Skeptical That Growth Will Take Root

Dec 15

Skeptical That Growth Will Take Root

DOUGLAS A. KASS, A LONGTIME SHORT SELLER, has added a weapon to his arsenal: old-fashioned long investing. As its name attests, Seabreeze Partners Long-Short looks for overvalued and undervalued stocks. The fund, with assets of more than $100 million, has a gross year-to-date return of about 17%. Kass, 60 years old, is a whirling dervish when it comes to investment ideas. His colorful and incisive conversation is eclectic, sprinkled with a wide range of topics and references, from macroeconomics to Woody Allen.

Kass has been president of Seabreeze Partners Management since 2001, the year he launched the hedge-fund firm. The veteran investor’s resume includes working at First Albany, where he was head of institutional equities in the early 1990s. Kass is a familiar face to Barron’s readers. We interviewed him 18 months ago, at which time he was extremely bearish and pretty much on the mark. He is more bullish now, but he sees plenty of dark clouds. Kass spoke to Barron’s by phone last week from his office in Palm Beach, Fla.

Barron’s: Why did you make the switch from short-only to long-short?

Kass: Earlier this year, after almost five years, we decided to discontinue our dedicated short strategy. On Jan. 1, we launched Seabreeze Partners Long-Short, and there were several reasons behind that decision. Many of our concerns — including the shaky foundation of credit, a vulnerable housing market, a cooked consumer, and the danger and proliferation of unregulated and unwieldy derivative products — have been recognized in the marketplace. As a partnership, we profited from this and from our negative outlook in ’08 and in the prior years, and we did extremely well. But we no longer wanted to be restricted by being a dedicated short seller with one hand tied behind our back. I’m reminded of a quip by Woody Allen, who once said that bisexuality immediately doubles your chances for a date on Saturday night.

Being long and short doubles a hedge fund’s chances of making profits. We attempt to bring a short-seller’s skepticism and creative short themes to a long-short product. Most long-short hedge funds have a long bias, and many tend to hedge with S&P futures or exchange-traded funds — not with carefully researched individual short ideas and themes. We approach long-short with a short bias. Our bread and butter has been identifying, through bottom-up research, shorts and constructing short themes. A short expertise is very important in a period of subpar market returns, in a trendless market and in an economic setting in which growth is lumpy, inconsistent and at times unpredictable — conditions that are likely over the next several years.

What’s your assessment of this year’s market, starting with March’s trough?

I said in March that we were making a generational low in the U.S. stock market. The domestic economy was getting “less worse.” In other words, we were experiencing what I described as the second-derivative economic recovery, which was materially ignored by investors, and negative sentiment was stretched to the extreme. Valuation had moved to remarkably low levels. For example, stocks were trading at below replacement value, versus a multiple-decade premium of about 40% to replacement value, and stocks were trading at historically low multiples to normalized earnings. I am still of the view that we won’t see the March low again in our lifetime. However, there is a difference between establishing an important low and the resumption of a bull market. And I do not believe we have embarked on anything close to a new bull market.

How does this market look in terms of stock-picking?

Prices on Wall Street remain far ahead of the conditions on Main Street. The market appears to be discounting around 4% GDP [gross domestic product] growth for next year. What we believe we are witnessing is nothing but a poor start to a bad economic recovery. We’ve spent hundreds of billions of dollars on stimulation. We have a zero-interest-rate policy, which basically created a 2.8% GDP growth rate in the third quarter. But what happens when a portion of that stimulus is withdrawn and monetary and tax policies are reversed? It is clear that the fourth quarter has gotten off to a tentative start, whether you look at housing, manufacturing, production or retail sales.

What else do you think the consensus is overlooking, with its view that recovery is in the works?

I’m acutely aware of the risk of saying this, but it is truly different this time. Here are some nontraditional headwinds that we expect to undermine economic growth. First, the credit aftershock is going to continue to haunt the economy. The unregulated shadow-banking industry, which includes numerous consumer-lending companies, is really maligned. The securitization market is still adrift and not operating, and both [sectors] will not fill the role of credit feeders, if you will, as they did a few short years ago. Second, housing has stabilized, but its recovery is going to be muted. And I really don’t see any growth drivers to replace the important role taken by the real-estate markets in the prior upturn. Third, commercial real estate has only begun to enter a cyclical decline. It might not be as deep as many expect, but it won’t provide much of a contribution to growth the way residential real estate did. Fourth — this is really important — municipalities have historically provided economic stability as we came out of economic weakness. But no more. We all recognize that municipalities are broadly in disrepair, as their receipts are out of whack with their revenues. And, finally, it is important to recognize the emergence of a very negative attitude toward wealth in our country and that our fiscal condition as a nation has very negative long-term implications. That’s one of the reasons why I am skeptical about the low yields in the Treasury note and the bond market. We are going to have sales-tax increases, along with local and state and federal tax increases — possibly dramatic ones — in order to fund the deficit and to appease the populist administration.

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