What kind of firm was it?
It was a registered investment advisory firm that managed about $300 million in institutional accounts. They had their own strategy on how to invest.
Were you allowed to make your own trading decisions, or did you have to follow their guidelines?
I could buy any stock I wanted, but it had to meet their investment criteria.
What were those restrictions?
The price/earnings ratio had to be below 15. Earnings had to be growing by at least 20 percent per year. There were also some balance sheet and liquidity conditions that had to be met.
Was that a help or a hindrance?
It was a huge impediment because it dramatically narrowed the universe of companies that I could invest in.
What stocks were you missing because of this policy?
For example, I couldn’t buy a Microsoft or a Cisco; instead I had to buy a Novell or a 3Com.
Because the price/earnings ratio was greater than fifteen?
Right.
Do you feel it is a flawed investment policy to try to buy stocks that have low price/earnings ratios?
Not necessarily. I would never adopt that type of strategy myself, but
I feel that any sound strategy will work as long as you stick to it.
Were there any restrictions on the stocks you bought for your own account?
I was allowed to buy any stocks I wanted to, as long as they were not the same names I was buying for the company’s clients.
What was the difference in performance between your own account and the accounts you were managing for the company?
For the company accounts, I would only be up an average of 15 to 20 percent per year, while on my own account, I was averaging well over 100 percent per year.
Did you try going to management and saying, “Look, here’s what I’ve been doing for my own account without any restrictions. Let me trade the company accounts the same way.”
Sure, but they had geared the firm to follow their particular philosophy, and that’s what the customers bought into. The last thing an investor wants to see is a change in strategy.
My idea, however, was to try to adapt to any new strategies that seemed to be working. Eventually I built up enough capital in my own account so that I could go my own way. I started a fund with $1.3 million, about half of which was my own.
How did you get investors?
Strictly word of mouth. I didn’t do any marketing.
I see that you’re here completely on your own, which is amazing for a hedge fund managing $150 million. Don’t you have any help?
I have a secretary who comes in every other day.
That’s it? Don’t you need any additional assistance?
I hired someone last year—a great guy who is now off on his own—but I knew immediately that it wasn’t for me.
Why is that?
I found that having another opinion in the office was very destabilizing. My problem is that I am very impressionable. If I have someone working for me every day, he may as well be running the money because I’m no longer making my own decisions.
I like quiet. I talk all day on the phone, and that’s enough for me. I don’t need committees, group meetings, and hand-holding to rationalize why a stock is going down. I even like the fact that my assistant only comes in every other day, so that every alternate day I am completely on my own and can sit here and germinate.
I understand that completely, because I work in a home office. I find that when you work on your own, you can get completely engrossed in what you are doing.
Exactly. That’s the main reason I like to be on my own. People come in here and ask me, “How could you manage this much money on your own? Don’t you want to become a bigger firm?”
What do you tell them?
Well it’s worked for me so far. The only thing that matters is how well do, not the amount of zeros I’m managing.
With your track record, you could easily raise a lot more money.
That would just kill everything. The only way I can possibly maintain my track record is to make sure I don’t overwhelm myself with assets. Right now, if I have a good quarter, it ramps up the amount of money I am managing. By growing through capital appreciation, I can evolve my trading style to accommodate the increase in assets managed.
I guess you would rather make 50 percent plus on a $150 million than 20 percent on $1 billion.
Exactly. A lot of people who do well and decide to dramatically increase their assets find that their first year is their best year. After that, it’s downhill. Of course, they still make huge sums of money. But I want to feel good about coming in every day. I want to have happy customers and see my assets steadily growing. I don’t want to be cranking out a great living on a business that is deteriorating. I have almost no overhead, so I still make a great income. There is no need to get greedy.
Do you think the experience of coming close to the edge of bankruptcy helped you become successful?
Definitely.
In what way?
The odd thing about this industry is that no matter how successful you become, if you let your ego get involved, then one bad phone call can put you out of business. My having seen the abyss might spare me from making that phone call. I know how quickly things can go bad. Any stock can go to zero, and you need to realize that.
When I talk to potential new investors I focus on my mistakes. Because if you are going to invest with someone, you want that person to have made mistakes on his own tab and not to make them on yours. Someone who has never made a mistake is dangerous, because mistakes will happen. If you’ve made mistakes, you realize they can recur, and it makes you more careful.
We’ve talked about the mistakes you’ve made early in your career. What mistakes have you made during your more recent successful years?
This year I got very bearish without waiting for prices to confirm my opinion.
What made you so blindly bearish?
I became very concerned about the rise in interest rates. In the past, higher interest rates had always led to lower stock prices, and I assumed the same pattern would repeat this year. The market, however, chose to look at other factors. I didn’t wait for the market to confirm the fear of higher interest rates, and I lost money very quickly. I was down 7 percent in March, which is a pretty big one-month drop for me.
Any other mistakes come to mind?
In January 1998 I invested in a bunch of small-cap initial public offerings (IPOs), which all performed incredibly poorly in the first quarter they went public.
What was your mistake there?
My mistake was getting involved in illiquid securities without doing sufficient research.
What prompted you to buy these stocks?
Market sentiment. The market was getting very excited about conceptual IPOs—stocks with a dream and a story but no earnings. When stocks like these go sour, they can go down 70 percent or more very quickly. It was as if a tornado had swept through my portfolio. I was down 12 percent for the month and decided to liquidate everything. One stock that I bought at 18, I sold at 2.
If these stocks were down that much, wouldn’t you have been better off holding them in case they bounced back? What happened to these stocks after you liquidated them?
They bounced, but not by much. As I liquidated these stocks, I used the money to buy the types of stocks that I should’ve been buying—good companies at much higher prices.
So you had deviated from your philosophy.
Yes, once again. It’s like a junkie who is off drugs for three years and then runs into some crack dealer who is able to convince him to start again. I don’t mean to blame other people for convincing me. It was my own fault for allowing myself to be susceptible to these stories. I think I’ve learned not to trade on those types of stories anymore. The good news is that I quickly switched back to buying the types of companies that I like. By the end of the quarter, I had recovered all my losses.
Absolutely. By cleaning out my portfolio and reinvesting in solid stocks, I made back much more money than I would have if I had kept the other stocks and waited for a dead cat bounce.
Do you talk to companies at all?
I used to visit companies all the time when I was working for the investment advisory firm.
Did it help at all?
Hardly at all. I found that either they told me what they had previously told everyone else, and it was already factored into the price, or else they lied to me. Once in a blue moon you would learn something valuable, but there was a huge opportunity cost traveling from company to company to get that one piece of useful information.
Can you give me an example of a situation where management lied to you.
The examples are almost too numerous to remember.
Pick out one that stands out as being particularly egregious.
I saw Autumn Software* make a presentation at a conference. I had never heard such a great story. They produced software that was used in computer backup systems all around the world. The management team was very believable and articulate. The stock was high, but I felt it was a big momentum horse. I bought half a million shares, and the stock started to crumble almost immediately.
I called management and asked them what was happening. “We have no idea,” they said. “Business is actually better than last month.” One day I was out at Nantucket, and I received a phone call informing me that Autumn had just preannounced that they would have a disappointing quarter. The stock, which had closed at 30 that day, opened at 7 the next morning. It was funny because every time I had talked to the company, “business had never been better.” That proved to me that as an outside investor you never know the truth.
Is this an example of a situation in which you ignored your own rule of paying careful attention to how a stock responds to news, or if it goes down for no apparent reason?
Unfortunately for my former employer, I was still learning that lesson at the time.
Did that experience sour you completely on talking to management?
Not completely. I might call a company’s management when its stock is very low and no one is talking to them, because that is when they are usually desperate enough to talk to anyone. My hope is that I might learn about some catalyst that could cause the stock to turn around.
What are the traits of a successful trader?
I think a lot of successful traders are unemotional, hardworking, and disciplined. Ironically, I find myself lacking on each of those counts. I get very emotional; I really don’t work that hard; and I’m not as disciplined as I should be. I would attribute my own success to having both conviction about my gut feelings and the ability to act on them quickly. That is so critical.
So in your own case, you’ve been able to offset some other drawbacks simply by having the ability to pull the trigger?
Exactly, that’s a very good point.
What is the biggest misconception people have about the stock market?
Currently, the biggest misconception is the widespread belief that it is easy to make a living trading in the stock market. People feel they can give up their jobs and trade for a living; most of them are bound to be disappointed.
What are the trading rules you have posted on your computer?
Be patient—wait for the opportunity.
Trade on your own ideas and style.
Never trade impulsively, especially on other people’s advice.
Don’t risk too much on one event or company.
Stay focused, especially when the markets are moving.
Anticipate, don’t react.
Listen to the market, not outside opinions.
Think trades through, including profit/loss exit points, before you put them on.
If you are unsure about a position, just get out.
Force yourself to trade against the consensus.
Trade pattern recognition.
Look past tomorrow; develop a six-month and one-year outlook.
Prices move before fundamentals.
It is a warning flag if the market is not responding to data correctly.
Be totally flexible; be able to admit when you are wrong.
You will be wrong often; recognize winners and losers fast.
Start each day from last night’s close, not your original cost.
Adding to losers is easy but usually wrong.
Force yourself to buy on extreme weakness and sell on extreme strength.
Get rid of all distractions.
Remain confident—the opportunities never stop.
I know you have no desire to be working with anyone, but let’s say five years from now you decided to pursue a new career making films. Could you train someone to take over for you and invest in accordance with your guidelines?
I could teach someone the basic rules, but I couldn’t teach another person how to replicate what I do, because so much of that is based on experience and gut feeling, which is different for each person.
After you reach a certain level of financial success, what is the motivation to keep on going?
The challenge of performance and the tremendous satisfaction I get from knowing that I contributed to people’s financial security. It’s fantastic. I have a lot of clients, some of whom are my own age, who I have been able to lead to total financial independence.
How do you handle a losing streak?
I trade smaller. By doing that, I know I’m not going to make a lot, but I also know I’m not going to lose a lot. It’s like a pit stop. I need to refresh myself. Then when the next big opportunity comes around—and it always does—if I catch it right, it won’t make any difference if I’ve missed some trades in the interim.
What advice do you have for novices?
Either go at it full force or don’t go at it at all. Don’t dabble.
Is there anything pertinent that we haven’t talked about?
It is very important to me to treat people with fairness and civility. Maybe it’s a reaction to all the abuse I took in the New York trading rooms. But, whatever the reason, the everyday effort to treat others with decency has come back to me in many positive ways.
* * *
Stuart Walton had no burning desire to be a trader, no special analytical or mathematical skills, and was prone to emotional trading decisions that caused him to lose all or nearly all his money on several occasions. Why, then, did he succeed, let alone succeed so spectacularly?
There are five key elements:
Persistence. He did not let multiple failures stop him.
Self-awareness. He realized his weakness, which was listening to other people’s opinions, and took steps to counteract this personal flaw. To this end, he decided to work entirely alone and to set aside a small amount of capital—too small to do any damage—to vent his tip-following, gambling urges.
Methodology. Walton became successful exactly when he developed a specific market philosophy and methodology.
Flexibility. Although Walton started out by selling powerhouse stocks and buying bargains, he was flexible enough to completely reverse his initial strategy based on his empirical observations of what actually worked in the market. If he believes a stock he previously owned is going higher, he is able to buy it back at a higher price without hesitation. If he realizes he has made a mistake, he has no reservation about liquidating a stock, even if it has already fallen far below his purchase price. Finally, he adjusts his strategy to fit his perception of the prevailing market environment. In Walton’s words, “One year it might be momentum, another year it might be value.”
Diagnostic capability. Most great traders have some special skill or ability. Walton’s talent lies in not only observing the same news and information as everyone else, but also in having a clearer insight into the broa
d market’s probable direction—sometimes to the point where the market’s future trend appears obvious to him. This market diagnostic capability is probably innate rather than learned. As an analogy, two equally intelligent people can go to the same medical school, work equally hard, and intern in the same hospital, yet one will have much greater diagnostic skill because ability also depends on intrinsic talent.
Walton’s case history demonstrates that early failure does not preclude later success. It also exemplifies the critical importance of developing your own methodology and shutting out all other opinions.
* * *
Update on Stuart Walton
Walton left trading in the midst of a roaring bull market after eight years in which he achieved a remarkable triple-digit average annual return (gross). He returned to trading in the midst of a bear market (January 2001), out of step with the changed environment. In the twenty-one months since his return, he experienced an indexlike cumulative decline, losing 6 percent more than the S&P 500 and 4 percent less than the Nasdaq. In this follow-up interview, we discussed the reasons for Walton’s drastic performance reversal and the changes he has made in his trading approach as a result.
You had an eight-year run with exceptional returns, then took a sabbatical, and experienced a terrible year on your return. What happened?
When I stopped trading in mid-1999, the Nasdaq had not yet reached its frenzied overdrive phase. It had been going up over 20 percent per year, but in the mere eight months after I quit, it shot up another 75 percent. So I didn’t trade through that period of explosive price gains and market euphoria. Similarly, I didn’t trade through the subsequent bursting of that bubble. When I returned in 2001, since I hadn’t lived through the excesses the market had gone through, I didn’t fully appreciate the extent of the emotional damage the market had sustained in 2000. My most recent trading experience had been the success I had witnessed in the 1990s by zigging and zagging to the rhythm of the markets. As a result, instead of playing for the big trade, which was the continuation of the downmove, I was still trying to play the market from both sides. With the benefit of hindsight, it is clear that I suffered from a lack of perspective.
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