Worldly Possessions

The managers at Montgomery Global Long-Short Fund

Shorting stocks in the bull market of recent years took guts. It took even greater fortitude to do so with close to 20% of assets invested in some of the least stable, most thinly capitalized emerging markets around the world. But going short as well as long has proved a winning strategy for the San Francisco-based Montgomery Global Long-Short Fund, and for the hardy public investors who have put nearly half a billion dollars into its hedge fund-like portfolio.

Last year the fund topped its 53% return of 1998 with a sensational 135% return - in the main by shorting to hedge long positions, by leveraging aggressively, and sometimes by investing in derivatives. Its huge success prompted Montgomery to close the fund to investors in May 1999. But it was reopened this February - in time for the equity markets to peak in March, encounter unprecedented volatility in April, and endure a dearth of trading interest in the first half of May. The fund returned 11.37% for the first quarter of 2000 through March 31, before the markets turned really nasty, compared to the S&P 500's 2.3%. Through April 30, the year-to-date return for the fund has slipped to a -2.02, though Morningstar still ranks the fund in the top 1% of the international hybrid category for the latest 12 months.

Today's weak equity markets are much more friendly to short sellers than the briskly rising markets of the late 1990s, when the S&P 500 clipped along at 20% or better for four years in a row. Montgomery Global Long-Short Fund thrived in that setting because it goes both long and short. That is, it often hedges its long equity positions in fast-growing companies with short positions in the weaker companies in the same sector. The fund also shorts stocks that have deteriorating fundamentals or diminishing market share. "We don't just visit companies with an intent to purchase a stock," says Bob Rezaee, the fund's manager specializing in global technology. "If we find trouble, we can exploit that opportunity as well. We're not a bear fund, nor a blind bull fund."

In shorting stocks, the fund borrows the securities, hoping that the price will drop by the time it buys them back and returns them to the broker. The long-short discipline makes the fund nimble enough to profit both from rising and weak stocks, and minimize its risk in market downturns. But losses from short selling can be substantial - sometimes total. Predicting a stock's decline has been hazardous in the momentum-driven bull market of recent years. What's more, a broker can suddenly recall the borrowed shares if the price shoots upward, forcing the fund to swallow a big loss. That's why few public funds use shorts. "This fund is attempting to duplicate what investors generally find only in hedge funds," says Rezaee. "But unlike a hedge fund, which requires an investment of at least a half million dollars, our fund is for the masses."

Montgomery Global Long-Short's six stock pickers speak ten languages and prowl the world for fresh opportunities. Explains Oscar Castro, the fund's senior portfolio manager, "When you have a group of specialists following sectors around the world, you find a lot of very good both on the long and short sides. It would be a waste not to take full advantage of that knowledge."

The fund closed in May 1999 with $166 million in assets, but reopened this February and now totals $460 million. Its strong initial performance attracted too many investors. "We were unprepared to handle that," says Castro. While closed, the fund replaced one manager and added two others. The back-office capabilities needed for shorting and investing abroad gives the fund a hefty 2.35% expense ratio.

Castro, a 45-year-old Venezuelan, and Rezaee, a 37-year-old Iranian, talked with us about their fund's strategy in a recent interview.

What percent of assets are currently short positions?

Castro: The fund is 30% short and 70% long. Earlier this year it was about 20% short, but now is the most bearish it's ever been. We can go net short - more than 50%. But since we are fundamental, bottom-up stock pickers, the fund will be net long the vast majority of the time.

How do you determine long and short proportions?

Castro: Three ways. Most often we find stocks that will underperform in a bull market and pair them with our best names - our long positions - in the same sector. The second way is to find stocks with valuations and/or momentum that is not sustainable. The third tool is derivatives. We sometimes use index options or index futures to hedge our position in a particular market or region. We use this technique when market volatility increases. We back into our overall short-position percentage based on how we feel about the long positions in our portfolio and the number of strategic shorts we find. We don't say, 'Okay, the overall market is doing X, so let's be Y% short.'

In shorting, how can you feel confident the price is going to fall when so many investors are buying on dips or on momentum?

Rezaee: We're very discriminating about shorting stocks. We look for stocks that have had abrupt surges in the recent past - that appear overbought. More important, we focus on the weakest players - third- and fourth-tier companies that are trying to establish themselves at any cost. We also manage risk by taking a long position in a market leader and pair it with a short position in the weakest player. We establish our positions when investors are euphoric about the stock but we can see a disconnect between the euphoria and the fundamentals.

Why does shorting make sense in a bull market?

Rezaee: It's a means of mitigating portfolio risk. Shorting in a bull market isn't always effective. It's been a recipe for disaster for a lot of the hedge funds. That's why we're not dogmatic about shorting.

We look for special opportunities where the speculative bubble is disconnected from reality. We make sure the stock has deteriorating fundamentals and valuations that are stretched.

How do you control for short-side risk?

Castro: First by pairing shorts with longs, as noted. Often, when a strong company releases positive news, such as an increase in market share, shares of the weaker player we shorted go down, allowing us to profit on both sides. Our other shorts are more opportunistic, where we identify a company-specific weakness. Among our shorts, 60% are in the hedging category, which we use to reduce the risk of the overall portfolio. The rest are opportunistic.

Montgomery Global

Long-Short Fund

Montgomery Asset Management

101 California Street

San Francisco, California 94111-9361


Portfolio manager: Oscar Castro, et al

Manager's tenure: 2 years

Fund started: December 1997

Minimum initial investment: $2,000

Load (front-end): 0%

12(b)-1 fee: 0.25%

Net assets: $544 million

Dist. yield (trailing 12 months): 0%

P/E ratio: 45.2

P/B ratio: 11.2

Median market cap: $7.7 billion

Expense ratio: 2.35%

Turnover: NA

3-year alpha: NA

3-year beta: NA

3-year r-squared: NA

3-year standard deviation: NA

1999: 135.07%
1998: 53.39%
1997: NA
1996: NA
1995: NA
12-month (annualized): 81.79%
3-year (annualized): NA
5-year (annualized): NA
Top Five Holdings
S1 Corporation US: 1.86%
Juniper Networks Inc.: 1.86%
LSI Logic Corp: 1.72%
Davnet Ltd.: 1.47%
Nippon Telegraph & Tel. Corp.: 1.45%
Equity Allocation
As reported in the June issue of Morningstar's Principia Pro.

Annualized returns are through April 30, 2000.

Give us an example of a short that did not work.

Castro: The Spanish company Telesp Celular Participadoe was created about three years ago to ride the wave of demand for fast food in Spain. Telesp is basically the Domino's of Spain. Initially we bought as a long position and made good money on it. Then, in 1999, we decided Telesp's story was too easy to replicate and the increase in competition would fold the company. But the company has continued to grow, although not as much as the market expected. Our short position has hurt us. The lesson: Don't bet against a management that continues to convince investors that its success story isn't over.

What about a short that has succeeded?

Rezaee: Veritas Software, which is focused on the storage arena, is one of our long positions that has done exceptionally well. We found a second-tier competitor, Legato Systems, and shorted it. We benefited both from Veritas' success and its victimization of Legato.

Which stocks are you shorting now?

Rezaee: We're reluctant to be specific because we want to maintain cordial relationships with the companies. Some hedge funds are vocal about their short positions, which tanks their relationship with management and makes it difficult to take the temperature of the market.

Did you clean up on shorts during the April market downturns?

Castro: To tell the truth, it wasn't a good period for us. This type of fund should have taken advantage of it much more aggressively than it did. Recently we've added managers because the size and scope of this portfolio require more eyes and team effort. We're still not through that transition, however.

Rezaee: The market change happened so abruptly that we didn't have time to react. It is very frustrating, because over 75% of our companies that have reported so far have exceeded expectations. Less than 10% of companies are missing results. Fundamentals continue to be very strong, but we knew valuations were very much stretched and we wanted to exploit the possibility of the pullback. But it happened too quickly.

With 18% of assets in emerging markets, which countries are most promising?

Castro: After the Asian crisis, people had doubts that the region could recover. But it's obvious now that Korea and Taiwan have come back with a strength that has left many investors startled. The technology companies there, like Samsung, have become global competitors again. Thailand, the Philippines, and Malaysia have had an incredible bounce back from a very precarious situation. We are at the very early stages of taking advantage of that. The Brazilian economy is picking up as it shifts from producing raw materials and basic metals to becoming a diversified economy.

How do you reduce the volatility of investing in emerging markets?

Castro: Go to church every Sunday and pray! There's no way to avoid it: Emerging markets are volatile in nature. Political, economic, and even social events can drag down a market, and they're hard to pinpoint. But these markets also present huge opportunities with incredible outsize potentials. We have a strong emerging markets team that has years of experience, and we are confident in their ability to continue making money in these markets.

What kinds of opportunities are you finding today in Europe?

Castro: The European community has a population around 20% larger than the U.S. - about 310 million people - with a level of wealth similar to the U.S. We don't kid ourselves that the French, Italians, Germans, and Dutch will start speaking the same language and forget their customs. We understand the difficulties that these countries will face trying to integrate. But it is obvious to us that the European community would like to have the same growth the U.S. has gone through in the last 10 years. As a result, they are accelerating the liberalization of many industries - the deregulation of the telecom industry, the airlines and transportation in general, the electric utilities and financial services sectors. Because we see the world as our playground, we can learn from one country's experience and apply that knowledge to another area.

For example, if you want to know what is going to happen with wireless telephone service around the world, go to Finland or Hong Kong. The penetration of cellular telephones in those countries is above 50%, while the penetration in the U.S. is close to 30%. Most likely the U.S. will follow the patterns we've already seen in Finland and Hong Kong, which will allow us to take advantage of those opportunities in the U.S. market. Both the U.K. and Spain are the furthest ahead on deregulating electric utilities - information that will help us make decisions about France, Germany, or even the U.S. when that industry starts deregulating.

Rezaee: Because technology gets adopted at a rapid pace in the U.S., we often look to the U.S. to determine the best practices and those that are prone to failure. Then we apply that experience to companies on a global scale. Micron Technology, the domestic competitor of Samsung Electronics, admits that it respects Samsung as an aggressive competitor doing the right things strategically. An investor focused on domestic stocks will be indifferent to Samsung, but we take the information, scrutinize it, and make an investment conclusion.

Will international markets outperform the U.S. market this year?

Rezaee: If we identify the right trends - wireless service, for example - and bet on those trends on a global level, we don't need to get so fixated on country-specific investments. The same is true when we see industries that have been challenged and have difficulties - we avoid those investments on a global scale. More and more, there is a dependency that is being created among all countries and all economies. So we have to stay close to the fundamentals of these businesses to ensure they'll continue to experience success.

Are there any particular sectors you're really hot on right now?

Rezaee: I don't think the themes are going to radically change. Certainly deregulation plays a big role in areas like utilities. Technology will continue at a rapid rate and wireless companies will deploy Internet infrastructures so the masses can come on board.

More than ever, government and businesses are acknowledging the importance of adopting technologies because they don't want to be left behind. Ten or 20 years ago, a country that was rich in natural resources had a competitive edge. But in a knowledge-based society, natural resources aren't as important as technology. And countries besides those in North American and Europe are acknowledging this. We're really trying to exploit that trend.

What are some of your recent stock picks?

Rezaee: We've tried to moderate our bets in some of the stocks that have had phenomenal runs. Recent buys have continued to be in the semiconductor industry. Recent pullbacks in the market have afforded us an opportunity to step in and buy stocks in companies that have solid fundamentals. In the U.S., we've bought companies like Check Point Software. This company provides firewall technology, an essential element of Internet security.

Another company we bought is Atmel Corp., which provides flash memory and other semiconductor components with some 50% of its revenues attributed to the wireless industry.

Any surprises in the exporting of technology trends to other countries?

Rezaee: The surprises are often cultural. For example, the French tend to be a bit more reluctant to blindly adopt technology, so the level of Internet penetration there has been relatively moderate. Partly that is due to high access fees in France; people have to pay both a monthly fee and a high connection fee.

When we invest, we can't blindly look at product adoption in other countries and assume it will happen everywhere. I think it's far more likely in Europe that connectivity to the Web may involve a cellular device versus a PC. We look at those sorts of factors when we do our analysis.

What stocks have you been selling lately?

Rezaee: We've been trimming our positions in the Internet infrastructure software arena. Companies like Vignette Corp. and Veritas Software. These are companies that continue to do exceptionally well and we acknowledge the strength of their business and dominance.

But at the end of the day, we've had parabolic moves in these stocks largely because the masses and the day traders have become fixated on these stocks and are indiscriminately buying without much consideration for the valuation. And that concerns us.

Aren't there still plenty of shorting opportunities in overvalued technology sectors?

Rezaee: That's true. More so in the areas of the Internet, e-commerce, and e-retailing. There aren't just one or two players in each vertical, but 10 or 15. A general rule is that three players in each vertical are going to dominate 70% of the market share. So we have overcapacity, and you have to scratch your head and say, there is no way all these players can survive.

Are you bearish about the market today?

Rezaee: I'm not extremely bearish. I think the market will become far more selective and also more valuation sensitive. People will become more risk averse, so the likelihood of indiscriminate buying will diminish significantly.

Unfortunately, in the last few months, many investors put more time evaluating a microwave purchase than their stocks. The pain that was inflicted upon us in the last few weeks was sufficient to wash out a lot of excesses, but we aren't totally out of the woods. I think it was healthy, but we need to go through a healing process, and time is of the essence now.

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