Through December I made a number of changes to the ESG Alpha portfolio to position it for the new year. Perhaps the most significant change was in the area of asset allocation. For most of 2006 the portfolio remained at the high end of its long exposure limit with a net long exposure of 75% of portfolio value. In December net long exposure was pared to 50% to reflect my near-term concerns on the market.

I found multiple candidates for shorting via my quant screens but, unfortunately, many were attractive private equity candidates given that they were poorly managed but had high free cash flow yields. The stocks I shorted were Adesa (KAR), Federated (FD), Shuffle Master (SHFL) and OSI Pharmaceuticals (OSIP). SHFL dropped significantly after I shorted it and I had to cover. KAR, per my prior comments, is being taken out by a private equity buyer. I had thought, incorrectly, that the stock was too expensive for a private equity buyer to be interested. Fortunately, the take out price was only modestly higher than where I placed the short. I also decided to cover an existing short, Pinnacle Entertainment. The net effect of this activity was to add only one new short position which was insufficient to achieve my allocation goal. My purchase of a position in the ProShares Ultrashort QQQ (QID) solved this problem. QID is an ETF which seeks daily investment results that correspond to twice (200%) the inverse of the daily performance of the NASDAQ-100 Index. The Fund employs leveraged investment techniques to achieve its investment objective. The one drawback is the price of 95bp – steep by ETF standards. On the long side I added to a few existing positions (Senomyx, Coldwater and Suntech) and established new positions in two large cap stocks, Genzyme and CVS.