Stock Market Wizards

by Jack D. Schwager

  [He searches his memory and then laughs.] One of our shorts was Ultrafem. It was a one-product company that was trading at over a $100 million capitalization. The product was a substitute for feminine pads that used what the company termed “a soft cup technology.” The company had put out press releases trumpeting the superiority of their product to conventional alternatives. I called the manufacturer and got them to send me five free samples, which I gave to five women friends. After they tried it, they all came back to me with virtually the same response: “You’ve got to be kidding!” I shorted the stock. The stock was trading in the twenties when I conducted my “market research;” it’s now trading at three cents with a market capitalization of $260,000.

  Where did you get out?

  We covered our position recently.

  You held it all the way down!

  This was probably my number one short pick of all time, but unfortunately we had very few shares on the way down because we were bought in on a lot of our stock.

  By “bought in” do you mean that the stock you borrowed was called back? [In order to short a stock, the seller must borrow the shares he sells. If the lender of those shares requests their return, the short seller must either borrow the shares elsewhere, which may not be possible, or else buy back the shares in the market.]

  Exactly, and the stock was fully locked up [there weren’t any shares available to be borrowed]. That’s when I learned that the short game is very relationship dependent. If there is a scarcity of stock available for borrowing and I’m competing with a large fund manager who does more business with the brokerage firm than I do, guess who’s going to get those shares. This occurred back in 1997; we were a lot smaller then.

  Why would loaned shares be called back?

  Because the investor requests the stock certificate in his name. [Unless an investor specifically requests the stock certificate, the stock will be held by the brokerage firm (“in the Street name”) and loanable.]

  Why would an investor suddenly request receipt of his stock certificate?

  Companies whose stock price is very vulnerable because of weak fundamentals will often attract a lot of short selling. Sometimes these companies will encourage their investors to request their stock certificates in their name, in the hopes of forcing shorts to cover their positions when the loaned stock is recalled. Sometimes a few firms will buy up a large portion of the shares in a stock with a heavy short interest and then call in the shares, forcing the shorts to cover at a higher price. Then they will liquidate the stock for a quick profit.

  Are you implying that large fund managers will sometimes get together to squeeze the shorts?

  It is illegal for portfolio managers to get together to push the price up or down—that’s considered market manipulation. Does it happen anyway? Sure, it happens all the time. During the past five months, just about every stock with a heavy short interest got squeezed at one time or another.

  Do most stocks that are squeezed eventually come down?

  I am a firm believer that if a stock is heavily shorted, there is usually a good fundamental reason. Most of the time, those stocks will end up much lower. In the interim, however, even a near-valueless stock can go up sharply due to an artificial scarcity of loanable shares.

  How do you time your shorts? Certainly there are a lot of overpriced stocks that just get more overpriced.

  The timing is definitely the tough part. That is why we spread our short position across so many stocks and use rigorous risk control on our shorts. I don’t mind if I have a long position that goes down 40 percent, as long as I still believe that the fundamentals are sound. If a short goes 20 to 30 percent against us, however, we will start to cover, even if my analysis of the stock is completely unchanged. In fact, I will cover even if I am convinced that the company will ultimately go bankrupt. I have seen too many instances of companies where everything is in place for the stock to go to zero in a year, but it first quintupled because the company made some announcement and the shorts got squeezed. If that stock is a 1 percent short in our portfolio, I’m not going to let it turn into a 5 percent loss. We’ve had a lot of short positions that we closed out because they went against us and that later on collapsed. But we are much more concerned about avoiding a large loss than missing a profit opportunity.

  The discussion of the inherent danger of being short a stock that is subject to a squeeze leads to a conversation about Watson’s childhood experience with poisonous snakes, which was described at this chapter’s opening.

  Did you feel any fear while you were holding those snakes?

  No, I would describe the feeling as closer to excitement. I was a pretty hyperactive kid.

  Is there anything that you are afraid of?

  I’m going skydiving next week—that scares me.

  Why is that?

  I thought about that. I realized what scares me—things I can’t control. When I held those snakes, I had control. I’m planning to learn race car driving in Italy this year, and that doesn’t scare me because I’ll have control of the car. But I have no control over the parachute. I just hope that the person who prepares my chute doesn’t have a bad day.

  Why are you going skydiving if you have no control?

  I just had my birthday this past Saturday; it was one of my gifts. I don’t have any choice. Maybe the person who gave me the present will forget—but I doubt it [he laughs].

  What do you look for when you hire an analyst?

  For a number of reasons, everyone I hire is in their twenties. First, they will work eighty to a hundred hours a week. Second, they haven’t made so much money that they will sit back and relax. Third, they won’t think twice about calling up a CFO, distributor, or customer. I also hire people who want to win.

  Picking stocks is as much an art as a science. There are some people who no matter how hard they work, how much research they do, or how many companies they call, will not succeed because they don’t have the knack of figuring out what is and isn’t going to work.

  Did you ever hire anyone who didn’t work out?

  The first person I hired. He was one of the smartest people I have ever known. The problem was that he didn’t have any intuition, and he didn’t get the risk side. For example, he would say, “We have to short Yahoo at 10 because it is worth zero.” He didn’t have any instinctive feel for what was going on in the market.

  So much of your approach seems to be tied to speaking to company management. If tomorrow you awoke in the financial Twilight Zone and found yourself to be an ordinary investor instead of a fund manager with hundreds of millions in assets, how would you alter your approach?

  Well, first of all I would still have a telephone. I might not be able to call the CFO, but I could call other employees of the company, as well as consumers and distributors of their products. Also, the Internet today allows you to get a tremendous amount of information without speaking to anyone. You can get the company’s 10-Qs and 10-Ks [the quarterly and annual company reports required to be filed by the SEC], company press releases, insider trading statistics, and lots of other valuable information. Also, I could still go to the mall and check out a company’s product, which is a big part of what we do.

  Anything stand out as your best trade ever?

  [He thinks for a while.] I usually don’t get excited about winners; I’m too busy looking for the next trade.

  What lessons have you learned about investment?

  Do the research and believe in your research. Don’t be swayed by other people’s opinions.

  Anything else?

  You have to invest without emotions. If you let emotions get involved, you will make bad decisions.

  You can’t be afraid to take a loss. The people who are successful in this business are the people who are willing to lose money.

  * * *

  One of the most common trading blunders cited by the Market Wizards is the folly of listening to others for advice—a mistake that proved very costly to
some (Walton and Minervini for example). Steve Watson was lucky: He learned the lesson of not listening to others’ opinions from a college course instead of with his own money.

  Watson begins his investment selection process by focusing on stocks that are relatively low priced (low price/earnings ratio), a characteristic that limits risk. A low price is a necessary but not sufficient condition. Many low-priced stocks are low for a reason and will stay relatively depressed. The key element of Watson’s approach is to anticipate which of these low-priced stocks are likely to enjoy a change in investors’ perceptions. In order to identify potential impending changes that could cause a shift in market sentiment, Watson conducts extensive communication with companies and their competitors, consumers, and distributors. He is also a strong proponent of such commonsense research as trying a company’s product, or in the case of a retailer, visiting its stores. Finally, Watson looks for insider buying as a confirmation condition for his stock selections.

  Shorting is considered a high-risk activity and is probably inappropriate for the average investor. Nevertheless, Watson demonstrates that if risk controls are in place to avoid the open-ended losses that can occur in a short position, shorting can reduce portfolio risk by including positions that are inversely correlated with the rest of the portfolio. On the short side, Watson seeks out high-priced companies that have a flawed business plan—often one-product companies that are vulnerable either because the performance of their single product falls far short of promotional claims or because there is no barrier to entry for competitors.

  Watson achieves risk control through a combination of diversification, selection, and loss limitation rules. He diversifies his portfolio sufficiently so that the largest long holdings account for a maximum of 2 to 3 percent of the portfolio. Short positions are capped at about 1.5 percent of the portfolio. The risk on long positions is limited by Watson’s restricting the selection of companies from the universe of low-priced stocks. On the short side, risk is limited by money management rules that require reducing or liquidating a stock that is moving higher, even if the fundamental justification for the trade is completely unchanged.

  Watson has maintained the pig-at-the-trough philosophy he was exposed to at Friess Associates. He is constantly upgrading his portfolio—replacing stocks with other stocks that appear to have an even better return/risk outlook. Therefore, he will typically sell a profitable long holding even though he expects it to go still higher, because after a sufficient advance, he will find another stock that offers equal or greater return potential with less risk. The relevant question is never, “Is this a good stock to hold?” but rather, “Is this a better stock than any alternative holding that is not already in the portfolio?”

  * * *

  Update on Steve Watson

  Not long after our interview, Watson turned over the day-to-day management of his funds to two of the company’s portfolio managers to allow him to pursue other interests on the West Coast. (He declined to discuss these new endeavors on the record.) Watson remains an investor in the funds and retains investment decision involvement through frequent phone consultations with his appointed portfolio managers. Insofar as Watson made his dramatic career shift near the end of the bull market, one has to wonder whether his innate market sense might have influenced the timing, at least on a subconscious level.

  Why did you decide to shift away from active fund management?

  I hired two guys I really respect, and I thought they would do well. It’s like the old man passing on the torch.

  But you’re not an old man—you’re a lot younger than I am!

  I wanted to pursue new challenges.

  What’s your long-term view of the market?

  I have never seen microcap stocks so cheap, but I also have never seen so many stocks that are lacking a catalyst to make them move higher. So the ingredients are there for a rebound, but the timing is not imminent. I just reviewed two hundred microcap stocks yesterday and was amazed by how many are trading at or below cash. Their businesses aren’t great, but they’re cutting costs. With their cost structures reduced, if the economy begins to improve and you get any increment in revenues, they’ll be in position to put up good earnings. Although the market probably still has some more weakness ahead of it [this interview was conducted August 2002], I’m quite optimistic about the longer-term outlook—say, beginning in 2003.

  * * *

  DANA GALANTE

  Against the Current

  Imagine two swimmers a mile apart on a river who decide to have a race, each swimming to the other’s starting point. There is a strong current. The swimmer heading downstream wins. Is she the better swimmer? Obviously this is a nonsensical question. An Olympic swimmer could lose to a novice if the current is strong enough.

  Now consider two money managers: one only buys stocks and is up an average of 25 percent per year for the period while the other only sells stocks and is up 10 percent per year during the same period. Which manager is the better trader? Again, this is a nonsensical question. The answer depends on the direction and strength of the market’s current—its trend. If the stock market rose by an average of 30 percent per year during the corresponding period, the manager with the 25 percent return would have underperformed a dart-throwing strategy, whereas the other manager would have achieved a double-digit return in an extraordinarily hostile environment.

  During 1994–99 Dana Galante registered an average annual compounded return of 15 percent. This may not sound impressive until one considers that Galante is a pure short seller. In reverse of the typical manager, Galante will profit when the stocks in her portfolio go down and lose when they go up. Galante achieved her 15 percent return during a period when the representative stock index (the Nasdaq, which accounts for about 80 percent of her trades) rose by an imposing annual average of 32 percent. To put Galante’s performance in perspective, her achievement is comparable to a mutual fund manager averaging a 15 percent annual return during a period when the stock market declines by an average of 32 percent annually. In both cases, overcoming such a powerful opposite trend in the universe of stocks traded requires exceptional stock selection skills.

  Okay, so earning even a 15 percent return by shorting stocks in a strongly advancing market is an admirable feat, but what’s the point? Even if the stock market gains witnessed in the 1990s were unprecedented, the stock market has still been in a long-term upward trend since its inception. Why fight a trend measured in decades, if not centuries? The point is that a short-selling approach is normally not intended as a stand-alone investment; rather, it is intended to be combined with long investments (to which it is inversely correlated) to yield a total portfolio with a better return/risk performance. Most, if not all, of Galante’s investors use her fund to balance their long stock investments. Apparently, enough investors have recognized the value of Galante’s relative performance so that her fund, Miramar Asset Management, is closed to new investment.

  Most people don’t realize that a short-selling strategy that earns more than borrowing costs can be combined with a passive investment, such as an index fund or long index futures, to create a net investment that has both a higher return than the index and much lower risk. This is true even if the returns of the short-selling strategy are much lower than the returns of the index alone. For example, an investor who balanced a Nasdaq index–based investment with an equal commitment in Galante’s fund (borrowing the extra money required for the dual investment) would have both beaten the index return (after deducting borrowing costs) and cut risk dramatically. Looking at one measure of risk, the two worst drawdowns of this combined portfolio during 1994–99 would have been 10 percent and 5 percent, versus 20 percent and 13 percent for the index.

  Galante began her financial career working in the back office of an institutional money management firm. She was eventually promoted to a trading (order entry) position. Surprisingly, Galante landed her first job as a fund manager without any prior experience in
stock selection. Fortunately, Galante proved more skilled in picking stocks than in picking bosses. Prior to founding her own firm in 1997, Galante’s fourteen-year career was marked by a number of unsavory employers.

  Galante likes trading the markets and enjoys the challenge of trying to profit by going the opposite of the financial community, which is long the stocks that she shorts. But the markets are an avocation, not an all-consuming passion. Her daily departure from the office is mental as well as physical, marking a shift in her focus from the markets to her family. She leaves work each day in time to pick up her kids up at school, a routine made possible by her western time zone locale, and she deliberately avoids doing any research or trading at home.

  The interview was conducted in a conference room with a lofty, panoramic view of the San Francisco skyline. It was a clear day, and the Transamerica building, Telegraph Hill, San Francisco Bay, and Alcatraz stretched out in front of us in one straight visual line. The incredible view prompted me to describe some of the palatial homes that had served as the settings for interviews in my previous two Market Wizard books. Galante joked that we should have done the interview at her home. “Then,” she said, “you could have described the view of the jungle gym in my backyard.”

  Note: For reasons that will be apparent, pseudonyms have been used for all individuals and companies mentioned in this interview.

  * * *

  When did you first become aware of the stock market?

  My father was a market maker in the over-the-counter market. When I was in high school, I worked with him on the trading desk during summer vacations and school breaks.

  What did you do for him?