King of the retail jungle
Hedge fund manager David Berman profits by thinking like a patient predator.
By David Berman

(FORTUNE Magazine) – "I USED TO BE A VICTIM OF PEOPLE LIKE ME," SAYS HEDGE fund manager and onetime accountant David Berman. "Every time I bought a stock, someone smarter than me was selling it. Every time I sold, someone smarter was buying." So when he formed a firm to manage his own money in 1997, Berman decided to focus on a single sector and master it. His choice? Retail. This son of a furniture maker spent a year walking malls and eventually developed a custom index--the DeeBee (as in David Berman)--to compare sales vs. inventories at U.S. retailers. His specialization strategy has paid off: Berman says he has averaged a return of 17% after fees over the past eight years with only three down months. He now manages more than $100 million through Durban Capital, a hedge fund he named for his hometown in South Africa and launched in 2001. A big part of his formula is that he's willing not to buy if prices aren't right. FORTUNE's Julie Schlosser phoned Berman in Cape Town (where he spends three months every year) to chat about the sector's latest batch of strong sales reports, why they don't necessarily bode well for stocks, and what investors can learn from crocodiles.

Despite lackluster holiday sales, the S&P 500 retailing index is up 11% for the past year. Can retailers keep beating expectations in 2005?

February surprised everybody, retailers included. It surprised me. There are a bunch of theories why. Perhaps tax refunds are better than people thought they'd be. Fashions are pretty good. And I think weather has been a positive factor. It was about four degrees warmer than usual across the country in February. But to a large degree, during this time of year the retail group gets moved for macro reasons.

Which macro factors affect retailers?

Sometimes the best months for retail sales have been the worst months for stocks. If it is the best month for retail, what happens to interest rates? They go up. And that's not good for retailers. You may have that now. The Fed hasn't been able to slow the economy down, but bond yields are going to do the job. Greenspan has been very ineffective with raising rates. But the long range is out of his control. The rates have gone up to over 4½%. Home loans may start going higher, and that will slow things down. I'm not a bond expert, but those yields may well go higher because this economy is really rocking. Or at least people think it's rocking.

How do you figure out if a stock is a good value?

I maintain that I am not smart enough, and I don't think anyone really is, to know what the P/E should be. My job is to understand what the EPS [earnings per share] should be. I look for facts. That's why I measure inventories. I have my people visit stores and malls to see how much the items are marked down and how long the lines are at the registers. I'll buy a stock if I think the company is going to beat numbers and short it if it is going to miss numbers. It is that simple.

Your DeeBee index measures sales growth vs. inventory growth. Is that how you predict whether a company will beat Wall Street's earnings estimates?

We summarize every publicly held retailer in America. That's almost 300 companies. We've been doing this quarterly for many years. On an individual level, it gives us a great sense of which companies are going to do well because their inventories are well controlled and which ones have potential for missing numbers. It gives us a sense of the profitability of the group going forward. And it also gives us a sense of the future strength of the economy, because retail leads the way. If inventories are depleted what does that mean? It means retailers are going to be ordering more faster, and that means the back end of the economy is going to do well. It is a lot of work, but it is really worth it to us.

What do you mean when you say you use a "Crocodile Approach"?

Just wait and be patient for the right opportunities. The crocodile can go for almost two years without eating food. It has very small legs and can't go very fast. It waits by the riverbed. If its prey doesn't come, it just sleeps all day. You want to be like the crocodile and wait for the prey to come to you. You don't want to rush off to the prey. You want to wait for the big zebra and grab him and eat it up. With that in mind, I've never been afraid to build up a big cash position. You can't lose money if you're in cash. That's why I don't have many down months. I've never used leverage. In fact, some of my investors will be upset with me, but until recently I rarely had much more than 50% of my money invested--both long and short--at one time. That means I am half in cash. I recognize that is too low. It needs to increase. But it's because of the Crocodile Approach.

Last month Federated Department Stores, parent of Macy's and Bloomingdale's, announced plans to acquire May Department Stores. Is it a sign that the department stores are truly dying?

The merger is a function of Wal-Mart's power. Wal-Mart by our numbers has 21% of the sales of publicly held retailers, excluding autos. And roughly 8% of total sales. Almost one in every ten sales in America is done in Wal-Mart. That has totally changed the retail landscape. As a result the department stores are really being squeezed. They're having to scramble to stay competitive. It is probably just a natural evolution of the retail landscape. There is just a slow deterioration in the department store mode.

What is the DeeBee index's top-rated stock right now?

I can tell you who is good on my inventory list but they might already have a high P/E. At the top is American Eagle Outfitters (AEOS, $29). It just reported sales up 37% while inventories are up only 14%. That bodes well for future margins and profits. But a large amount of that is reflected in stock price. I own it, but I've been reducing my position. American Eagle has got great management. They've beefed up their staff over the last couple of years. They just hired some good people for a new concept that they will be announcing soon. It will give them another leg of growth. They are firing on all cylinders. Nordstrom (JWN, $55) also had good results, with sales up 9% and inventory up only 2%. That's the best in the department store category. The problem is that those results are already factored into the stock price. Remember, the concept of who is going to beat earnings and the stock price are two different things.

So the crocodile isn't running out to snap up zebras?

I am really concerned that the retail group has had a nice run. Many companies are looking worse this year in terms of inventory growing faster than sales. It's hard to find good longs. I'm in sleeping mode, waiting patiently for opportunities. ■