Stock Market Wizards

by Jack D. Schwager

  Do you see short sellers being made scapegoats for the market decline? What is your opinion about such criticism?

  The people who are saying that should be happy there are short sellers out there because they are the ones who are buying. Short sellers are the ones who have the reason to buy and the power to buy, and the rallies we have seen in this bear market have been driven by short-covering. The only time in my life I felt bad about short selling was after September 11; I would have felt guilty shorting then, so we didn’t do much of anything at the time.

  Identifying companies that employ overly aggressive accounting is an important element in your approach. Has the recent spate of highly publicized accounting scandals meaningfully changed the situation?

  In the past, as long as a company reported good earnings, even if it was just beating the street estimate by a penny, no one looked at how they got that number. The market frequently all but ignored the red flags we look for such as negative cash flow, excess receivables, excess inventories, and aggressive revenue recognition. The good thing for us is that now if people see these factors in a company, it’s an issue.

  What other changes do you anticipate as a result of the market’s much closer scrutiny of accounting issues?

  One issue I expect will garner increasing attention is the still widespread use of pro forma accounting instead of GAAP accounting.

  Please define pro forma accounting.

  Pro forma accounting is an artificial creation of the late 1990s, which takes out all sorts of charges that the company claims are non-operating charges, when in reality they often are. There are some companies that even take out costs that occur every quarter, which is the very essence of an operating charge. The SEC requires GAAP reporting, and that is the number a company lists in its annual report; but a company can report any number it wants to the street. The biggest culprit is First Call because they accept pro forma earnings as the company’s earning estimate, so that’s what the street looks at. Some brokerage companies—Merrill Lynch was the first—are now reporting earnings both ways. For a lot of companies, there are huge deviations between the GAAP and pro forma numbers. Even for the S&P 500 index as a whole, pro forma earnings are about 20 to 30 percent higher than GAAP earnings—the difference is that large! One of the things we are doing to identify possible shorts is to look for companies that have a large gap between pro forma earnings and GAAP earnings.

  Are frauds likely to become less prevalent because of all the publicity and legislative actions (both enacted and pending)?

  Greed is something that never goes away. Maybe the types of frauds we’ve seen will change, but there will always be some new scheme to take advantage of investors.

  * * *

  MARK D. COOK

  Harvesting S&P Profits*

  Mark D. Cook drives his pickup truck off the road, up the hill overlooking his father’s farm on the outskirts of East Sparta, Ohio. The weather is unseasonably warm and feels very much like a day in late spring, but it is still late winter. The rolling fields stretch out before us in various shades of brown. “I wanted you to see this,” Cook says. “When it greens up in spring, there is no more beautiful sight in the world.”

  I paint the scene in my mind and visualize easily enough how it could appear quite pleasant with the renewal of spring. But to see this landscape with the sense of majesty implied by Cook’s voice, you have to look at it through the eyes of someone who has worked the land and sees it as a provider of sustenance and a link between generations.

  “When my dad bought this farm nearly sixty years ago,” Cook says, “the land was so poor you couldn’t grow ragweed a foot tall on it. Whenever my trading is going badly and I feel stressed out, I come up here. When I look out at all that has been accomplished through hard work, despite the difficulties that were encountered, it gives me a sense of serenity.” Cook is passionate about trading, but his love for his market career still comes in third place after family and the land.

  The first time I saw Mark D. Cook he was a fellow speaker at an industry conference, and he made an impression before he uttered a single word. He came up to the podium dressed in bib overalls. He did this to make a point about his roots, but his choice of dress was not merely show, there was also substance to it. Even though he has made millions trading, Cook continues to do some farmwork himself. It is difficult to justify his manual labor in any economic sense. Cook rationalizes his part-time farmwork, which is in addition to the fifty to sixty hours per week he puts in as a trader, by saying that he is a workaholic. This is true enough, but I also believe that Cook would feel a tinge of guilt if he worked “only” as a trader while his eighty-one-year-old father continued to farm full-time.

  Cook had brought me to his father’s farm as part of a tour of the local area. As we drove along, Cook pointed out various tracts of land, which he identified by a year number. “There’s 1997,” he said, referring to the farm he had bought with his 1997 trading profits. “There’s 1995,” he said a few moments later, and so on. He apparently has had a lot of good years. Cook is almost zealous about converting his trading profits into real assets—and for Cook farmland is the ultimate real asset.

  The highlight of the tour was linked to another outlet for Cook’s trading profits: rare farm tractors. Cook shares his father’s enthusiasm for collecting antique tractors, a mutual hobby that led to the creation of the Cook Tractor Museum. You won’t find this museum, which is situated next to Cook’s farmhouse trading office, in any guidebook. The museum’s exhibits are displayed in a large metal shed structure that was built in 1996 to house the burgeoning rare tractor collection.

  Cook picked up his father, Marvin, so that he could accompany us on the museum visit. Marvin Cook, who is the epitome of the taciturn farmer, turned into Mr. Tour Guide as soon as we entered the metal shed. He described the unique characteristics of each tractor model on display and the history of its manufacturer, who in most instances had disappeared from the American scene long ago. The museum contains some real rarities, including two of only five American tractors (only one other is known to still exist), built by an Ohio company that went out of business before the line went into full production.

  Cook next took me to the farm he had bought with his 1994 trading profits. Cook currently leases the land for coal mining, and we hiked across the rolling fields and scrambled down a scree-strewn slope to view the open-pit mining operation. Buying this land gave Cook particular satisfaction because it was the alternative property his great-grandfather had considered purchasing before settling on the original family farm-stead in 1890.

  I had begun my interview with Cook the previous evening at Tozzi’s, an eighty-five-year-old, family-owned establishment that is the best restaurant in Magnolia, Ohio. It is also the only restaurant in Magnolia (population: 1,000). The lack of competition, however, apparently hasn’t had any adverse influence; the food was very good and the service attentive. After the two-hour dinner, Cook was only getting warmed up in talking about his career. We continued the interview at Cook’s 125-year-old farmhouse office, a dark walnut-paneled room, unadorned except for a cow painting (Cook’s wife, Terri, was the artist). At around 1 A.M., we were still not finished. Knowing that Cook wanted to get an early start the next morning, I decided to leave the remainder for the next day. We continued the interview the next morning at breakfast and finished it later that day in the airport parking lot, seated in Cook’s pickup truck.

  Cook’s early attempts at trading were marked by repeated setbacks, experiences he relates in the interview. Cook, however, never gave up. Each failure only made him work harder. Finally, after many years of carefully tracking the stock market, filling volumes of market diaries, and assiduously recording and analyzing every trade he made, his trading became consistently profitable.

  Once Cook became confident in his trading abilities, he entered several market contests, registering an 89 percent gain in a four-month competition in 1989, and 563 percent and 322 perce
nt returns in back-to-back annual contests beginning in 1992. His annual returns in the six years since then have ranged between 30 percent and a stratospheric 1,422 percent. These statistics are based on defining percent return as annual dollar profits divided by beginning year equity, a conservative definition that understates Cook’s true performance, because he frequently withdraws profits from his account but never adds funds. For example, in his low-return year (based on our definition of percent return), his withdrawals during the year exceeded his starting capital. Cook provided me with his account statements for his most recent four years. During this period, he was profitable on 87 percent of all trading days, with one-third of the months showing only winning days.

  * * *

  How does a farm boy end up trading the S&P?

  I started trading because of a cow.

  You’ll have to explain that one to me.

  In 1975, while attending Ohio State University as an agricultural business major, I was on the national cattle judging team for Ohio. That experience helped me get a summer job as one of the two cowboys that took Elsie the Cow around the country as publicity for Borden.

  Was this like Lassie? When Elsie died, did they replace her with another Elsie?

  They changed Elsies after the tour was over, which lasted about thirteen weeks.

  Where did you go on this tour?

  All over. We even received the key to the city from Mayor Daley in Chicago because the city’s mascot was a cow. I was also interviewed on several TV and radio shows.

  What kind of questions would they ask you about a cow?

  Oh, how much milk did she produce? What kind of cow was she? How much crap did she produce in a day? How old was she? What did she eat? Does she kick? How come she doesn’t have any flies? Whenever I got that last question, I said, “We give her a bath every day; she’s cleaner than you are.”

  One night we were on a radio show in Chicago. The host was Eddie Schwartz who had an all-night talk program back in the 1970s before talk programs became big. We were on for hours. At about 3 A.M. he asked us, “Hey, what would you guys like to do now?”

  “We’ve been on the road constantly,” I answered. “We haven’t gone out with any women for a while.”

  “No problem,” he said. “What kind of girls would you like?” he asked us.

  I was a bit of a ham, so I said, “The first two girls who get down here in bikinis, we’ll show them a night on the town.”

  “Girls out there,” he announced, “did you hear that?”

  “I wasn’t serious,” I quickly added.

  “No problem,” he said. “You heard them out there,” he told his audience. It wasn’t fifteen minutes before two girls wearing bikinis showed up at the studio.

  Before we left, he said to us, “I get a lot of obnoxious calls. I’d love to get a tape of your cow mooing so that I could turn it on whenever I have an annoying caller.” We always kept Elsie on a local farm when we traveled. We arranged to meet Eddie at the farm the next morning.

  Wait, wait, not so fast. What happened to the bikini girls?

  Nothing happened, because my wife may read this [he laughs].

  The next morning when Schwartz arrived at the farm, he said, “Are you sure you can get her to moo, Mark?”

  “Oh sure, I can get her to do anything.” I tied her up to a wagon and placed the tape recorder inside.

  “She isn’t mooing,” he said.

  “No problem,” I said. “Just move everybody out of the way. I’ll calm her down, and as soon as I walk away, she’ll start crying. She’ll cry because she is a celebrity, and celebrities need attention.”

  “You’re just pulling my leg,” he said.

  “No, I’m serious,” I said, “just watch.” I walked away, and it wasn’t long before Elsie started bellowing at the top of her lungs. He used that tape on Chicago radio for years.

  Being Elsie’s cowboys also helped us get into the Playboy Club. One night while I was in Chicago, my boss joined us. I said, “We should go to the Playboy Club.”

  “Oh sure, Mark,” he said. “How are we going to get in?” You could only get into the Playboy Club by invitation.

  “Don’t worry,” I told him, “I can get us in.”

  “And how are you going to do that?” he asked.

  “Just wait and you’ll see,” I told him. When we arrived at the club, I walked up to the imposing guard at the door and said, “You allow celebrities in, right?”

  “Oh yeah,” the man said, “we like celebrities. Who are you?”

  “It isn’t who I am,” I answered, “but whom I represent.” I pulled out my Elsie the Cow identification card. This was just after we had done the Mayor Daley ceremony.

  “Oh sure,” he said skeptically. He no doubt had heard every type of story by people trying to get in, although this was probably the first time someone had tried to use his pet cow to gain admittance.

  “I have my girlfriend right here with me,” I said as I pulled out a photo of Elsie standing next to me.

  “Just a minute,” he said as he went behind the padlocked door. He came back out with a celebrity key and let us in.

  This is all very interesting, but what does it have to do with your becoming a trader?

  After graduating college, I wanted to get a job as a stockbroker. I couldn’t get hired. Nothing in my résumé seemed to help—not my grades, nor the fact that I played college basketball. Finally, I rewrote my résumé, prominently mentioning that I had been Elsie’s cowboy. Shortly thereafter, I received a call to interview at a local brokerage office in Canton, which ultimately led to a job offer. The woman who screened résumés for the firm later told me, “I get hundreds of résumés. When I saw yours I said, ‘Hey, this is the guy who took care of Elsie the Cow.’” I had been in Canton when I did the tour, and she had remembered seeing the picture in the local newspaper. That’s how I got into the business, because of a cow.

  Why did you want to become a stockbroker? Were you trading stocks?

  I started trading stocks after I graduated college. By buying and selling cattle, I was able to build up a $20,000 stake.

  Had you done any research? Did you have any methodology?

  No, I just plunged right in. I still remember my first two trades: I bought Columbia and Sambo’s. Columbia got bought out; and Sambo’s went bankrupt. Starting out, I experienced the best and the worst and was hooked.

  Do you remember why you bought those two specific stocks?

  Yes, a lot of the research went into it. I bought Columbia because I had seen a documentary on the making of Close Encounters of the Third Kind, which Columbia was going to release, and I thought the movie was going to be a big hit. Columbia was bought out before the movie was released, so it didn’t end up making any difference.

  What about Sambo’s?

  When I went to the Rose Bowl with my fraternity brothers, we went out to eat at a Sambo’s. I had never heard of the chain before and thought it was neat, so I bought the stock. That’s a summary of my total research. I didn’t know anything more about either of the two companies. Then the stockbroker I was dealing with said, “Mark, you like action. Why don’t you try stock options?”

  “I don’t know anything about options,” I told him. He gave me a booklet to read. After reading it from cover the cover, I called my broker and said, “It sounds pretty risky me.”

  “Oh no, it’s just like trading stocks,” he said.

  In April 1978, I made my first option trade: I bought two Teledyne calls at $9 apiece for a total premium of $1,800. I sold the options two days later for $13, earning a total profit of $800 on my $1,800 investment. I said to myself, “Boy, this is a lot easier than shoveling manure and milking cows.” For my next option trade, I bought Teledyne calls again, and again I made money. I thought I was going to be a millionaire in no time flat. I was doing so well that I thought, “Why trade with only a small part of my capital; I might as well use all of it.” I kept trading Teledyne option
s. Finally, I put on an option position that went down. I thought I would hold it until it came back. It went to zero and expired on me. I lost all the money I had.

  The whole $20,000?

  That plus the approximate $3,000 I had been ahead before that trade. I remember filing my income tax for that year. I had made $13,000 in income and lost $20,000 in stock option trading. The worst thing was that I was only able to deduct $3,000 of losses against my income. So I had to pay income tax, even though I had a negative income.

  Did you learn anything from that experience?

  Yes. I learned that I wanted my money back. I’m not a quitter in any shape or form. I was determined to learn everything I could about stocks and options. That was the beginning of my pursuit to become a stockbroker. The only reason I wanted to become a stockbroker was to get my money back.

  Did your parents know you had lost all your money?

  Oh no, they probably thought I had my money in a CD.

  Well, you did have your money in a CD.

  Pardon?

  A call debacle.

  That’s exactly right. My goal was to make $100,000 a year. By the time I was hired as a stockbroker in 1979, I had studied options quite thoroughly. I started trading options again, but I still kept losing money steadily. I analyzed my trades and found that I was losing money because I was holding on to options for several weeks or longer, and they would end up going to zero. I realized that the money I had lost had been made by the traders who sold the options that I bought. I decided from that point on, I would only sell options. I adopted a strategy of simultaneously selling both the calls and puts in high-volatility stocks.

  The margin on short-option positions at that time was sometimes less than the premium I collected from the sale of the options. In 1979 when gold prices exploded, I sold options on gold stocks. I figured out that I could sell a combination [the simultaneous sale of a call and put] on ASA for more money than the margin I had to put up for the trade. At that time, the margin department hadn’t figured this out. As a result, I could put on any size position and not get a margin call. There was only one slight problem—the stock took off on me. I made a little bit on the puts, which expired worthless, but lost a lot on the calls, which went way in the money. It was back to the drawing board again.