New York (HedgeCo.net) – Brookdale Capital Management is an investment management firm based in Dallas, Texas. The firm has a particular focus on liquid alternative investment strategies across all asset classes including equities, credit, commodities, currencies, and derivatives. The Brookdale Defensive Long/Short strategy is on the HedgeCoVest Platform and it has an equity focus with a particular bias towards defensive sectors. We had the opportunity to speak with fund manager Adnan Rehmatullah recently.
HedgeCoVest: Thank you for taking the time to talk with us Adnan. If you would, describe your investment approach?
Adnan Rehmatullah: The strategy is based on four investment principles or what we call “pillars”. The first pillar is the strong belief that markets tend to overreact. Companies tend to get excessively punished and excessively rewarded and we try to capitalize on these extremes which are often driven by human behavior. The second pillar is that fundamentals matter. Technical factors and market dynamics are important, but fundamentals will ultimately dictate price in the medium and long terms. The third pillar is that we have to stay objective. Don’t get caught up in the hype and the news; allocate capital and invest objectively without emotion and personal biases. The fourth pillar is that portfolio construction matters.
HedgeCoVest: What do you mean by that last statement?
AR: We place a lot of importance on portfolio construction. Because we believe there is finite “alpha”, or excess returns, available, we want to retain any alpha that is generated by minimizing or limiting the possibility of errors from portfolio construction. We only utilize leverage to initiate short positions, we do not materially move exposures to try and time the market, and we maintain a diversified portfolio to avoid large position concentration.
In addition, we break our portfolio down into “books”. Each book is sector specific. Long and short positions are matched by sector to limit sector basis risk which improves the volatility profile of the strategy.
HedgeCoVest: Can you tell us more about the stock selection process?
We focus on the defensive sectors such as Consumer Staples and Healthcare, excluding biotech or insurance stocks. These sectors provide relatively consistent earnings and are generally less sensitive to economic, structural and technological changes. Because we think that cash generation should be the primary driver of valuations, we construct our portfolio to match this principle. On the long side, we are looking for quality companies with good fundamentals and great cash flow that have fallen out of favor for one reason or another. On the short side it is the opposite. We are looking for companies with poor fundamentals, lagging cash flow and yet for some reason they seem to be loved by the majority of investors.
We have a process that evaluates each company within the sectors that we cover using internally built models which are updated daily. If a company doesn’t meet our requirements any longer, we exit our position. There was a company that came out with earnings last night and when I updated the information this morning they didn’t meet our stringent requirements any longer. We exited the position this morning.
HedgeCoVest: Given your focus on defensive sectors, do you evaluate the Utilities sector as well?
AR: No we do not, the reason being that utility stocks tend to be more yield driven and they are in an industry that is heavily regulated with regards to what they can charge and so forth. Because of this, intra-sector dispersion within the Utilities sector is quite limited, leading to very few opportunities to generate excess returns.
HedgeCoVest: What differentiates your strategy from the rest of the alternative investment world?
AR: The first thing that comes to mind is being focused on the defensive sectors of consumer staples and healthcare. These two sectors aren’t real popular with hedge funds, but that is a benefit during a hedge fund related crisis. If there is a sector changing event and the sector is crowded with hedge fund participation, the selling can be tough to deal with. With staples and healthcare you don’t have too many other hedge funds operating in the same realm.
Secondly, I would say the focus on the process and stock selection. Cash flows are so important in the long run that we feel our stock selection process will provide a more consistent approach to excess returns. We do the same thing over and over and it doesn’t matter if it is March, November or December and it doesn’t matter whether we are in a bear market or a bull market. We are always invested in the best opportunities the market provides.
HedgeCoVest: What would you say are the strengths of your strategy?
AR: We use a process based approach and we don’t believe that market timing is a sustainable way to provide alpha to your clients. We maintain 100% long exposure and 50% short exposure at all times. We believe this gives us the best chance at providing sustainable alpha. The constant portfolio construction along with the stock selection process—for both the long and short side, are the keys to our approach. We are looking for consistency more than we are high returns. Having the discipline to stick with our process and remaining objective is the key to providing consistent returns. I am not going to be the most popular guy if we have another 1999 type market where the market soars higher on the back of tech stocks.
HedgeCoVest: What are the weaknesses to the approach?
AR: Like I said, if we see hyper-growth or a market that is led by a single sector, we are going to lag the market.
HedgeCoVest: At this point in time, do you use leverage in your portfolios?
AR: On the long side we do not use any leverage, but obviously when we are selling short we have to use margin to do it. Again, our portfolio construction is a constant 100% long exposure and 50% short exposure for a net long exposure of 50%. This helps us protect the downside.
HedgeCoVest: Is there a type of market where you feel like your strategy outperforms other investment approaches?
AR: We tend to outperform in a choppy or directionless market. Because of our discipline and objective approach, we don’t get caught up in the day to day or week to week dynamics. This gives us an advantage over a lot of other funds.
HedgeCoVest: How many stocks do you typically keep in the portfolios?
AR: We tend to hold 50-60 stocks on both the long side and the short side at all times. We try to keep the exposure to a given stock between 2-5% for long positions and between 1-3% on the short side.
HedgeCoVest: What is the average holding period for the stocks in the portfolio?
AR: On the long side it tends to average between three to six months and on the short side it is about the same, but perhaps a little bit shorter. Because we are buying stocks with great cash flows and fundamentals that are out of favor for one reason or another, they tend to move back to proper valuation levels within a quarter or two.
HedgeCoVest: What measures do you take to reduce or eliminate risk?
AR: One thing we do is stay away from the biotech sector within healthcare. There are too many variables that can change and the valuations are totally different than the rest of the sector. Another thing we do is we won’t short a stock where more than 30% of the float is sold short. You can get caught up in a short squeeze and the losses can mount in a hurry. We also won’t take a position where we represent more than 20% of the average daily trading volume.
HedgeCoVest: Shifting our focus to a more macro view, what observations have you made about the market and what is your outlook going forward?
AR: It has been an interesting year so far in that we have alternated from losses to gains from one month to the next, but looking deeper into the numbers we started seeing a divergence between large-cap and small-cap stocks and it has grown. Growth oriented names, their valuations continue to rise. That is indicative of and perhaps contributing to the volatility and it is manifesting itself even in the intraday movements. Investors seem to be catching on to this and are hesitant to pay for the higher valuations. These developments caused value oriented companies and portfolios to lag in the first quarter.
HedgeCoVest: When you say there is a divergence between large-cap and small-cap, when this has happened in the past, is it predictive in any way? Does it indicate what we should expect going forward?
AR: It is to a degree. It mainly manifests itself in the valuations. To give you an idea, the current valuation on the Russell 2000 index is near the upper end of its most recent 15 year historical range. This small cap index currently ranks in the 70th percentile. So you have a situation where, in terms of the valuations, there is a 70% risk to the downside and only a 30% chance to the upside. Keep in mind this metric is representative of the entire index meaning approximately 50% of the constituents are closer to the 80th and 90th percentile. These types of indicators suggests to us that there is going to be a rotation over the next 6-12 months where value names will become more in favor and the growth oriented names will fall out of favor to a degree. We are seeing this in the overall market and even within the sectors themselves.
HedgeCoVest: Thank you for taking the time to talk with us today Adnan. We appreciate learning more about Brookdale Capital and getting your take on the market and economy heading forward.