Stock Market Wizards

by Jack D. Schwager

  What was your job at Bear Stearns?

  I had no specific responsibilities; I was just told to figure out how to add value to the company. I started a couple of months before the 1987 stock crash. While all my friends are trading stocks and bonds, and the market is crashing and layoffs are going on, I’m sitting there without any specific responsibility and a mission to figure out how to make money in the Bear Stearns style.

  And exactly what is that?

  To commit very little capital, take on very little risk, and still make a significant return consistently. And if you can’t do that, they don’t want to put their money into the trade. They are a very smart firm.

  Even though you were left to come up with your own ideas, you must have had an immediate superior.

  Sure, Elliot Wolk.

  Did you learn anything from him?

  A great deal. One useful piece of advice he gave me, which summarized the philosophy of Bear Stearns was: Never make a bet you can’t afford to lose. My extreme aversion to risk traces back to Bear

  Stearns. To this day, I am deeply appreciative of the opportunity they gave me and for what I learned at the firm.

  Why did you leave Bear Stearns?

  Kidder made me a great offer. It was really hard to leave. My initial intentions were to stay at Bear Stearns for my whole career.

  Was this the proverbial deal you couldn’t refuse?

  Yes.

  Did Bear Stearns try to counteroffer?

  I met with Ace Greenberg, Bear Stearns’s CEO at that time, over the course of two days, but his only real response was advice. He told me that the deal sounded too good to be true and that I should just continue to make my bet with Bear Stearns. It turns out that he was right. It’s a shame, because I was really excited about going to Kidder

  Peabody. Not only did the firm have a great history, but the opportunities that existed with General Electric as the majority shareholder were truly remarkable. Unfortunately, some misunderstandings and miscommunication with management caused an uncomfortable situation. At that point, it was best for me to just leave.

  I already know the situation you’re talking about. It was amply reported in the press. I prefer to get the story directly from you, however, as opposed to secondhand. I also know that the resulting legal suits were resolved, and therefore there is no legal restriction to your talking about the case.

  The only restriction is that I really love not to dwell on it [he laughs]. I am glad it is all over. Kidder was great for me in many ways and bad for me in many ways. Essentially, they offered me a great deal to come over, and then the deal changed. Then they said a number of things that were very insensitive and impolite. So I left them and won the arbitration on the contract dispute. A suit on race discrimination ended up being unsuccessful—good riddance.

  [Based on public documents, this suit was not lost on the merits of the discrimination case, but rather because the New York Court of Appeals ruled that the standard registration form signed by Fletcher as a condition of employment compelled arbitration. Although the court ruled against Fletcher’s petition because it felt such a decision was dictated by the letter of the law, the written opinion appeared to reflect a reluctant tone: “We stress that there is no disagreement among the members of this court about the general proposition that racial, gender, and all other forms of invidious discrimination are ugly realities that cannot be countenanced and that should be redressable through the widest possible range of remedies…”]

  If you don’t mind my asking, other than this particular episode, have you encountered prejudice elsewhere in the industry?

  I have definitely experienced some things, but it is usually more subtle. I really prefer not to dwell on it.

  I’m just curious whether prejudice is still a factor.

  Frankly, whenever there’s a difficult situation, race is always one of those easy cards to play. For example, if someone is envious. Usually, nothing is direct. Ultimately it’s a very subtle issue, and you never know for sure. Someone acts in a certain way, and you think it is one thing, but eventually you find out that it’s not. In the last eight years, I haven’t seen anything…actually, I guess I have seen a number of things that are somewhat direct [laughing]. My view is that as long as I do the best I can for the people who put their trust in me—my investors, my employees, and the companies I invest in—then everything else will take care of itself.

  When I read about the whole episode, I thought it was pretty gutsy of you to bring a legal suit instead of taking a settlement. I assume that you just wanted to fight back.

  I didn’t want to be adversarial, but they were sooo…. You got me talking about it; I didn’t want to talk about it. [He laughs long and hard.] Kidder was great, GE was great, and I really wanted to be there for a long time. If they had said to me, “We’re going to pay you half the amount we agreed to, and we’ll work out the remainder,” I probably could have lived with that. I wouldn’t have minded those issues if they were prepared to let me be part of the team and really participate and contribute going forward. But far worse than the compensation issue was the treatment—the attitude that I didn’t belong and some of the comments from senior management.

  So it wasn’t just one person.

  No, it wasn’t just one person.

  But what’s odd is that you did so well for them.

  Sometimes, I think that makes it worse.

  But that’s what I don’t understand. They hired you. It’s not as if they suddenly discovered you are black. Oh well, I guess there is

  no reason to expect prejudice to be logical. How did you go about starting your own firm when you left Kidder?

  I went back to Ace Greenberg. Bear Stearns set me up with an office and gave me access to its very supportive clearance department, which provided financing and brokerage services for professional investors.

  What did Bear Stearns get out of this deal?

  I still had very friendly relationships with the people at Bear Stearns.

  To some extent, they just wanted to help me out. But it was also beneficial to them because they gained a customer. Based on their previous experience with me, I’m sure they assumed that I would generate significant brokerage business for them.

  After I left Ace’s office, I went downstairs to the computer store and bought myself a Macintosh, which I set up on my dining room table. I constructed the spreadsheets for a transaction opportunity I saw would be feasible over the next few days and then faxed the sheets to a Fortune 50 company for whom I had done similar deals that had worked out well. They liked the idea and gave me the go-ahead. The next day I opened the account at Bear Stearns and did the other necessary preparations for the trade. On the third day, I executed the transaction, and on the fourth day, I went to the bank to open an account for $100 so that I could receive the fee as a wire transfer. In effect, Fletcher Asset Management was funded for $100.

  Could you elaborate on the strategies you’re using today.

  A common theme in all our strategies involves finding someone who is either advantaged or disadvantaged and then capitalizing on their advantage or minimizing their disadvantage. Arbitrage opportunities are very difficult to find without that type of an angle.

  We are still pretty active in the dividend capture strategy we talked about earlier. Our primary current activity, however, involves finding good companies with a promising future that need more capital, but can’t raise it by traditional means because of a transitory situation. Maybe it’s because their earnings were down in the previous quarter and everyone is saying hands-off, or maybe it’s because the whole sector is in trouble. For whatever reason, the company is temporarily disadvantaged. That is a great opportunity for us to step in. We like to approach a company like that and offer financial assistance for some concession.

  For example, in a recent deal involving a European software company, we provided $75 million in exchange for company stock. However, instead of pricing the stock at the prevail
ing market price, which was then $9, the deal was that we could price the stock at a time of our choosing up to three years in the future, but with the purchase price capped at $16. If the price of the stock falls to $6, we will get $75 million worth of stock at $6 per share. If, however, the stock goes up to $20, we will get $75 million worth of stock at a price of $16 per share because that was the maximum we agreed to. In effect, if the stock goes down we’re well protected, but if the stock goes up a lot, we have tremendous opportunity.

  Are you then totally eliminating the risk?

  The risk is reduced by a very significant amount, but not totally. There is still risk if the company goes bankrupt. This risk, however, is small because we are only selecting companies we consider to be relatively sound. In fact, a senior officer of one of the companies we previously invested in is now part of our own staff and helps us evaluate the financial prospects of any new investments. With this expertise in-house, it would be rare for us to choose a company that went bankrupt.

  The logic of the transaction is pretty clear to me. As long as the company doesn’t go bankrupt, if the stock goes down, stays about unchanged, or goes up moderately, you will at least break even, and if it goes up a lot, you can make a windfall gain. Although there is nothing wrong with that, doesn’t it imply that the vast majority of times these transactions will end up being a wash and that significant profits will occur only sporadically? Why wouldn’t you end up with an equity curve that is fairly flat most of the time, with only occasional upward spikes?

  Two reasons. First, the money we invest in the company doesn’t just lie idle; it generates annual income—8.5 percent using the example we just discussed—until we price the stock. Second, since the maximum price we will have to pay for the stock is capped—$16 in our example—we can sell out-of-the-money calls against this position, thereby guaranteeing an additional minimum revenue.

  [By selling options that give buyers the right to buy the stock at a specified price above the current price, Fletcher gives up part of his windfall profit in the event the stock price rises sharply. But, in exchange, he collects premiums (that is, the cost of the options) that augment his income on the deal regardless of what happens to the stock price.]

  But are there always traded options in the companies you are financing through these stock purchase agreements?

  Well, it’s not always possible to get a perfect hedge. But even when there are no options traded for the specific company, we can sometimes use private “over-the-counter” options. We can also use index options against a basket of companies in our transactions. The assumption is that if the stock index rises a lot, then the stocks of the companies we have invested in are likely to rise sharply as well. In fact, since we are buying stocks that have been under pressure and are more speculative in nature, if the market does well, these stocks may rise more than the average.

  Taking into account the interest income and the option-selling income, it appears that you are virtually guaranteed to make at least a moderate profit on every transaction of this kind, and only lose in the disaster scenario.

  Even in the disaster scenario, which again is unlikely because of the way we select our stocks, we can still sometimes protect ourselves by buying out-of-the-money puts, which at the strike prices implied by a bankruptcy are pretty cheap.

  How long have you been employing this type of strategy?

  For about seven years, and it has now grown to become our single most important market activity. The strategy actually evolved from the dividend capture strategy. [The strategy described previously in Fletcher’s example of U.S. investors holding shares in an Italian computer company.] One variation of the dividend capture strategy is dividend reinvestment, wherein companies allow shareholders to reinvest their dividends in the stock at a discounted price. We have been very active in buying shares from parties who did not want to be bothered with reinvestment. We would therefore be the recipient of $1 million of dividends and then elect to reinvest it, receiving $1.05 million of newly issued stock.

  Why would a company give you more stock than the amount of the dividend?

  Because the companies that provided this offer wanted to conserve their capital and were willing to grant shareholders a 5 percent discount as an incentive to reinvest their dividends in the stock.

  Is it common for companies to offer this type of dividend reinvestment?

  It is popular among companies with high dividends who don’t want to cut their dividends but need to preserve capital. For example, it was particularly prevalent among the banks in the early 1990s when they were trying to increase their equity.

  Eventually, some companies started to offer shareholders the option to purchase additional discounted shares in an amount equivalent to the dividend reinvestment. Then some companies began waiving limits, allowing investors to buy virtually any amount of stock at a discounted price.

  In the early 1990s, many banks were actively pursuing this type of program, and we participated heavily. That experience led us to going to a major U.S. electronics company in 1992 in what proved to be our first private equity funding deal. At the time, this company couldn’t raise capital through a stock offering because they’d had a bad quarter and the prevailing attitude was: “I don’t want to buy newly issued stock from that company.” That’s probably the best time to buy newly issued stock. When do you want to buy it—after they’ve reported record earnings [he laughs]? But that’s the way it works, and it was a perfect opportunity for us to step in and say here’s the check.

  We told the company that we would buy $15 million worth of stock from them over a period of time. We stressed that we wanted it to be a very friendly and supportive deal. Therefore, instead of buying stock at a discount, we proposed being compensated by an option to buy more stock in the future. In this way, our incentives were perfectly aligned with the interests of management and shareholders. As we discussed earlier, in this type of arrangement, our most significant profit opportunity arises when the company does very well, although because of our hedge, we should be consistently profitable.

  We had a wonderful relationship with this company. In fact, their former CFO ended up joining us. He’s the one at Fletcher Asset Management who explains who we are to the companies we approach and manages the negotiations and ensuing relationships.

  There’s no better salesman than a satisfied customer. How did you sell a major corporation on your financing transaction, since you had never done anything like that before?

  That’s a good question. When I first approached them, we were this tiny firm working out of rented space at Bear Stearns. Their initial reaction was: Who are you? Merrill Lynch couldn’t get us a secondary offering, Lazard is our adviser, and you are calling out of the blue to tell us that you can do the deal.”

  I talked to a neighbor in my apartment building, Steve Rattner, who was a senior banker at Lazard. I told him that I was interested in doing a deal with a company that his firm was advising. I asked him to help me. He made a few phone calls, and the next thing I knew, I was on a flight to Chicago along with a banker from Lazard and our attorney to meet with the company. When the deal was all done, Steve said to me, “That was an extremely interesting transaction. Have you thought about taking on outside capital?”

  Didn’t the idea of raising outside capital to fund your transactions occur to you before this deal?

  Sure, the idea had come up a number of times before. However, every time we considered it, we asked ourselves why we should take money from investors, and give up the bulk of the profits, when we can borrow money to do the deal, and keep 100 percent of the profits?

  Exactly, so why did you start a fund open to outside investors?

  The big change was realizing that a friend like Steve could get us in the door where such a great transaction could happen. Wouldn’t it be nice to have other friends like that who had a vested interest in our success.

  So the primary motivation wasn’t necessarily raising extra
capital, but rather getting investors who would be allies.

  Yes, that was the point Steve made that caught my attention. Raising capital, however, did provide some additional benefits over borrowing by allowing us to do many more transactions, thereby reducing our portfolio risk through greater diversification.

  Using the U.S. electronics company as an example, I assume that if Steve had not been there, the deal would never have happened.

  Exactly. We have some incredibly insightful people as investors whom I can call for advice.

  It almost sounds as if you have selected your own investors.

  Essentially, we have. We have turned away a number of investors, particularly in the U.S. fund.

  If someone comes to you and wants to invest a couple of million dollars, you won’t automatically open the account?

  Oh no, we have actually researched everyone who wanted to invest before they invested.

  So you actually screen your investors.

  Yes, investors are screened by either us or our marketing representatives.

  And the reason?

  If we were just looking to raise as much money as we could, sure, the more the merrier. At this point, we just want supportive investors. It is not worth the trouble having an investor who would be a distraction. Maybe in the future, with other pools of money, we may be less judgmental, but right now we want investors who will be friends and allies.

  But, surely, not every investor is someone who will have useful contacts or be a source of advice.

  If they are not, though, then they are usually either friends or family. For example, the head trader’s mother, who is a retired librarian, is one of our investors, as is my own mother, who is a retired school principal. In fact, eight of our mothers and mothers-in-law are investors in the fund. By the way, our mothers are the most demanding investors.