LongShort Investing

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Long/Short Investing Portfolio
ConstructionAmit Chokshi Stamford CFA
SocietyNovember, 19 2008
Kinnaras Capital Management LLC
www.kinnaras.com
225 Flax Hill Road Suite 1 Norwalk, CT
06854 Phone [phone] Fax
860-529-7167
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Disclaimer
All analysis, recommendations, and conclusions
provided herein by Kinnaras Capital Management
LLC (Kinnaras) are based on publicly available
information. Projections, estimates, and related
statements are based on various assumptions by
Kinnaras regarding the future performance of any
companies discussed herein are subject to
economic, industry, regulatory, and other
uncertainties. No representations, express or
implied, are made as to the accuracy or
completeness of such statements, estimates, or
projections, or with respect to any other
materials herein. Actual results may vary
materially from the estimates and projected
results contained in this presentation. This
presentation is for general information purposes
only and is not an offer or solicitation to buy
or sell any security. Neither Kinnaras nor any
associated persons or entities makes any
warranty, express or implied, as to the
suitability of any security, or assumes any
responsibility or liability for any losses,
damages, costs, or expenses, of any kind or
description, arising out of your use of this
presentation. You understand that you are
solely responsible for reviewing any security,
its offering, and performing additional due
diligence as you may deem appropriate, including
consulting your own legal and tax advisers, and
that any information provided in this
presentation shall not form the primary basis for
your investment decision. This material is based
upon information Kinnaras believes to be reliable
but Kinnaras does not represent that it is
accurate, complete, and/or up-to-date and, if
applicable, time indicated. Kinnaras does not
accept any responsibility to update any opinion,
analyses, or other information contained in this
presentation. Kinnaras manages funds that are in
the business of buying and selling public
securities. It is possible that future
developments will cause Kinnaras to change its
position regarding companies discussed in this
presentation.
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Background

• Education
• Bryant College, May 1999, B.S. Finance
• Emory University, MBA 2003
• Professional
• Morgan Stanley 1999-2001 Investment Banking
  Analyst (Generalist)
• Royal Bank of Scotland 2003-2006 Leveraged
  Finance/MA Associate
• CFA Charterholder, NASD Series 7, 63, 65

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Industry Landscape

• Sell-Side
• Investment Banks
• Corporate Finance
• Mergers Acquisitions
• Institutional Sales Trading
• Research Equity and Fixed Income

• Buy-Side
• Mutual Funds
• Pension Funds
• Endowments
• Leveraged Buyout Funds
• Venture Capital
• Registered Investment Advisors
• Separately Managed Accounts
• Investment Banks
• Private Wealth Management
• Prop Desks
• Hedge Funds

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Hedge Fund Returns
Source Hennessee Group LLC
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Hedge Fund Returns
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Hedge Fund Returns Good, Bad, Ugly?

• Good risk-adjusted and absolute returns relative
  to indices but
• Survivorship Bias Bad managers quit and
  unsuccessful funds are removed from indices
• Backfilling New managers usually start reporting
  after a period of good performance and indices
  backfill historical data inducing upward bias
• Watch for asset weighted hedge fund indices
• Performance of large managers can dominate an
  index
• Favors asset gatherers
• Self-Selection Bias Hedge fund indices need
  managers to report data, badly performing
  managers may refuse
• Short Time Period Most hedge fund indices only
  go back to 1990s

Source CSFB/Tremont Index
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Sample Hedge Fund Strategies
Dedicated Short Kynikos Associates Kingsford
Capital Seabreeze Capital
Activist Steel Partners Jana Partners Third Point
Multi-Strat FrontPoint Partners SAC Capital
Advisors Fortress
Global Macro Quantum Fund/Soros GS Global Alpha
Distressed Debt Cerberus Harbinger SPO Advisory
Value Pershing Square Greenlight Capital Sellers
Capital
Quantitative DE Shaw Renaissance
Fixed Income/Credit Oaktree Capital GLG Partners
Convertible Arb Citadel (heritage)
While Long/Short is an index strategy it is
also a tactic that is employed by many of the
fund strategies above
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Long/Short Investing

• Generally what one thinks of when discussing
  hedge funds
• Alfred Winslow Jones generally regarded as
  creating the first hedge fund through his use of
  long/short strategies in 1949 but even Ben
  Grahams partnership in the 1920s utilized
  long/short at onset
• Implementations include market neutral,
  directional, portable alpha
• Market neutral Reduces market (beta) exposure
  such that company risk is only reflected in the
  portfolio
• Usually implements paired trades
• Long Staples, short OfficeMax but focus on beta
  L/S exposure as opposed to gross dollar L/S
  exposure
• Can result in strong risk-adjusted returns
• Directional Manager tailors portfolio to allow
  for positive or negative net market exposure
• Majority of L/S managers have a net long bias
• Portable Alpha

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Kinnaras L/S Strategy

• Similar to value-focused L/S funds such as
  Pershing Square, Greenlight Capital, ValueAct,
  Third Point, and Sellers Capital
• Do not engage in pair trades and am willing to
  assume industry risk
• Why hedge short financial positions in 2007-08
  with a long? Autos?
• Some of the best longs/shorts do not have ideal
  offsetting trades (i.e. CROX)
• Discomfort with position risks are addressed by
  reducing or eliminating the positions
• Generally do not short indices since more value
  and less risk can be realized by shorting
  individual names
• Despite current market events, indices have
  negative expected values from selling short as
  they generally rise over time
• Can win more by shorting individual names since
  shorts will fall in a falling market and if
  analysis is correct
• Usually net long since the market tends to rise
  over time
• Disregard Beta Backward looking and only
  considers volatility
• More focused on business fundamentals and
  valuation in determining risk as opposed to
  historical volatility of stock

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Long/Short Sources of Return (Bull Market 20)

• MARKET NEUTRAL

100MM FUND
Gains (Losses)
25
90MM Long
23MM
18
90MM Short (Proceeds Posted)
(14MM)
2 Short Rebate
2
10MM Cash
0MM
Market Neutral example above generates a 8
return compared to market return of 20
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Long/Short Sources of Return (Bear Market -20)

• MARKET NEUTRAL

100MM FUND
Gains (Losses)
15
90MM Long
(14MM)
22
90MM Short (Proceeds Posted)
22MM
2 Short Rebate
2
10MM Cash
0MM
Market Neutral example above generates a 8
return compared to market return of -20
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Long/Short Sources of Return (Bull Market 20)

• 75 NET LONG

100MM FUND
Gains (Losses)
25
90MM Long
23MM
18
23MM Short (Proceeds Posted)
(4MM)
2 Short Rebate
2
10MM Cash
0MM
Net Long example above generates a 19 return
compared to market return of 20
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Long/Short Sources of Return (Bear Market -20)

• 75 NET LONG

100MM FUND
Gains (Losses)
15
90MM Long
(14MM)
22
23MM Short (Proceeds Posted)
6MM
2 Short Rebate
2
10MM Cash
0MM
Net Long example above generates a -8 return
compared to market return of -20
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Devils in the Details

• Maximizing the returns of L/S is highly dependent
  on managers skill
• Previous examples impound expectations that the
  managers longs and shorts both outperform the
  market
• Longs go up more than the market in bull markets
  and go down less than the market in bear markets
  while shorts go up less in bull markets and down
  more in bear markets
• In previous examples if the managers longs and
  shorts equal the markets performance, funds are
  generating just the cash and rebate rate of 2
  before trading fees and expenses
• In a multi-year context, low absolute returns can
  be costly even if risk-adjusted returns are
  strong
• Also requires the right stock picking skills in
  terms of paired trades
• Long Staples, short OfficeMax what happens if
  OMX goes up more than SPLS?

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Evaluating Investment Candidates
LONGS
SHORTS

• Valuation High trailing earnings extrapolated
  into future
• Accounting that doesnt reflect true economics
• Fads and frauds
• Management Contradictory words/actions
• Things are great followed by major insider
  sales
• Catalyst Identify what levers drive the stock
  down, groundwork is usually required
• Less concentrated relative to long portfolio,
  will maintain 5-30 shorts but capital commitment
  will be much lower
• Time horizon lt12 months Markets go up and rising
  tide impact places short positions at risk
• Short sell gains are taxed at ordinary income
  no tax benefit for holding a short over a year

• Valuation Cheap based on valuation analyses
• DCF, public comparables, MA comparables
• Capital return metrics Return on Invested
  Capital, ROE, ROA
• Management quality
• Catalysts Value can be its own catalyst but real
  catalysts are helpful
• Sometimes requires more groundwork by fund
  manager
• Focus on total return dividends, ability to
  create synthetic dividends
• Concentrated Dont dilute best ideas or get too
  concentrated
• Diminishing marginal benefits of adding stocks
  once roughly 8 diverse stocks are in a portfolio
• Targeted range 12-20 longs
• 12-48 month time horizon

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Integrating Longs and Shorts

• Market neutral and paired L/S conducts security
  selection for longs and shorts in tandem as beta
  is the main focus
• If you like one company as a long (short),
  identify a candidate in the same industry to
  hedge with and then select level of net exposure
• Maintain and match liquidity on both the long and
  short side
• Dont be too concentrated long and diversified on
  the short side
• Few longs will not closely participate in market
  moves while the bulk of the diverse short book
  will causing portfolio management issues
• Also high level of non-systematic risk on the
  long side
• Generally match capitalizations Dont be short
  very liquid stocks 10B and long illiquid
  lt100MM stocks
• Caveat Popular trade was short megacaps/long
  smallcaps but those trades were spread across
  many stocks and basically implied Russell 2000
  outperforms DJIA
• Be cognizant of hidden industry/macro bets i.e.
  short XOM/long UAUA
• As industry risk is assumed, risk controls in
  terms of position sizing, trading stops, and
  specific stock hedges (options) become more
  important
• Sell discipline, avoid evolving hypotheses

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Recent Challenges

• Prime Brokers have had to abruptly change their
  rules in some cases due to liquidity crisis
• Prime brokers are in many cases tied to brokerage
  houses and face their own solvency issues
• Regulation T Need 50 for initial margin (i.e.
  short 1000, need 500 in collateral)
• In some cases for certain stocks 100 collateral
  is required even if stock is above 5 threshold
  meaning to short 1000 you may need 1000
  collateral
• Definitions of collateral has been adjusted in
  some cases
• Some stocks dont count for the same value as
  prime brokers want cold hard cash
• Borrowing rates have increased for those wishing
  to employ leverage
• Impact of changes ranges from annoyance to
  terminal depending on a funds leverage and
  strategy
• Equity funds that use little leverage can work
  around these issues but leveraged credit funds
  can be liquidated overnight

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Getting a Job

• Do you like to read SEC filings, construct
  financial models, conduct valuation analyses,
  invest your own money in companies?
• If yes, focus on a multi-step/year plan dont
  need a job working for Eddie Lampert right out of
  college
• Investing/security analysis should be your main
  goal, not necessarily working for a hedge fund
• Many RIAs manage separately managed accounts and
  operate like hedge funds (i.e. Chieftain/Glenn
  Greenberg)
• If your perfect job is not immediately available,
  keep in mind that securities analysis can be
  learned in many settings corporate finance,
  commercial banking, capital budgeting
• Work anywhere geographically
• Identify employers 13Fs, websites
• Make yourself smarter by reading constantly
• More letters after your name CFA, etc.
• Give a reason for why you should be hired
  Demonstrate real interest by knowing about the
  firm, its strategy, know holdings, etc. (all
  within reason) and also provide an investment
  idea or your take on a holding of the firm/fund
• Be patient but persistent
• Questions?