Peter Power/The Globe and Mail
Hedge fund manager David Picton is bullish on North American stock markets over the next six to 12 months, after which he expects the party will lose steam, big time.
"We are going to continue our rally, but it's going to be choppy," suggested Mr. Picton, a co-founder of Toronto-based Picton Mahoney Asset Management Inc.
The recent sharp rally has been surprising given the uncertainty surrounding government stress tests of U.S. banks that could force some of them to raise capital, the 44-year-old manager said in an interview.
Since their early March lows, the S&P/TSX composite index has surged more than 32 per cent, while the S&P 500 index has climbed more than 34 per cent.
"A total of 50 per cent off a market bottom would be very consistent with previous bear market rallies," said Mr. Picton, who also manages the Synergy mutual funds for CI Financial Corp. "So there is 10- to 15-per-cent upside over the next six to 12 months."
Despite the market carnage over the past year, his $242-million Picton Mahoney Market Neutral Equity Fund has gained 8 per cent for the year ended April 30, compared with a 33-per-cent loss for the broader Canadian market.
Mr. Picton screens for stocks with strong earnings momentum and positive changes, and uses the opposite criteria when looking for stocks to short.
What will drive the market and then cut off the momentum?
I believe that there will be a foundation from very good economic data combined with pretty good valuation in the stock market, and massive amounts of money that is sitting on the sidelines. Just when we start to get comfortable is when you are going to see the markets start to run out of gas. The economy, instead of continuing in this nice upward trajectory, will settle in a period of below-trend growth that lasts for a number of years. That is when we are going to deal with the excesses that we have dealt with from the past bubble.
Do you call this current rally a bounce in a bear market?
Yes, but the bear market may not be so much a bear market but just a long sideways trading range where we go back and forth. ... I don't believe that we are going to get back to the lows we saw, but I do believe that we are going to go back and forth for ... at least a couple of years.
You were relatively upbeat going into 2008. What happened?
Our outlook was based on a typical soft-landing environment, and we were probably driven most offside by further declines in real estate prices than we thought, the related credit crunch and the failure of the financial system. Some of these banks were too levered, and we didn't take that into account. ...With the rout being as widespread as it was, we ended up performing in line with the market [which was 33-per-cent in the red]in [our Canadian Synergy]mutual funds. But what happens to the broad market shouldn't be of concern to a market-neutral fund. It's a really good diversifier for a portfolio.
Your Market Neutral fund outperformed over one year, and was up 1.3 per cent in 2008 when many hedgies were deep in the red. How does your fund work?
In Canada, it is unfair to lump all so-called hedge fund managers all together. If you look at most of them, they don't do a lot of hedging. They don't short a lot of stocks. We have designed our Market Neutral fund to have half of the volatility of the broad market over time, and to be zero correlated with the movements of the broader market. Essentially ... we will buy a dollar's worth of stock, and we'll short a dollar's worth of another stock so we end up to be 100-per-cent long and 100-per-cent short at the same time.
The concept of a market neutral fund is not what many perceive as a hedge fund. Why?
Hedge funds were initially developed as a way to protect peoples' investments. They were not to be heavily exposed to market movements. They were meant to be balanced in their construction, and long and short stocks, so there was no relationship to the broad market. As a result, there have been many long-term successful hedge funds that went about making reasonable returns without going for the fence. ... Somewhere along the way, this changed and hedge funds became associated with higher-risk strategies, much leverage and outsized returns. That wasn't our focus. ... That is what made us different last year.
What advice would you give investors now?
Most investors and people in the investment business have grown up in the buy-and-hold environment from the early 1980s to 2000, and they have prospered. I think we are now in a much more active environment where you have to look for vehicles to fight through the trading range. I think hedge funds are one way of doing that.
Secondly, you might have to become more active in your portfolios. ... You might have to raise cash when things are good, and spend that cash toward the bottom of the trading range. That is what we intend to do in our mutual funds that we manage.
***
PICTON'S PICKS
Royal Bank of Canada
(RY-TSX)
Canada's largest bank, which has a strong balance sheet and retail franchise, reported first-quarter results that exceeded expectations. Like its Canadian peers, Royal faces loan losses shorter term, but it is "more global" and can increase market share outside this country because of weaker competition amid the credit crisis, Mr. Picton said. Its shares closed yesterday at $43.89.
Cdn. Natural Resources Ltd.
(CNQ-TSX)
The oil and gas company's first-quarter profit beat analysts' expectations. Because its Horizon oil sands project has started production, any concerns about debt have been alleviated, he said. "You have one of the biggest oil companies in Canada with the best growth profile going out over the next couple of years." Its shares closed yesterday at $60.34.
Shaw Group Inc. (SGR-NYSE)
The U.S.-based nuclear engineering and construction service company has a minority stake in nuclear giant Westinghouse Electric Co. "You have a company that has a significant portion of its revenue coming from nuclear facility maintenance, and it is now signing contracts to build nuclear facilities - recently in Florida and North Carolina," Mr. Picton said. Its shares closed yesterday at $30.12 (U.S.).
Shirley Won