care if that were the case.
A: You're probably right.

Q: What sectors of technology are you more bullish on right now?
A: Broadly speaking, the semiconductor space has continued at full throttle. What we're seeing there is order rates, backlogs and revenues not just accelerating but doing better than what analysts have been expecting. That corresponds to better semiconductor capital-equipment performance, as well -- the AMATs and the Paradigms of the world. There has been a noticeable absence in semiconductors of the kind of panic selling that has hit most tech stocks the last couple of months. That's good news and bad news. It's good news because we have been long a lot of them. The bad news is we may be in the process of building up expectations that can't be sustained. My guess is that over the next six to 12 months, our exposures in semiconductor names will probably start shifting to the short side from the long side.

Q: How about one you still like?
A: Alliance Semiconductor . They make memory products, SRAM and DRAM, used in cell phones, PC servers and Internet infrastructure in both computers and communications. They sell to 3Com and Lucent and those kinds of folks. A lot of their competitors, like Cypress , are capacity-constrained right now. That is providing those who aren't with a lot of upside potential.

Q: Isn't everybody outsourcing?
A: Alliance is in a unique position. They have a meaningful ownership in a fabricating plant in Taiwan called UMC , which gave them the right to book capacity in advance. That's the reason they made the investment; they anticipated the potential shortage. Its earnings are in the process of exploding as average selling prices rise and gross margins expand. What else is interesting about the stock is that it has got more than its current stock price in the value of its portfolio of publicly traded shares.

Q: It has a venture-capital side to it?
A: It has 850,000 shares of Vitesse , a $59 stock. It has 283 million shares of the UMC fab, whose ADRs trade at $3.50 a share. It has 2.1 million shares of Chartered Semiconductor , whose ADR trades at 67. It has 490,000 shares of Broadcom at $174. The total value of the investments is around $1.25 billion. With 43 million shares outstanding that's about $29 in value in the investments alone. Yet Alliance is trading at 19 1/2 a share. That's fine and well, but in and of itself it would not attract us to the story. We care about surprises. They have little analyst coverage, their current backlog is $74 million, which is about two quarters worth and double the last quarter's. They are going to see sequential revenue growth of 20%. The consensus estimate for the calendar year is 44 cents a share, and we think that's laughably conservative. My guess is they come in north of 60 cents a share. If you get any kind of reasonable multiple, and we're not talking about a bull-marketcrazy semiconductor-multiple but, say, 25 times something that is growing, that 60 cents a share gets you $15 on top of the asset value of $29, and you get an incredibly conservative operating business valuation of $44 a share.

Interview, Part 2