A hedge-your-bets approach with 30% gains

In mid-to-late September of 2001, investors were depressed and angry. World markets careened out of control in the wake of the Sept. 11 terror attacks, and the Dow Jones Industrials ($INDU) stormed to their worst one-week decline since the 1930s.

The surprising 20% surge in the market that followed then came as a shot from the blue, facilitated in part by what I came to consider a "defiance dividend" as Americans relieved their anxiety by hitting the mall and buying battered stocks. Faced with extreme visions of our mortality, combined with revulsion toward a vicious foe, we collectively decided to shop our way back to mental health -- and both the economy and stocks were temporarily the better for it.

A year later, we were at a similar crossroads in the market, but the psycho-social outlook had changed. No longer unified in defiance, we were divided in distress. Only half the public, according to polls, had the stomach to ring Saddam Hussein's doorbell with cruise missiles -- an ominous sign for energy and defense stocks, which were priced for war. And back-to-school retail reports suggested that we didn't have much interest in ringing cash registers at stores either, an ominous sign for retail and technology stocks -- which, lousy as they were, were priced over the summer for a solid Christmas.

During times that deserve neither optimism nor pessimism, a hedged portfolio makes a lot of sense: Buy a group of stocks that are likely to go up in case things work out well, and short a group of stocks that are likely to go down in case things go poorly. This is exactly the approach I wrote about in September 2001. I published a column that leveraged MSN Money's StockScouter rating system to offer 10 high-ranked stocks to go long and 10 low-ranked stocks to go short.

As it turned out, the combined portfolio gained 29.75% over the following 12 months, not including transaction costs, as the shorts fell 47.1% and the longs gained 15.8%. Both sides outperformed the S&P 500 ($INX), which fell 12% over the same period. Here are the stocks, ranked by the value they added to our profit and loss statement:

*September 25, 2001.

The success of the StockScouter long/short portfolio validates the robustness of the system, which is accessible at MSN Money either through individual stock pages or through the Screener.

There were certainly some surprises in the group:

• Not long after the list was published, Riverstone Networks (RSTN, news, msgs) tripled in value as many high-beta but low-quality technology stocks went along for the "defiance dividend" ride. In the fullness of time, however, StockScouter's jaundiced view of the shares was realized, as the stock sank 90% from our initial price.

• The emerging success of gold stocks did not become apparent to most investors until early in 2002, but StockScouter was an early believer in Meridian Gold (MDG, news, msgs), and rode it for an 88% gain in a year.

• The value of real-estate investment trusts was pooh-poohed during most of 2001 and also only became a big story in 2002. Yet StockScouter had glommed onto Annaly Mortgage Management (NLY, news, msgs) in September and held on for a nice 40% gain.

• In the loss column, StockScouter's view of OTG Software was interrupted by a buyout offer from Legato Systems (LGTO, news, msgs) at a premium. The other subpar performances came from the purchase of IDACorp (IDA, news, msgs), which sank in sync with investors' diminished confidence in the power-trading business following Enron's demise.

In September of 2002, I performed the same exercise, offering another long/short portfolio for the coming 12 months. They were all generated by the StockScouter system in the same manner as the previous portfolio. For the longs, I used my Scouter Top Rated screen (click here), which seeks equities with the highest StockScouter ratings; the greatest number of favorable market-cap, sector and investment-style "tailwinds;" prices over $5 and average daily volume greater than 100,000 shares. For the shorts, all metrics were reversed, though the minimum price was raised to $7.

The longs, frankly, are an uninspiring bunch, but who ever thought we'd get 40% in capital appreciation out of a REIT in the past year? We've got a carpet maker, a slot-machine maker, a drug maker, two drug distributors, a container maker, a mortgage maker, a loan maker, a check processor and an oil and gas driller. The names tilted more toward growth than value and are biased a bit more toward mid-caps than small- and large-caps. If anything, the list tells me that companies with firm control of their niches can at least keep trudging doggedly along in a tough economy, with the growth names potentially gaining market share on their peers, and the value names potentially seeing a bump in their price-to-earnings multiples. Unless the economy completely melts down over the next year, I don't see why we shouldn't get another 10%-15% advance out of this crew.

The shorts already look like a list of the walking wounded. AMR Corp. (AMR, news, msgs), the parent of American Airlines, has been hobbled by the decline in both leisure and business flying in the wake of the terror attacks; Sierra Pacific Resources (SRP, news, msgs) has been afflicted by investors' distaste for all energy providers, even though it serves all the casinos in Nevada; Deutsche Telekom (DT, news, msgs), the largest telecommunications company in Europe, has been unwired by sinking prices and the high prices paid for wireless licenses. The rest are largely decent companies in unpopular businesses. And that is what makes short-selling so hard; with one turn of the economic wheel, these losers can be winners again.

This time, I hope the longs in my hedged portfolio far outperform the shorts.

Jon D. Markman is editor of the independent investment newsletters Strategic Advantage and Trader's Advantage. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at jon.markman@gmail.com; put COMMENT in the subject line. At the time of original publication, Jon Markman did not own any stocks mentioned in this column.

Rate this Article

Click on one of the stars below to rate this article from 1 (lowest) to 5 (highest). Low

Thank you for rating.

High

• View all top-rated articles
• E-mail us your comments on this article
• Discuss in a message board