Stock Market Wizards

by Jack D. Schwager

  In what way?

  They have no qualms about demanding an explanation for anything, from the reason for a slow start to the year to the reason for a particularly good month.

  What prevents competitors from coming in and doing private equity funding deals similar to the ones you did with the U.S. electronics company and the European software company?

  They come in all the time. In each of the strategies we have discussed, competition has increased and will continue to do so. That’s the nature of the market. Our advantage is that we were there first. What is unique about our firm is that we never imitate someone else’s strategy. Another advantage we enjoy is that we try to construct our deals so that they are fair to both the company and us. As a result of our approach, over time we have been able to evolve from doing deals with companies worth several hundred million dollars to companies whose market size is measured in billions.

  Even though you have an advantage, with this one core strategy providing most of your profits, what happens if the field becomes sufficiently crowded to reduce the profit margins meaningfully?

  Well, we are always working on developing new strategies. Our thinking is: Let the competition move in, we’ll be on to the next thing.

  For example?

  For example, right now we are deliberately using strategies that are uncorrelated with the stock market. There is tremendous demand, however, for an investment program correlated with the stock market that could consistently outperform the S&P 500. I would love to take on that challenge.

  A lot of people have come up with the idea of S&P enhancement programs. Haven’t any of these enhanced S&P funds been successful?

  Even the ones that have come close to doing it haven’t quite done it. These funds have attempted to beat the S&P 500 by 1 percent or a few percent, but they have not been consistent.

  How do they try to do it?

  At one extreme, PIMCO buys S&P futures for the stock exposure and tries to provide the additional 100 basis points return by managing a fixed income portfolio.

  Sure, that would work if interest rates are stable or go down. But if interest rates rise, aren’t they taking the risk of a loss on their bond portfolio?

  Yes, they definitely are. In effect, all they are really doing is taking the active manager risk in the fixed income market as opposed to the equity market.

  What other approaches have people used to try to consistently outperform the S&P 500 benchmark?

  Some people attempt to beat the S&P 500 by trying to pick the best stocks in each sector. They will balance their sector investments to match the S&P 500, but within each sector they will weight certain stocks more heavily than others. For example, they might weight their portfolio in favor of GM versus Ford, or vice versa, depending on their analysis.

  Have you thought of a way of consistently beating the S&P 500?

  Oh, sure.

  Then why haven’t you started trading it as a model program?

  We’ve been very busy. We will probably start it soon.

  How did the idea of an S&P 500 enhancement program come to you?

  I kept reading about the never-ending debate between those who felt active managers were better and those who felt you couldn’t beat the index, implying passive managers were better. I thought it would be really exciting to be able to consistently beat the index.

  I understand how the idea for the product occurred to you, but what I am asking is how did you get the idea of how to do it?

  I have to be tight-lipped here because we haven’t launched this program yet. I was able to talk about our other strategies because the competition has already figured out what we are doing and has begun to move in.

  So you haven’t initiated this S&P 500 enhancement program yet, but once you do, the competition will know what you’re doing.

  Then we can talk about it [he laughs].

  The strategies you describe sound so well hedged and your risk numbers are so low that I’m curious if you ever had a trade that went really bad, and if so, what went wrong?

  One of the companies we invested in declared bankruptcy. Our protective strategies worked well, but they can only work up to a limit.

  What is the whole story?

  Don’t make me relive it [he laughs]. This is our worst story by far.

  The worst story is always more interesting than the best story.

  Yes, I always focus on this episode whenever I talk to new investors. The company, which was a marketer of prepaid phone cards, needed financing. Although the deal was marginal, we decided to do it. Two weeks after the deal was completed, the company announced that all their financial statements were wrong and would be revised for the past two years. The stock dropped over 70 percent overnight. It happened so quickly that we didn’t have time to get our hedges fully in place. Although the company still had a viable business and assets, they declared bankruptcy to facilitate the sale of virtually all of their assets to another company.

  How did you extricate yourself from this situation?

  Fortunately, part of our deal was secured, placing us first in line in the bankruptcy proceedings. We have already recovered a large chunk of our capital and have a claim pending for more. If our due diligence is done correctly, then the companies we invest in should have significant liquidation value, which was the case here—the acquiring company wrote a check for more than $100 million. Of course, although the assets are there, we don’t know how much more money, if any, we will recover on our claim.

  What did you learn from this whole experience?

  The fact that the company negotiated aggressively for granting us less protection than is the case for our normal deals should have acted as a warning signal. The blindsiding that came from the financial restatement was really brutal, but I don’t know how that could have been avoided.

  You’ve grown from a one-man shop to a thirty-plus-person firm. What have you learned about the process of hiring people since you started your company?

  One of the best things I learned since starting a business was how to hire the right people. I used to hire anyone who insisted they were right for the job. If we had an open slot and someone said, “No problem, I could do that job,” I would hire that person because I knew that if I said that, I could do it. Through experience I learned that most people who try to aggressively talk their way into a position can’t do the job.

  What have you changed in your hiring practices?

  The people who have worked out best are the people that I had done business with successfully for years before I recruited them to join us. Literally, I went after them; they didn’t come after me. That’s been the big difference.

  * * *

  Fletcher’s initial success came from a brilliant insight: Even if the markets are efficient, if different investors are treated differently, it implies a profit opportunity. Every strategy he has employed, at its core, has been based on a discrepancy in the treatment of different parties. For example, the profit opportunities in his current primary strategy—private equity funding—are made possible by the fact that some companies have much greater difficulty attracting investment funds than other companies with equivalent long-term fundamentals. By identifying these temporarily out-of-favor companies, Fletcher can structure a financing deal that offers these firms funds at a lower cost than they can find elsewhere while at the same time providing him with a high-probability, low-risk profit opportunity.

  The two other main themes to Fletcher’s trading success are innovation and risk control. Although the specifics of Fletcher’s approach are not directly applicable to ordinary investors, these two principles still represent worthy goals for all market participants.

  * * *

  Update on Alphonse “Buddy” Fletcher Jr.

  During the bear market, Fletcher was successful in preserving capital, but not in maintaining his returns. Measured from the start of the bear market (April 2000) through September 2002, Fletcher’s original fund managed only a min
uscule 2 percent cumulative return. Still, this performance compares very favorably with the equity markets, which saw contemporaneous cumulative declines of 45 percent in the S&P 500 and 75 percent in the Nasdaq.

  Since the start of the bear market a little over two years ago, your flagship fund is up only a few percentage points. That’s a lot better than the indices, but before the advent of the bear market, was your goal to merely preserve capital during a protracted decline in equity prices, or did you expect to still make a double-digit return annually?

  The insurance provided by our hedges allows us to successfully preserve capital. It does not, however, generate quality investment opportunities. Although we are seeing many more opportunities to invest directly in companies, interestingly, the number of acceptable opportunities has declined, leaving us with returns well below the historic average for our aggressive funds. Our more conservative income arbitrage fund, however, has continued to perform, with the annualized return averaging near 9 percent since the start of the bear market.

  What have you learned during the past two-plus years of a bear market that you didn’t know or fully appreciate before?

  It’s more a matter of reinforcement than learning. The market of the past two years has underlined the importance of our emphasis on liquidity and the virtue of patience. We can’t control when acceptable opportunities will appear, but we can certainly try to preserve our capital until those opportunities arrive.

  An essential element of your core strategy is providing financing to companies. The accuracy of the company books is therefore very critical to your approach. In this light, have you been hurt by any instances of accounting deceptions that now seem to be coming to light in an almost routine fashion?

  An essential element of our strategies is to invest directly in companies, and fortunately we have not been hurt by these current accounting incidents. Long before this current rash of scandals, we concluded that not every company’s financial statements are complete and accurate. This skeptical approach has helped us avoid some problems.

  * * *

  AHMET OKUMUS

  From Istanbul to Wall Street Bull

  When Ahmet Okumus was sixteen years old, he visited the trading floor of the recently opened Istanbul Stock Exchange and was mesmerized. He was fascinated by trading, which on the Istanbul exchange resembled speculating far more closely than investing. It wasn’t long before his initial enthusiasm became an obsession, and he began cutting classes regularly to trade stocks on the exchange.

  Okumus knew that he wanted to become a money manager and realized that the country that offered the greatest opportunity for achieving his goal was the United States. In 1989, he immigrated to the United States, ostensibly to attend college but with the firm conviction that this was just a stepping-stone to his true career objective. Using a $15,000 stake from his mother, Okumus began trading U.S. stocks in 1992. This original investment had mushroomed to over $6 million by early 2000, an average annual compounded return of 107% (gross returns). In 1997, he launched his first hedge fund, the Okumus Opportunity Fund.

  I interviewed Okumus at his Manhattan office, a distinctly unimpressive space. Coming off the elevator, I was greeted by a receptionist who did not work for Okumus but who clearly was shared by all the tenants on the floor. Okumus’s office was small, badly in need of a paint job, and outfitted with ugly furniture. The single window offered little visual relief, providing a claustrophobic view of the side of the adjacent building. The office had one redeeming feature: it was cheap—actually, free (a perk for commission business). Okumus is evidently proud of this. Talking about how he got great deals on everything from his office space to his accountant, he says, “It’s my nature. I love to get good deals. I don’t pay up.” It is a comment that is equally fitting as a description of his trading philosophy.

  At the time of my interview, Okumus shared his small office with his college buddy, Ted Coakley III, whom he brought in to do marketing and assorted administrative tasks. (A subsequent expansion in staff necessitated a move to larger quarters.) Coakley’s faith in Okumus is based on personal experience. In college, he was Okumus’s first investor, giving him $1,000 to invest (in two $500 installments)—an investment that grew to over $120,000 in seven years.

  Prior to 1998, Okumus’s worst year was a gain of 61 percent (gross return). In 1998, a year when the S&P rose by 28 percent, he finished the year with only a minuscule 5 percent gain. I began my mid-1999 interview by questioning him about his uncharacteristically lackluster performance in 1998.

  * * *

  What happened last year?

  It all happened in December. At the start of the month, I was up 30 percent for the year. I thought the rise in Internet stocks was a mania. Valuations had risen to levels we had never seen before. For example, Schwab has been publicly traded for over ten years. At the time I went short, the ratios of the stock price to the valuation measures—sales per share, earnings per share, cash flow [earnings plus depreciation and amortization] per share, book value per share—were higher than they had ever been before. [As he talks about these events, the pain of the experience is still very evident in his voice.]

  What levels were these ratios at?

  As an example, the price/earnings ratio was at 54 to 1. In comparison, at prior price peaks in the stock, the ratio had been anywhere from 20 to 1, to 35 to 1.

  The valuation measures were at record highs and getting higher all the time. What made you decide to go short at that particular juncture?

  Insiders [company management] were selling heavily. In Schwab, insiders always sell, but in this instance, the insider sales were particularly high.

  Out of curiosity, why are insiders always net sellers in Schwab?

  Because the company issued a lot of options to management, which get exercised over time.

  What happened after you went short?

  The stock went up 34 percent in one week and was still going up when I finally covered my position.

  What other Internet or Internet-related stocks did you short in December 1998?

  Amazon.

  How can you even evaluate a company like Amazon, which has no earnings and therefore an infinite price/earnings ratio?

  You can’t evaluate it in any conventional sense. However, I had an idea of what price it shouldn’t be, and Amazon was at that level. When I went short, Amazon’s capitalization [the share price multiplied by the number of shares outstanding] was $17 billion, which made it equivalent to the fourth largest retailer in the United States. This seemed absurd to me.

  Also, book sales fall off sharply during the first quarter following the heavy Christmas season sales. I thought the prospect of lower sales in the next quarter would cause the stock to weaken. When I went short, Amazon was up ninefold during the prior year and fourfold during the previous two months.

  At what price was Amazon trading when you went short?

  I didn’t actually go short. I sold out-of-the-money call options. [In this transaction, the option seller collects a premium in exchange for accepting the obligation to sell the stock at a specific price above the market price. *] Since the options I sold were way out-of-the-money, the market could still go up a lot, and I wouldn’t lose. I thought I might be wrong and the stock could go up some more, but I didn’t think the stock would go up that much.

  What was the strike price of the options you sold? * Where was the market at the time?

  The stock was trading around 220, and I sold the 250 calls. The stock could go up another 30 points before I lost any money on the trade.

  How much did you sell the options for?

  I sold them for 11/8, but there were only three days left until expiration. I figured the stock was not going to go up 15 percent in three days. The day after I went short, one of the prominent analysts for the stock revised his price projection, which had already been surpassed by the market, from $150 to $400. Overnight, the stock moved from 220 to 260, and one day later it nearly re
ached 300. The options I had sold for 11/8 were selling for 48. [Options trade in 100-share units. Therefore, each option he had sold for $112 was now worth $4,800.]

  How much did you lose on that trade?

  The trade killed me. Amazon cost me 17 percent of my equity, and Schwab cost me another 12 percent.

  Had you used this type of strategy before—selling out-of-the-money calls?

  Sure, but these types of price moves were totally unprecedented. There are a lot of Internet stocks that are up twenty-or thirtyfold during the past year, but I’m not touching them. I’m just sticking to what I know best: fundamentals and value.

  What lesson did you learn from this entire experience?

  Not to short Internet stocks [he laughs].

  Any broader lessons?

  Don’t get involved when there is too much mania. Just stick to things that have some predictability. You can’t forecast mania. If a stock that should be selling at 10 is trading at 100, who is to say it can’t go to 500.

  What was your emotional state during this entire experience?

  The funny thing is that I was already upset at the start of December because the year was almost over, and I was up only 25 percent, which was my worst year ever. After I took the loss on Schwab and Amazon and was barely up for the year, I was devastated. I remember going to Bloomingdale’s with my girlfriend and not being able to stay in the store because every time I saw a price sign, it reminded me of the stock market. After ten minutes, I just had to leave. For about a week after I got out of these trades, I couldn’t look at the Investor’s Business Daily section that showed how the market was doing to date.

  Was this your worst emotional experience in the market?

  Absolutely. It was by far the worst experience; I had never felt like that before.

  But when I look at your track record, I see that December 1998, when you lost 16 percent, was only your second worst month and was far eclipsed by August 1998, when you lost a staggering 53 percent. How come August 1998, which seems so much worse on paper, doesn’t register on your emotional barometer?