Stock Market Wizards

by Jack D. Schwager

  The reason my August 1998 decline was so large was that I was caught 200 percent long during the month’s big stock market decline. Even though I was down much more during August, I was confident in the fundamentals of my stocks. They were just selling at ridiculously low valuations. The price/earnings ratio of my portfolio was only 5. Some of the stocks I was long were even selling below net cash—you never see that. I knew the stocks I held were absolute bargains and that they couldn’t stay that low for long. I wasn’t worried about their going down much further. In contrast, in December I lost money because I was short Internet stocks, and there was no way to know when they would stop going up.

  So the difference between August and December was your confidence level: In August you felt completely confident, even though you lost much more, and in December you felt out of control.

  Exactly.

  Even though you recovered August’s entire huge loss in only two months, do you consider it a mistake to have put yourself in a position of being 200 percent long during a bear market?

  Yes. This led to one of the three changes I made to my trading rules at the start of 1999. The first, which we discussed before, was don’t participate in mania. The second was never to have more than a 100 percent net position, either long or short. [In August 1998 Okumus had been 200 percent long and 0 percent short, or 200 percent net long.]

  What was the third change in your trading rules?

  I started using options for the specific purpose of reducing downside volatility.

  Was this change a response to investor feedback? Were some of the investors who were impressed by your net returns scared off by the volatility in your returns, especially the 53 percent decline in August 1998?

  Yes, the rule changes I made were definitely influenced by investor feedback. Investors told us that they didn’t want month-to-month volatility. Consequently, I started focusing much more on month-to-month performance. Before, when I was managing money for only myself, my family, and a few clients, my sole goal was long-term capital appreciation. It was as if I were running a marathon and only concerned about my finish time; I didn’t care about the individual split times. Now that I am managing much more money for investors who are concerned about the monthly numbers, it’s as though I’m running a marathon, but everyone is paying attention to every hundred meters. As a result, even though my main goal is still long-term capital appreciation, I’m focusing a lot more on the monthly numbers because I want to grow the fund much larger.

  How did you first get involved in the stock market?

  I was always interested in finance and currencies. As a kid, I would read the sports page of the newspaper, just like my friends, but I also read the financial page. In 1986, they opened the Istanbul Stock Exchange. The newspapers didn’t even have a stock market column until 1987. When they did start reporting stock prices, I noticed that the prices changed every day. It got my attention. I figured if you were smart, you could make money off of this because there had to be a reason why prices were changing.

  At first, I just followed prices in the paper. Then I realized that the stock exchange was close to my school. One day, I skipped school to go down to the exchange and see how it worked.

  Describe the Istanbul Stock Exchange.

  It’s completely modernized now, but at the time there was a bar across the middle of the room, which separated the spectators from the floor brokers. In the front of the room there were boards with bid and asked prices for each stock.

  How many stocks were traded on the exchange at the time?

  About thirty.

  Was there one floor broker for each stock?

  No, the floor brokers worked for different brokerage firms; they could all trade in any stock.

  How did you interact with the broker if you wanted to buy or sell a stock?

  You would yell, “Hey, come here.”

  How big was the exchange?

  Oh, about ten times bigger than this office [translation: extremely small].

  How long did you watch the market before you made your first trade?

  I watched it for a few weeks. One of the stocks, a construction company, which I knew was constantly getting new contracts, went down almost every day. This didn’t make any sense to me, so I decided to buy some shares. The broker warned me not to buy the stock, assuring me that it was headed lower. But I bought the stock anyway because I knew it was a good company. Within two weeks after I bought it, the stock doubled. That experience really got me hooked. I said to myself that logic works. I realized that stocks moved for a reason, and I was determined to find the reason.

  At the time, there was no market research whatsoever. I started doing my own research. The Istanbul Stock Exchange published sheets that showed current and previous year revenues, earnings, debt, and a few other statistics. No one paid any attention to these numbers. Since there were no books or articles available on the stock market, I just tried to interpret the statistics logically.

  For example, if a company made $20 profits for every $100 in sales, I assumed it was a good company; if it only made $2 profits on every $100, I figured it wasn’t so hot. I looked at the shares outstanding and the amount of profits, and I calculated what I thought the stock should be selling at. In effect, I created the price/earnings ratio for myself. When I came to the United States to attend college, I discovered that the price/earnings ratio and the other statistics I was looking at were the basic data people used to analyze stocks.

  Did you continue to be net profitable after your first winning trade?

  I did pretty well. Within a year or so, the people at the brokerage firm I was using started listening to me for advice. During this time, the stock market in Turkey went down from 900 to 350 and then back to 900. During the big decline, I managed to more than hold my own, and then when the market went back up, I did very well.

  How were you able to make even a small profit during the phase when the stock market was going down sharply?

  The stock market in Turkey is very speculative. The exchange has a 10 percent daily price limit. [The maximum permissible daily price move (up or down) in each stock was limited to 10 percent. Typically, when a market reaches limit up, trading will virtually cease, as there will be many buyers, but few sellers. An analogous situation would apply when the market is limit down.] Daily price limits are very common. I had a rule that I would buy a stock if it went down the daily limit three days in a row and then sell it on the first short-term bounce.

  In other words, you were taking advantage of speculative excesses. Do you still trade that way?

  No, I trade on the fundamentals.

  Say you select a stock because you like the fundamentals. How do you decide when to begin buying it? Do you still wait for a sharp sell-off before you buy it?

  Not necessarily. I have an idea of the value of the stock in my head, and when the stock goes low enough relative to that price, I’ll buy it. For example, say I believe a stock has a value of $35. In order to give myself a wide margin of safety, I might buy it if it goes down to $20.

  Do you always wait for the stock to reach your price before you buy it?

  Definitely. I am never in a rush. I wait patiently until the stock gets to my number.

  Using that approach, I assume you miss a lot of stocks.

  Certainly, but my main goal is to make money on every investment, not necessarily to catch every trade. I don’t have to make a lot on each trade, as long as I make something. Since 1992, 90 percent of my trades have been winners.

  What percent of the stocks you research and decide to buy actually come down to your price?

  Not many, maybe 10 to 20 percent. I follow what the other value managers in the industry are doing, and I know why they buy the stocks they do. I’m much stricter on my entries than they are. They may be willing to buy a company at sixteen times earnings, whereas I’m not willing to pay more than twelve. “Buy low and sell high” is something a lot of people say but very few people
do. I actually do it.

  When did you come to the United States?

  I came here in 1989 to attend college. The funny thing is that when I came to the United States, the Turkish stock market, which had gone from 900 to 350 and back to 900 while I was trading it, went from 900 to 4,000 in six months. I was very upset.

  Did you come just to attend college, or did you have any thoughts of trying to stay permanently?

  My intention from the very beginning was to become a fund manager in the United States. This is the biggest market, and in the United States the sky is the limit, whereas in Turkey, the opportunity is very limited.

  Did you ever look at the United States stock market before you came here?

  No, but from the first day I arrived in the United States, I started to focus on the U.S. stock market. I wanted to learn what made stocks move.

  How did you start?

  By reading as much as I could.

  What books did you find most beneficial or influential?

  I very much liked Stock Market Logic by Norman Fosback. For one thing, that book taught me to focus on insider trading [buying and selling by a company’s senior management and board of directors], which has become an important element in my approach. I also found books on Warren Buffett’s methodology very useful.

  What aspect of Warren Buffett’s methodology appealed to you?

  The concept of determining a stock’s value and then buying it at a discount to that number in order to allow for a margin of safety.

  What other books did you find useful?

  One Up on Wall Street by Peter Lynch gave me an appreciation of the importance of common sense in stock investing. Peter Lynch also pointed out that your odds in a stock are much better if there is significant insider buying.

  How do you measure whether insider buying is significant?

  I compare the amount of stock someone buys with his net worth and salary. For example, if the amount he buys is more than his annual salary, I consider that significant.

  So you’re looking at a breakdown of insider buying statistics, not just the total numbers.

  I am very detailed. I don’t think there is one other person who is more focused on insider activity than I am.

  What else is important in interpreting insider trading activity?

  You have to make sure that insider buying represents purchases of new shares, not the exercise of options.

  Is insider buying an absolute prerequisite, or will you sometimes buy a stock you like that reaches your entry price target, even if there is no insider buying?

  Most of the time I won’t. I want to see the insiders putting their money in their own company. Of course, if management already owns a significant portion of the company, they don’t have to buy more. For example, insiders already own about 65 percent of the shares in J. D. Edwards—a stock I currently like—so I don’t need to see any additional buying. In contrast, in some companies, insiders only own about 1 percent of the firm. In companies with low insider ownership, management’s primary motivation will be job security and higher bonuses, not a higher stock price.

  Do you do your research by computer or manually?

  Manually. I think that’s the best way because you learn much more.

  What is the universe of stocks that you are following?

  Anything on the Big Board and Nasdaq.

  How many stocks is that, roughly?

  About ten thousand.

  How can you possibly do research on ten thousand stocks manually?

  I spend a hundred hours a week on research. I follow all the stocks that I have researched at one time or another during the past eleven years, which is a substantial number. I also pay close attention to stocks making new fifty-two-week lows. A good company that I’ve identified from previous research does not have to make a new low for me to get interested. If it is down a lot, even if it doesn’t hit a new low, I’m on it.

  How are you aware of all the stocks that have witnessed significant declines?

  Besides looking at the list of new fifty-two-week lows, the Daily Graphs chart book contains about half the stocks I follow, and I review it weekly to see which stocks have declined a lot.

  So you’re always looking at stocks that have done poorly.

  Always. I usually don’t even consider buying a stock unless it’s down 60 or 70 percent from its high. In the seven years I have traded U.S. stocks, I have never owned a stock that made a new high. I think that must be a pretty unusual statement.

  Are you implying that when you flip through the charts, you only pay attention to stocks that have been moving down?

  That’s correct, with one exception: If the stock has been moving sideways and the earnings have been moving up, I might pay attention.

  Then are all the stocks you buy at or near recent lows?

  Not all. If it’s a company that I know well and the fundamentals are very strong, I might go long, even if the stock is significantly above its low. For example, Microchip Technology is currently at $35, which is well below its high of $50, but also well above last year’s low of $15. Even though it’s well off its low, I’m still selling puts in the stock because their business is improving tremendously.

  * * *

  Selling puts represents a bullish position. The seller of a put receives a premium for the obligation to buy a stock at a price called the strike price during the life span of the option. This obligation is activated if the option is exercised by the buyer, which will happen if the stock price is below the strike price at the option expiration.

  For example, assume that a stock is trading at $13 and that a put option on the stock with a $10 strike price is trading at $1. If the stock is trading above $10 when the option expires, the seller will have a $1 profit per share (a $100 profit per option contract, which represents 100 shares). If the stock is trading below $10 at the option expiration, the option will presumably be exercised, and the seller of the option will be required to buy the stock at $10, no matter how low the stock is trading.

  Okumus, who typically sells puts with strike prices below the current market price (called out-of-the-money puts), will earn a profit equal to the option premium paid by the option buyer if the stock declines modestly, remains unchanged, or goes up. However, if the stock declines by a wide margin, he will be obligated to buy the stock at an above-market price (the strike price) at the time of the option expiration.

  * * *

  What motivates you to sell puts in a stock instead of just buying the stock?

  Any stock that I sell a put on, I am happy if they put me the stock [exercise the put option, requiring Okumus to buy the stock at the strike price]. I don’t sell a put on a stock unless I would be happy to own the stock at the strike price.

  For example, I’m currently short some $10 puts on J. D. Edwards, which is trading near $13. I hope they put me the stock because I would love to own it at $10. If they do, I’ll still have the premium, and if I buy the stock at $10, I know I will make money.

  But most of the time when I sell puts, the market never declines enough for the option to be exercised. This, of course, is okay too because I still keep the premium as a profit.

  In other words, selling put options is an alternative way for you to be buying stocks. If it doesn’t go down to the strike price, you still earn the premium, and if does go down to the strike price, that’s also fine because that’s the price you would have bought the stock at anyway.

  Exactly. By selling puts, I am getting paid by the market while I’m waiting for the stock to come down to my price. Also, for some stocks, it may only be possible to make money by selling puts as opposed to buying the stock.

  For example, value stocks have been very much out of favor in recent years. There are stocks that are trading at only five to six times earnings. The earnings are growing, insiders are buying, and the stocks are just sitting there. At the same time, the S&P is going up like crazy. You can’t make money by buying these stocks, but you c
an by selling the puts. If you sell put options, you don’t have to be right about the stock going up; all you need in order to make money is for the stock not to go down by much.

  Let’s say that there is a stock trading at 35, and you decide you would like to be a buyer at 30. Why not always sell the 30 put and collect the premium, since if it went to 30, you would buy it anyway? This way, you would always make the premium as a profit, whether the stock went down to 30 or not.

  Because you always have to consider your opportunity costs. If I sell puts, I need to put up margin against the position. Sometimes the premium I could collect for selling the put wouldn’t justify tying up the money needed for the position. I could do better investing that money elsewhere.

  Let’s go back to when you arrived in the United States. You said earlier that you started researching the U.S. stock market when you first came here, which also approximately coincided with the beginning of college. How did you allocate your time between studying for college and studying the stock market?

  On average I would say 35 percent school and 65 percent stock market, but the stock market percentage kept going up over time. By the beginning of my senior year, I was devoting 90 percent of my time to the stock market, and I quit school altogether.

  Weren’t you at all reluctant about quitting college a year before you were going to get your degree?

  No, because I just couldn’t wait to get started. Also, I was a finance major, and my teachers knew a lot less than I did about the stock market and investing.

  What did they teach you in college about the stock market?

  They teach you theories, and theories don’t work most of the time.

  For example?

  The efficient market hypothesis [the concept that the market immediately discounts all known information], which in my opinion is ridiculous.