Larry Dunn: Stock Selection is Key for Hedge Fund Manager
In a world that sometimes seems to live from minute to minute, from economic report to economic report, it’s important to remember that there traders like Larry Dunn.
A fundamental hedge fund manager, Dunn is not swayed by the latest news report or government statistic. For most short-term, technical traders, he represents the flip-side of the trading coin, but his basic philosophies of disciplined trading and minimal risk are lessons every serious trader can relate to. Dunn establishes long-term positions in stocks, building his positions around stock selection and a careful risk management that usually limits his market exposure to around 20% (when many of his brethren work at four times that level).
A native of Queens, N.Y., Dunn got an undergraduate degree in finance from the University of Wisconsin. Like many who are attracted to the markets, he discovered an independent streak early. His first job in finance at General Electric (in Milwaukee) served, as he puts its, “to show me how much I hate working for big corporations.”
In the early 1980s, he moved back to New York and started working on an MBA–while making ends meet as a hotel bell man. His long-term fascination with the market led to real trading: He also started making decent money trading stocks, holding his positions for six months or so.
| Basically, I always had a love of the stock market and always kind of felt I’d be a hedge fund manager. But how I got there was a very eclectic process. |
After having finished school getting married, he decided he needed a change of pace and made his way out to California. He first worked as a bond trader and for a small broker-dealer in San Diego before moving to L.A. and landing a position as Director of Research with California Business Magazine. There, he researched an wrote about various stock picks, honing his trading philosophy and stock-picking skills.
Dunn then moved closer to the action itself, landing a position with Michael Milken, where he served a four-year stint as an analyst (see below for more comments on that period) before working with short-selling hedge fund. He enjoyed the experience, but was itching at this point to open up his own fund.
In 1997 he did just that that, dubbing it the John Galt Fund, after the self-reliant, free-market hero of Ayn Rand’s Atlas Shrugged. In trading, a few statistics often do the work of a thousand words: His year-to-date performance stands at 52%, and his compounded annual rate of return since inception is around 47%.
What makes these numbers all the more impressive is his average exposure of around 20%, which means that while a typical mutual fund might have 97 cents on the dollar in the market and 3 cents in cash, Dunn is only risking 20 cents. He is typically around 60-100% gross long and 60-100% gross short.
“Right now (mid-August 1999) I’m running 80% long and 72% short, which means my net exposure is only 8%,” he says. “I try to take the market out of the portfolio, so to speak, and make money through superior stock selection.”
We talked to Larry about what he sees happening in the market and how its affects his broad-perspective trading style.
ME: What do you think about the current market environment, and especially the situation of the Internet stocks?
LD: First, I’m not a market caller–I don’t live and die with what the market does. I think it’s totally ridiculous that there are all these “professionals” who have nothing to do but trade off government statistics. Most companies’ prospects don’t change within a year or two based upon what the government does–unless we get into a total recession where nothing is being spent. With my stocks, it doesn’t matter what’s going on with the government, or employment, or inflation, or whatever. I can’t control that stuff.
Although my fund obviously has a solid record, I can say I’ve been basically cautious, just because from a fundamental standpoint, and historically–from a human nature basis–the market is significantly over-valued.
| I don’t believe there is such a thing as a “new era” |
I do not believe we’re in a “new era,” I don’t believe there is such a thing as a new era. Many things may have changed, but I don’t think we as people have changed that much. We’re going to hit a fear point. This market has been a lot stronger than one would have expected, but we’re going to hit a point where we do get fearful and really have a correction.
I think the Internet is an incredible thing, but I also think the valuations are totally absurd and there are many negatives people have to start thinking about how the Internet affects business and society.
Interest rates are trending up a little bit, and when you look at a virtually fully-employed economy, we’ll start seeing some pressures. The interesting thing is that the real world is getting inflationary, but the Internet is such a deflationary force. The Internet is very deflationary because there’s such competition for every sale because of the easy access and ability to comparison shop and purchase. Obviously, the numbers on the Internet are not yet big enough to affect the inflation numbers–it’s only 1-2% of retail sales–but when we get to that 10-20% number, which we will get to, it’s going to be tough. It’s the classic profitless prosperity on the Internet.
I don’t think you can be a middle man on the Internet. You have to have a service that has some proprietary advantage with a true brand name–not something like Amazon, but a brand name with a product, like ^TIF^, where you have a decided advantage and someone can’t just come in and compete with you the next day.
| I don’t think there’s one penny of discount in the market for potential Y2K problems |
I don’t think this is any time to be thinking you can make a whole lot of money on the upside (as a long-term trader). I mean, if this market goes up to 12,000, which is about the most bullish call you hear from anyone, that’s only an 8% gain from here when you’re risking 20-30% to get that. Also, I’m not an expert on Y2K, but it at least stands a chance of being something that could affect the market. I don’t think there’s one penny of discount in the market for potential Y2K problems, and there’s certainly no uncertainty discount for Y2K.
Corporate earnings look great this quarter at first blush, but if you take them over two years, they suck! Over two years, you’re looking at 5.5% growth. Right now, it’s just a market that does a great job of finding only the positives–always looking for a reason to rally.
But on the other hand, I’m in business and I have to make money. And I’ve made a much better return than most traditional hedge funds and money managers while keeping my risk minimal. Last August, when everyone was dying, I was down 1.8%, and that was after having a solid first seven months of the year.
Most people live and die the market: They only make money because they’re in the 20 big-cap names, and they have no value from a portfolio management standpoint. You might as well just get an index fund.
ME: Let’s talk a little about your trading approach, specifically stock selection. How do you go about making trading decisions–what works for you?
LD:
| I’m usually looking out to the next year to three years–I’m not looking ahead to just the next quarter |
I take both a top-down and a bottom-up approach to picking stocks for my portfolio. The top-down aspect is just looking at the business world we’re in now: What will the fast-growing areas be? Where will the money be spent?
I’m usually looking out to the next year to three years–I’m not looking ahead to just the next quarter–and when I develop my opinion about what’s happening I look for opportunities in stocks that are really going to participate–companies that are perfectly positioned when a certain environment emerges.
But I’m not going to buy a Cisco, for example, in the case of networking stocks. I don’t pay a 5-10 multiple of the growth rate, or earning or sales. I buy stocks trading at a fifth, a quarter, a half of the growth rate–a very low PEG (price-earnings to growth) ratio. I don’t like things that are growing less than 25-30%, and many of the stocks I pick are growing over 100% and I’m paying 10 to 20 times earnings. Most of the big-cap stocks trade at PEG ratios of four to five: they’re growing at 5-12% and trading at 35-50 times earnings.
ME: Does this kind of an approach land you in many thinly traded, volatile stocks?
LD: It can. You have to find stocks that fit the criteria I just outlined, and that are under-followed, misunderstood, or just too small to be bought by some of the large guys, that you know are in the right group and when they do what you think you’re going to do, someone’s going to notice, and then they will buy them.
So, many times you’re buying stocks that are not as liquid as you’d like, but the liquidity grows, if you were right, obviously. If you’re not, you’re going to live in that position for the rest of your life. Positions can be brutal to get out of, and you have to be thinking about liquidity in everything you do.
ME: What’s the bottom-up part of the equation?
LD:
| I tend to have a bias toward communication stocks and parts of technology because that’s the growing part of the economy |
I scour numerous publications and the Internet, and talk with other buy-side guys–I get no help from the sell side (investment banks)–to come up with other stock selections that don’t necessarily fit into my top-down view of the world. But, they’re such compelling ideas, because of the positioning, or because a really good spin-off company becomes available and it’s practically being given away because it’s misunderstood. Many times I’ll buy businesses where they own one to three other public or private businesses that are literally giving it away. It could come from anywhere. I tend to have a bias toward communication stocks and parts of technology because that’s the growing part of the economy.
ME: Do you trade only stocks, or do you mix in other things?
LD: I’ll buy both index an equity options, calls and puts. I always have some Russell 2000 puts in the portfolio.
ME: Is there a technical component to your trading?
LD: I’ve always been a student of the market. I have a good understanding of markets, a good feel for them. What I do is adjust my short exposure a lot, because, as I’ve said, that could be anywhere from no exposure to 40% net long. I don’t base this on traditional technical analysis, but on my fundamental interpretation of what’s happening–which I think turns out to be the same kinds of things a technical person would chart out.
But if I find a great stock, I don’t really care about an eighth or a buck. I’m looking at a name I want to own for three to five years that I want to be a three-to-ten bagger (increasing in value 3 to 10 times); I’m not going to try to figure out if this is the exact entry point.
ME: You’ve talked about how you pick stocks, but when do you decide to get out?
LD: I run the portfolio to have six to eight core positions that make up 5-10% of the portfolio each. Then I’ll have another 30 to 40 names that are more short-term, catalyst-driven, trading-type long names, but the bottom line is I get out when I see the fundamentals going away. Luckily, I haven’t yet in any of my core names.
| I think my fundamental interpretation of what’s happening turns out to be the same kinds of things a technical person would chart out |
The only two ways I get out is if the fundamentals are going away–if I see something happening there that I don’t like, regardless of what the stock price is doing–or if things are going fine fundamentally but the stock has moved so fast that the multiple is too high and it’s not the compelling value it used to be to me (note to readers: check out the Trading Insight of the Day on Monday, August 23).
I’ll also lighten up on a position because of the general nature of the market, and this is probably a situation where if I were a true technician, I’d be explaining things in technical terms, like, “I know this is going to pull back 20% after this run, so I’ll pare down a little,” and so on, and then re-establish the full position after the drop; if it doesn’t drop, then I’m a little light on the upside because I’m not going to buy it on the way up.
ME: What are the specific inputs you look at to make a trade?
LD: The classic things: Is the business still growing as I expected, is it growing the way I expected, are their margins going down even though their revenues are going way up? I think you used to get much more value-added from being a guy who could really break down a balance sheet and income statement. I learned a ton from Michael Milken in that sense: he was someone who could really break down a balance sheet or income statement and really get to the essence of what’s important.
ME: Do you ever use any stops of any kind?
LD: No. Number one, I don’t need it because I live in front of the screen–I’m never not here when the market is open, and I know what I own. I think stop-losses just guarantee losses from my trading perspective, especially in the market we’re in now when you can get volatile and violent intra-day moves on any given day.
Dunn closed with a short, but compelling bit of advice that every trader (technicians and fundamentalists alike) should always keep in mind, but especially during these times of rocket-ship stock rides and 24-hour media coverage.
“Remember history, because it repeats itself . . . eventually.”