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Feb 3 2014 | 8:18am ET
Christopher Gildea and Scott McGraw run a long/short equities strategy with a straightforward goal:
“We are a hedge fund that does deep research and analysis and only gets involved in those situations where we can generate alpha,” Gildea told FINalternatives during a recent interview.
It's a goal they met in 2013: their Delaware-based Merit Fund was up 26.36% (net of fees) during a year when the average hedge fund returned about 8%.
Gildea and McGraw, who had worked together at Pennsylvania-based money manager Gardner Lewis Asset Management, launched Merit Investment Management in 2010 with anchor money from an insurance company. In 2012, they converted a separately managed account, the Absolute Return Strategy, into the Merit Fund, which, as of end-2013, accounted for $30 million of the $106 million Merit Investment had under management.
“Chris and I worked together for four years and realized that we had a very similar investment strategy and way of evaluating stocks,” McGraw told FINalternatives. “[W]e were able to work across a variety of strategies, including long/short and also work across multiple market caps, sectors...[T]he focus was really on meeting and evaluating a ton of companies, about 300 to 400. And so we built Rolodexes of companies and CEOs we know and understand.”
The insurance company that seeded them has stuck with them, he said, becoming “a great client.”
“They've continued to add capital to the fund—when we converted to the fund structure, they made an additional contribution that brought us to $25 million to get out of the gate in December of 2012, and we've grown that through appreciation, market performance and also additional clients that we added in 2013.”
Long & Short Of It
McGraw who, before joining Gardner Lewis spent time Bank of America Securities, Merrill Lynch and Accenture, describes the Merit Fund strategy as a combination of “a Warren Buffet-like approach on the long side” with “really targeted, opportunistic short-selling to try to deliver alpha on short positions as well.”
They run a concentrated portfolio—they now have 12 long positions and 13 shorts which they said could reach a maximum of 15 on either book.
On the long side, they seek to invest in “great businesses with a long-term investment horizon,” said McGraw. Some of the companies that currently meet those criteria include Rite Aid, CSX and Apple.
Their optimal holding period, said Gildea, is “forever, but typically the situation doesn't work out that way, and there's a fundamental change or the valuation gets significantly diverged from what it's intrinsic valuation really is. What we tell investors is, we initially take a look at a company with a three- to five-year holding period expectation. That doesn't mean we hold companies necessarily for three years or five, it's just how we try to value the business. And since inception I believe our turnover on the long side is about 15%.”
On the short side, he said, they “truly don't want to pair trade or hedge a company exposure that we have on the long side or hedge a sector exposure we have on the long side. We're purely looking for situations where there's an absolute return possibility and part of the reason for that is, things really changed after 2008, hedge funds prior to that used to be able to short stocks, do the market average and collect their interest on their credit balances and deliver positive returns to their investors. That situation doesn't exist anymore.”
What they look for, he said, is companies whose published financials or public disclosures “misrepresent real economic performance or outlook in the business.”
“It's a focus on finding accounting irregularities or poor disclosure that doesn't adequately give the investor good insight into segment performance or one-time anomalies that might be helping them overstate what, long-term, sustainable earnings trend should be.” It's an approach to short-selling Gildea has employed successfully for 15 years, throughout a career that, prior to Gardner Lewis, included stints with GTA Acquisition and Fechtor, Detwiler & Co.
But all of this is done recognizing what Gildea terms “the inherent risk in being short.”
“There's a real cost to being short,” he said. “You've got a headwind just naturally because we're at the zero bound of interest rates.” As a result, the Merit Fund “would rather hold cash if we don't think we can make absolute returns.
“So, for instance, last year, clearly, if we thought the market was going to be at 30%, we probably would have had even less shorts on but the shorts we did put on, I think we were up mid-teens on our shorts, we probably delivered double-digit alpha in our shorts and we actually had a number of shorts that made money.”
McGraw admits that the Merit Fund's 2013 performance was “higher than we would have expected.”
“When we talk with investors and they say 'What are your targeted returns?' they're certainly much lower than what we had put up in 2013,” he said. “But I think we also recognize there are a lot of macro factors at work and a lot of things to gauge in the markets and so we probably had a little more market exposure than we would have originally planned a couple of years back. We averaged in the mid-'60s from a net exposure point of view.”
Merit is currently initiating a Founders Round and is in discussions with potential investors. McGraw believes the strategy has the capacity to manage up to $2 billion, “given our mix of small caps, mid caps and large caps.”