Market Watch : The Long and Short of It: SSI’s Hedging Works

Statistical Sciences Inc. has preached its novel stock market hedge strategy for 17 years. But nothing makes the word “hedge” sound so interesting as a bear market--such as the one Wall Street appears to be in.

Beverly Hills-based SSI, founded by John D. Gottfurcht in 1973, manages $260 million for about 60 clients, including Pepperdine University and Hawaiian Airlines. The firm is little-known in L.A. money circles, yet Gottfurcht and his staff of 20 claim an enviable investing record:

* SSI’s basic stock-picking plan, called Profits Plus, beat the Standard & Poor’s 500-stock index in seven of 10 years in the 1980s, SSI says.

* Profits Plus 70, a conservative stock plan that on average invests 70% of a client’s money in stocks and 30% in cash investments, beat a similar S&P;/cash portfolio in eight of the past 10 years.

* The SSI Hedge plan, a stock program designed for ultraconservative investors who would otherwise stick with short-term Treasury bills or other safe havens, has beaten Treasury bill returns six of the past 10 years.

It’s the Hedge plan that sets SSI apart from most money managers. Traditional hedge programs try to protect stock portfolios from sharp market declines by using futures or index options contracts. Those instruments are sold at a locked-in price while the stocks are bought. So, in theory, the portfolio is hedged if the stocks plunge.

SSI hedges in a different way. Each time it buys a stock that it believes is poised to advance, it also “sells-short” the weakest-looking stock in the same industry.

In a short sale, you borrow stock and sell it, betting that you can replace the loaned shares later at a lower price. If the stock indeed drops, your profit is the difference between the price you got in the sale and what you pay to purchase the stock later to cover the loan. If the stock rises, you lose.

Short-selling has a foul reputation, mostly because some short-selling pros have used nasty tactics--such as spreading lies about a firm--to make their shorted stocks drop.

So, not surprisingly, SSI has faced a major marketing job in pitching its Hedge program to some big investors--particularly pension funds, which are subject to close public scrutiny.

Yet, John Gottfurcht says, SSI is the antithesis of the traditional gunslinging short trader. SSI uses short sales solely as a means to a conservative end--a hedge--rather than as a speculative tool for big gains, he says.

For example, to balance a “long” position in Procter & Gamble, the Hedge portfolio has shorted Clorox. If consumer stocks in general zoom, SSI figures that P&G; will lead--which it did in the spring bull market. If those stocks plunge, SSI figures, Clorox looks weakest. Hence, the hedge.

Likewise, the Hedge plan has a long position in Texaco and a short position in Ashland Oil. That has worked well, as the stock of oil producers such as Texaco has jumped with higher oil prices, while stock of refiners such as Ashland has been pummeled.

“The idea we had in 1973 was to develop a strategy where we could do well in all different types of market environments,” Gottfurcht said. The Hedge plan isn’t aimed at aggressive investors, he said, but at investors who want controlled risk and consistency of return--but something better than what T-bills pay.

In the current market slump, SSI’s hedge portfolio is a standout. Year to date, it’s up 9%, the firm says. In contrast, an investor who stayed in T-bills has earned about 5%. Meanwhile, the market, measured by the S&P; 500, is down 5.7%.

It’s also a forgone conclusion, Gottfurcht notes, that a portfolio hedged with short sales will under-perform the market when the vast majority of stocks are rising.

That’s why hedging was such a tough sell in the 1980s, when the bull market raged, said Amy Jo Gottfurcht, who as SSI’s executive vice president has built the company with husband John since 1982. “In the 1970s nobody understood hedging, and in the 1980s nobody wanted it,” she said. But in the ‘90s, she said, the return to careful stock picking bodes well for hedging--because careful stock analysis will identify many probable losers as well as probable winners.

And in fact, short-sale techniques are finally gaining acceptance among a growing number of pension funds and other big investors. Pensions & Investment Age magazine reported in April that big investors had pumped about $950 million into short-sale strategies during the previous year--an amount unheard-of in the 1980s.

Yet many pension funds, in particular, face barriers to short-sale investing, and even those that use the strategy generally refuse to discuss it. Imagine, for example, a pension fund shorting the stock of the company whose employees are the pension beneficiaries. That might be difficult for many of the employees to accept, even if they thought it was a smart investment move.

Even if SSI faces a tough challenge selling the Hedge program, its stock-picking ability under its Profits Plus plans could win the firm greater recognition in the ‘90s. So far this year, the Profits Plus portfolio is down just 1%, versus the market’s 5.7% loss, and Profits Plus 70 is up 0.5%.

With a strong long-term record, why isn’t SSI managing a lot more than $260 million? Besides the difficulty in marketing the Hedge plan, Gottfurcht maintains that SSI has in general spent little time prospecting. Many clients have come as referrals from others. And some rival money managers say the Gottfurchts simply don’t sell their message well.

SSI’s strategy is computer-driven, which John Gottfurcht says was his orientation from the start. The firm uses a wealth of historical data on market trends and individual stock trends to guide its market timing and stock decisions.

The basic question is the same that any investor asks: How do I buy low and sell high? SSI breaks the question down into individual stock price building blocks, such as price-to-earnings ratio trends and corporate asset values.

In addition, SSI focuses heavily on money-flow trends, identifying patterns that indicate when a stock is building up to heavy buying--or selling--by institutions.

Amy Jo Gottfurcht, who manages the computer operations, says a key to SSI’s success is constant experimentation with historical data to determine “what events make a difference with a stock and what events are redundant” compared to what SSI already knows.

In late June, the company’s computer model turned negative enough to warrant a pullback from stocks, which has helped minimize the damage to SSI’s portfolios compared to the market.

For now, SSI is a firm for big investors only (its minimum is $250,000). John Gottfurcht says a pooled investment fund for smaller investors has been discussed.

As for SSI’s unheralded status in the Southland, Gottfurcht says he has no regrets spending more time on computer models than on marketing. “If our strategy weren’t so complex, a lot of other people would have been doing the same thing,” he said.

SSI’S LONG-TERM RECORD

Here is how two conservative investment plans of the money management firm Statistical Sciences Inc. have fared since 1980, compared to benchmark conservative measures. The Hedge plan is aimed at investors who want consistent performance and controlled risk. The Profits Plus 70 plan is for investors who aim for 70% of their portfolio in stocks and the other 30% in cash investments, on average.

HEDGE PLAN PROFITS PLUS 70 S&P; Year SSI T-bills SSI 500* 1980 28.2% 11.2% 43.9% 26.0% 1981 15.0 14.7 8.0 0.7 1982 8.0 10.5 27.2 18.2 1983 7.8 8.7 22.4 18.3 1984 16.4 9.6 1.4 7.2 1985 13.8 7.5 30.6 24.4 1986 18.4 6.0 22.9 14.8 1987 -2.7 5.8 5.4 5.3 1988 6.0 6.7 11.9 13.6 1989 16.4 8.5 25.5 24.5 10-year avg. 12.4% 8.9% 19.3% 15.0%

* Assumes 70% of portfolio in S&P; stocks, 30% in cash

Source: Statistical Sciences Inc.