Stock Market Wizards

by Jack D. Schwager

  What was the previous high in the stock?

  It was in the low thirties. The stock just blew way past it.

  Were you still bearish the stock when it went to 80?

  Yeah, nothing had changed.

  How do you handle that type of situation from a money management standpoint?

  I had never been in that type of situation before—not even remotely. Our portfolio is relatively diversified. The most I had ever lost on a single stock in one day was one-half of one percent. That day, I lost 4 percent on the stock.

  What portion of your portfolio was the stock?

  Before it went up, about 2.5 percent. That is a fairly large position for me, but I had a lot of conviction on the trade.

  Did you try to cover part of your position on the day the stock skyrocketed?

  The stock was up almost $10 right from the opening. I started scrambling around, trying to figure out what was going on. Then it was up $20. Then $30. I tried to cover some of my shorts, but I only wound up getting filled on about one thousand shares out of a total of forty thousand that I held.

  At the end of the day, you were still short thirty-nine thousand out of forty thousand shares, the stock had already exploded from 30 to 80, and you were still bearish on the fundamentals. What do you do in that type of situation? Do you decide to just hold the position because the price is so overdone, or do you cover strictly because of money management reasons?

  This was a unique situation. I never had a stock move against me like that. I’ve also never been short an Internet stock. Initially, being the realist that I am, I just tried to get the facts. I checked out all the companies that did Internet banking to see what kind of software they used, and Sanchez’s name was never mentioned.

  The next day the stock dropped $15. I thought the stock would go up again, because typically these types of situations last more than one day. I covered enough of my position to bring it down to 2.5 percent of my portfolio. Because of the price rise, it had gone up to 7 percent of my portfolio, and I can’t allow that. Then the stock went down some more. By the time it went back down to 50, I had reduced my short position to five thousand shares.

  What was your emotional response to this entire experience?

  I was almost in shock because I felt a complete lack of control. I had never experienced anything like it before. Most people are afraid to go short because they think the risk is unlimited. That never bothered me. I consider myself pretty disciplined. I always thought that I had a good handle on the risk and that I could get out of any short before it caused too much damage, which up to that point I had. But here, the stock nearly tripled in one day, and I didn’t know what to do. I was numb.

  I was struck by a horrifying thought: Could the same thing happen to any of the other stocks in my portfolio? I began worrying about which of my shorts would be the next company to announce an online Web page. I started combing my portfolio, looking for any stock that might become the next Sanchez.

  What eventually happened to the stock?

  It went back up again. But when Sanchez started to look like it was ready to roll over, I rebuilt my short position. Ironically, when it subsequently broke, I made more money on my new short position than I had lost being short when the stock exploded several months earlier.

  How large is your organization?

  There are just two of us. Zack works with me and is an integral part of Miramar. There is a lot of money out there, and interested investors call me almost every day. I tell them that I am closed to new investment.

  Is that because your methodology can’t accommodate any more money?

  I don’t want to grow. I don’t want to manage people; I want to manage the portfolio.

  Could you grow your size by just taking larger positions instead of expanding the number of shorts?

  I have only run shorts in a bull market. It’s a constant battle. I have to find the best way to fight the battle with the lowest amount of risk. I need to know that I can cover my short positions if I have to. The larger my short position, the more difficult that would be. I’ve seen what happens to people who grow too fast, and I have taken the opposite extreme. I want to be comfortable doing what I do. I don’t want to be scouring for new shorts because I am managing more money. I have my family, and when I go home, I don’t think about work. I don’t read Barron’s over the weekend.

  I suppose to some extent your attitude reflects a difference between male and female perspectives. Maybe, as a generalization, men want to become empire builders, whereas women don’t.

  That’s probably it.

  How do you select the stocks you short?

  I look for growth companies that are overvalued—stocks with high P/E [price/earnings] ratios—but that by itself is not enough. There also has to be a catalyst.

  Give me an example of a catalyst.

  An expectation that the company is going to experience a deterioration in earnings.

  How do you anticipate a deterioration in earnings?

  One thing I look for is companies with slowing revenue growth who have kept their earnings looking good by cutting expenses. Usually, it’s only a matter of time before their earnings growth slows as well. Another thing I look for is a company that is doing great but has a competitor creeping up that no one is paying attention to. The key is anticipating what is going to affect future earnings relative to market expectations.

  In essence, you look for a high P/E stock that has a catalyst that will make the stock go down.

  Right, but there is another key condition: I won’t short a stock that is moving straight up. The stock has to show signs of weakening or at least stalling.

  Can you give me an example of a typical short?

  Network Associates has been a stock that I have been short on and off for the past two years. The company was masking higher operating expenses by taking huge research and development charges related to acquisition each quarter. They were taking other expenses as one-time charges as well. The SEC eventually made them change their accounting procedures to take these expenses over time as opposed to one-time charges. After the SEC stepped in, the chairman came out and said something like, “It’s just an accounting issue. We don’t pay much attention to accounting.” He also made statements berating the shorts, saying they would get buried.

  When a company blames the price decline in its stock on short sellers, it’s a red flag. A company’s best revenge against short sellers is simply reporting good numbers. Decent companies won’t spend time focusing on short sellers. “Our stock was down because of short selling.” Give me a break. We represent maybe one billion dollars versus nine trillion on the long side.

  What was Network Associates’ product or service?

  Their primary product was an antivirus software, a low-margin item whose price had been coming down over time. They also bought out a number of companies that were making similar products, usually paying a large premium. The companies they were buying were stocks that I was short. I was upset because once they bought out these companies, I couldn’t be short them anymore. At one point, they were virtually giving away their antivirus product. All you had to do was look at the Comp USA ads. After adjusting for all the rebates, they were selling their software for only about five dollars. That told you that their product wasn’t moving.

  If they were so desperate in their pricing, didn’t their sales show a sharp drop-off?

  No, because they were stuffing the channels.

  What does that mean?

  They were shipping all their inventory to distributors, even though the demand wasn’t there.

  Why would a company do that if they know the product is just going to get shipped back?

  To make the revenues look better. Once they shipped the product, they can book it as sales.

  But they can’t keep that up forever.

  They did it anyway. But it did come back to haunt them; eventually, the stock collapsed.

  You mentioned that
it’s a red flag when a company blames shorts for the decline in its stock. What are some other red flags?

  A company that goes from its traditional business to whatever is hot at the time. For example, during the gambling stock craze, there were companies that went from having pizza restaurants to riverboat gambling. Right now, the same thing is going on with the Internet. One company we shorted recently went from selling flat panel displays to offering an Internet fax service, trashing their whole business plan in the process.

  Other red flags?

  Lots of management changes, particularly a high turnover in the

  firm’s chief financial officer. Also, a change in auditors, can be a major red flag.

  Can you give me an example?

  One of my shorts was Pegasystems, which was a software company that caught my attention because of high receivables [large outstanding billings for goods and services]. The company was licensing its software for a monthly fee, typically in five-year contracts, and recognizing the entire discounted value of the contract immediately.

  Is this a valid accounting procedure?

  It was certainly contrary to the industry practice. Apparently, the original accountants didn’t go along with the figures, because the company fired them and hired a new accounting firm. They said they were making the change because their previous accounting firm didn’t understand the business and wasn’t aggressive enough. But the incredible thing is that people ignored that red flag.

  You mean the stock still went up even after they fired their auditors?

  Yes.

  When did you get short?

  After they fired their auditors.

  Any other examples of questionable accounting?

  I’ve had a few shorts that turned into frauds. One example was a company that ran a vocational school that purportedly taught people computer skills. They were getting funding from the government, but they were providing very poor quality education. I became aware of this stock as well because of high receivables.

  What are receivables for a training company?

  Tuition fees. The students weren’t paying the tuition they owed. That’s what first drew my attention to the stock. Then I learned the company was being investigated by the Department of Education in response to student complaints that they were using old software and that the instructors were inept. I shorted the stock in the forties, and got out near 10. The stock eventually went down to 1.

  It sounds as if high receivables is a major indicator for you.

  Yes, it’s one of the screens we look at.

  What are some of the other screens?

  We also screen for revenue deceleration, earnings deceleration, high P/Es, high inventories, and some technical indicators, such as stocks breaking below their fifty-day moving average.

  Do you screen for these factors individually, or do you screen for multiple characteristics?

  Usually multiple characteristics, but you can’t screen for all these factors at one time, or else you won’t get any stock that fits all the search requirements.

  Although you have done fine as a 100 percent short seller, have you had any second thoughts about your choice since we have been in such a relentless bull market?

  No, I find short selling more rewarding because of the challenge. You make a lot of money in this business, and I think you need to work for what you get. To just sit there and buy Internet stocks every day doesn’t seem right. I can’t relate to it. In fact, I wonder how I will do if we ever do get into a bear market because I am so used to a bull market, watching people ignore bad news and taking advantage of that.

  But I would imagine that in a bear market, your job would be much easier.

  In August 1998 when the market went down fast and hard, I was more stressed out than I am normally.

  But you did very well during that period.

  I did great, but I thought it was too easy. I wasn’t fighting a battle. I felt as though I didn’t have to work. Any stock I went short would go down. It was a weird feeling. That’s what people do all the time on the long side; they just buy stocks, and they tend to go up.

  And you didn’t like that?

  No, it was very uncomfortable. Maybe I am a little sick; I don’t know what’s wrong with me.

  When a market suddenly breaks a lot, as it did then, do you reduce your short exposure?

  I did in that instance because it happened so quickly. I made 30 percent in one month. That has never happened to me before. I covered about 40 percent of the portfolio.

  What kind of risk control strategies do you use?

  If I lose 20 percent on a single stock, I will cover one-third of my position. I limit the allocation to any single stock to a maximum of about 3 percent of the portfolio. If a stock increases to a larger percentage of the portfolio because of a price rise, I will tend to reduce the position. I also control risk through diversification: There are typically fifty to sixty names in the portfolio spread across different industry sectors.

  Do you know other short sellers?

  Yes. With the exception of a couple of short sellers that have become my friends, most short sellers tend to be very pessimistic on the world and life. They tend to be very negative people.

  But you’re not?

  I don’t think I am. I think I am just a realist. One thing that differentiates me from other short sellers is my experience on the long side.

  Why is that important?

  Because it’s all about why people buy and sell. My experience in working with momentum-type managers gives me a sense of their thought processes, which helps me know when to get out of the way and when to press my bets. I have some friends who are short sellers that have never worked on the long side. They would call me up and ask, “Dana, why are they buying this stock? It has negative cash flow, high receivables, etcetera.” They look at the raw numbers, and they are realists. They don’t understand that a lot of people just buy the stock because it’s going up or because the chart looks good. We’ve gone to the stratosphere now. Most of the people I know who were short sellers have been blown away. They don’t even ask me those questions anymore.

  What advice could you give to the ordinary investor who trades only on the long side?

  A good company could be a bad stock and vice versa. For example, Disney is a good company—or at least my kids love it. But during the past few years we were able to make money on the short side because the company had become very overpriced on overly optimistic expectations that its business would grow robustly forever.

  * * *

  Although Galante is a 100 percent short seller, her ideas are still relevant to the long-only investor. Galante’s methodology can be very useful as a guideline for which stocks to avoid or liquidate. The combination of factors Galante cites include:

  very high P/E ratio

  a catalyst that will make the stock vulnerable over the near term

  an uptrend that has stalled or reversed

  All three of these conditions must be met. Investors might consider periodically reviewing their portfolios and replacing any stocks that meet all three of the above conditions with other stocks. By doing so, investors could reduce the risk in their portfolios.

  In addition, Galante cites a number of red flags that attract her attention to stocks as potential short candidates. By implication, any of these conditions would be a good reason for investors who own the stock to seriously consider liquidating their position. These red flags include:

  high receivables

  change in accountants

  high turnover in chief financial officers

  a company blaming short sellers for their stock’s decline

  a company completely changing their core business to take advantage of a prevailing hot trend

  * * *

  Update on Dana Galante

  After a career spent fighting a long-term uptrend, Galante in recent years finally found herself trading in the market direction. Therefore, it should come a
s no surprise that Galante has done quite well during the bear market. During the 2½-year period since the first month of the bear market (April 2000), Galante’s fund was up an imposing 89 percent (119 percent before fees).

  This is a rather unusual experience for you: shorting stocks in a bear market. After all the years of trading against the broad market trend, what does it feel like trading with the trend in your direction?

  The first year of the decline [2000], it felt pretty good because there were so many overvalued shorting opportunities. The second and third years of the decline, however, were just as difficult as the upmarket years because of the sporadic, sharp bear market rallies. Also, the lower valuations, especially now, make it difficult to find shorting opportunities.

  How do you compare the differences and similarities in being a short seller in a bear market versus a bull market?

  Previously, there was a lot more downside in stocks. Now, many stocks are getting to real value levels. As a result, our exposure levels are much lower now than they were during the bull market. In 1999–2000 we were 100 percent invested. This year [2002], our highest exposure was 70 percent, and right now we are only 20 percent invested.

  Are you concerned about having so much more company on the short side, particularly from other hedge funds (not just short funds)?

  In the twenty years I have been trading the markets, there has always been some new angle that affects what I do. I try to look at how I can capitalize on a new situation rather than worrying about how it may hurt me. In the case of new participants on the short side, I actually think it creates more opportunities because you get these short-term run-ups in certain stocks triggered by short-covering from people who don’t know what they are doing. There are a lot of former long-only managers who have decided to become hedge fund managers by also trading the short side, despite their lack of experience.