Stock Market Wizards

by Jack D. Schwager

  Eighteen.

  Do you remember how many people you had when I first interviewed you?

  [He laughs long and hard.] I also remember what you said about my office: “cheap, ugly furniture.” If I was an investor, I would love that!

  Since our interview, you launched a market neutral fund. What was the motivation for adding this fund?

  It was actually Sir John Templeton’s idea. He was worried about the market. He thought it made sense to combine my stock selection skills with a market neutral approach. I thought it was a good idea as well, but I was hesitant because I didn’t want to spend too much of my time coming up with short ideas; I was afraid it would interfere with my long side research. When I explained this to Templeton, he said, “Why don’t you just make up the difference between your long and short positions by shorting stock indexes?” That made a lot of sense to me. It is a very simple idea, but very effective. It made it possible for me to start the market neutral fund without detracting from my ability to manage the net long funds.

  At our original interview, you referred to the prior bull market as a “mania.” With the Nasdaq down over 80 percent from its peak at the July low and the S&P down about 50 percent at its corresponding low, do you think these prices sufficiently corrected for the prior excess, or do you believe the bear market will continue?

  Who knows? All I know is that I own good leading companies at bargain prices.

  * * *

  MARK MINERVINI

  Stock Around the Clock

  Minervini comes off as a bit cocky, not because he thinks he’s better than the markets—in fact, his respect for the markets and an appreciation of his own fallibility underlie his whole trading philosophy—but rather in the sense that he feels he is better than most of his peers. And, frankly, if he can even remotely continue to match his spectacular performance of the past five years in coming years, then this conceit may not be misplaced. I sensed that he took particular pleasure in the knowledge that as a self-taught dropout (from junior high school, no less!) he has run circles around most Ph.D.s trying to design systems to beat the market.

  After dropping out of school, Minervini supported himself as a drummer. Trying to get Minervini to talk about his early experiences as a musician was a futile and frustrating effort. Despite my repeated entreaties that a discussion of a trader’s background was essential in giving an interview some color and life, he seemed intent on not providing any details about his career as a drummer. I had the distinct impression that his responses were being guided by the hand of an unseen publicist. He either gave the most general of answers or somehow managed to divert the discussion back to the stock market. Sample question (asked with growing weariness): “Is there anything at all with any specificity that you can tell me about your experiences as a musician? Answer: “I was attracted to music because I liked the freedom, which is what attracted me to the stock market….” Finally, after much prodding, he summarily acknowledged that he played for several bands, cut a record, appeared on an MTV video, worked as a studio musician, and owned his own studio. End of story.

  Minervini became interested in the stock market in the early 1980s while still in his teens. His early dabbling soon grew into a full-time obsession. He sold his studio and used the proceeds to stake his trading. Initially, he lost everything—an experience he describes in the interview. He realized that his worst mistake had been depending on others for advice, so he embarked on an intensive program of self-education and research.

  After nearly a decade of research and market experience, Minervini developed a well-defined trading methodology. In mid-1994, confident that his trading approach was sufficiently refined, and encouraged by his steadily improving performance, Minervini consolidated his various accounts into a single account that was to become his track record. (Previously, he maintained several accounts, partially to facilitate comparing different strategies.) In the five and a half years since initiating this account, Minervini’s performance has been nothing short of astounding. His average annual compounded return during the period has been a towering 220 percent, including his 155 percent first place finish in the 1997 U.S. Investing Championship. Most traders and money managers would be delighted to have Minervini’s worst year during this span—a 128 percent gain—as their best year. But return is only half the story. Amazingly, Minervini achieved his lofty gains while keeping his risk very low: He had only one down quarter—barely—a loss of a fraction of 1 percent.

  Minervini launched his own hedge fund, the Quantech Fund, LP, in 2000. He is also president of the Quantech Research Group, an institutional research firm that provides stock selections based on Minervini’s proprietary selection methodology. Minervini spends his days managing money and his nights running computer screens and scouring company fundamentals.

  I interviewed Minervini in his midtown Manhattan office. The interview was conducted over the course of two afternoons. Minervini was clearly under the weather, acknowledging that he was running a temperature of 103 degrees. He chose not to cancel our meetings, however, because by his own admission, being interviewed in a Market Wizard book was one of his lifetime goals. He was not about to let a virus deter him from checking another item off his list of career objectives.

  * * *

  When I arrived, Minervini was in his office, looking at a stock chart on his computer screen and timing the entry of a trade. After hanging up the phone he commented to me:

  “I hope I don’t get a good fill.”

  Come again?

  A good fill is a death blow. The average investor who puts in a buy order when the market is at 27 is thrilled if he gets a fill at 26¾. I would probably just turn around and get out of the position. Stocks that are ready to blast off are usually very difficult to buy without pushing the market higher. If I put in an order for ten thousand at 27 and the floor comes back to me and says, “We can only do three thousand at 27. The market is at 27¼. What do you want to do now?” it reinforces my belief that the timing of the trade is right.

  What was the motivation for the stock you just bought?

  The motivation is always the same. Although I may hold the position much longer, I am buying the stock because I think it will go up within hours or at most days.

  Yes, but what gives you that conviction?

  You mean besides seventeen years of experience? The starting point is a quantitative screen based on the characteristics of the stocks that witnessed the largest and most rapid price advances during the past century. A good book on this concept, which may be out of print, is Superperformance Stocks by Richard Love.

  What are some of the common denominators of stocks that share this rapid price gain characteristic?

  They tend to be less familiar names. More than 80 percent of the stocks are less than ten years old. Although many of these stocks are newer companies, I avoid low-priced stocks. Stocks that are low are usually low for a reason. Typically, the stocks I buy are $20 or higher, and I never buy stocks under $12. My basic philosophy is: Expose your portfolio to the best stocks the market has to offer and cut your losses very quickly when you’re wrong. That one sentence essentially describes my strategy.

  What are some of the other characteristics of the largest winning stocks?

  One thing that would surprise most people is that these stocks typically trade at above-average price/earnings (P/E) ratios, even before they become big winners. Many investors limit their selections to stocks with low P/E ratios. Unfortunately, avoiding stocks just because the P/E seems “too high” will result in missing out on some of the best market moves.

  * * *

  A protracted discussion followed wherein I asked specifics about Minervini’s trade selection process. His answers could be described most kindly as general, and perhaps more accurately as evasive. Assuming that the target market audience for this book is not insomniacs, I see little purpose in repeating any of this conversation here. Finally, sensing that I was finding his responses frustratin
gly ambiguous, he continued in a measured tone.

  * * *

  Look, none of this is a black box. You have all these people trying to come up with formulas to beat the market. The market is not a science. The science may help increase the probabilities, but to excel you need to master the art of trading.

  People always want to know what’s in my computer model. I think that is the least relevant issue to successful trading. Of course you need an edge, but there are a thousand ways to get an edge. Some people use strategies that are completely opposite mine, yet we can both be very profitable.

  Developing your own strategy is what is important, not knowing my strategy, which I have designed to fit my personality. Understanding my trading philosophy, my principles, and my money management techniques, that may be valuable. Besides, I think most people overemphasize stock selection.

  What do you mean?

  I think people spend too much time trying to discover great entry strategies and not enough time on money management. Assume you took the top two hundred relative strength stocks [the two hundred stocks that outperformed the market average by the greatest amount during a specified number of past months] and placed the names on a dart board. Then each day, you threw three darts and bought the resulting stocks, and whenever any stock went down, say, 10 percent from your entry level, you sold it instantaneously. I would be willing to bet that you would make money because you are exposing yourself to a group of stocks that is likely to contain some big potential winners while at the same time you are cutting your losses.

  You’re not saying that if you took the entire list of stocks and threw darts, you would make money as long as you cut your losses at 10 percent. You’re specifying that the list has to be preselected in some way—in your example, the stocks with the highest relative strength.

  I was only using an extreme example to illustrate a point: Containing your losses is 90 percent of the battle, regardless of the strategy. In addition, if you put yourself in a position to buy stocks that have the potential to go up a lot, your odds will be better.

  In other words, the odds will be better if you buy stronger stocks.

  The odds will be better that you will buy stocks that go up a lot. Of course, the odds may also be better that you will buy stocks that go down a lot. But you don’t have to worry about that—do you?—since you are cutting your losses.

  Then I assume that, as a general principle, you believe in the idea of relative strength—buying stocks that have been going up more than the market averages.

  Or down less. One way to use relative strength is to look for stocks that hold up well during a market correction and are the first to rebound after the market comes off a relative low; these stocks are the market leaders.

  When you first started trading stocks, what method did you use to select your buys?

  [He laughs heartily at the recollection.] I didn’t have any method. I was buying low-priced stocks that were making new lows. I was also taking tips from brokers.

  Tell me about that.

  The worst experience was in the early 1980s when my broker talked me into buying a stock that was trading just under $20. The stock came off about 4 or 5 points, and I was really concerned. He told me not to worry. He assured me that the stock was a bargain and that the sell-off was a once-in-a-lifetime buying opportunity. He claimed that the company had developed an AIDS drug that was going to get FDA approval. He actually convinced me to buy more. The stock kept on sinking. Eventually I couldn’t buy any more because I ran out of money. The end of the story is that the stock fell to under $1, and I lost all my money.

  How much did you lose in that trade, and how much had you lost up till that point?

  Altogether, I lost about $30,000 to $40,000, with about half the amount on that trade. Even worse, part of the loss was borrowed money.

  Did that experience cause you to lose any of your zeal for the stock market?

  No, but it was very upsetting and discouraging. I literally cried. What hurt the most was that I thought I had lost my chance because I had wiped out my trading stake. But no matter what happened, I never stopped believing that there were great trading opportunities available every day. It was just a matter of my figuring out how to identify them. My mistake had been surrendering the decision-making responsibility to someone else. I was convinced that if I did my own work, I would be successful.

  What gave you that conviction? It certainly wasn’t your trading results.

  It’s just my personality. I don’t give up very easily. Perhaps the single most important factor was that I had a great passion for the game. I think almost anyone can be net profitable in the stock market given enough time and effort, but to be a great trader, you have to have a passion for it. You have to love trading. Michael Jordan didn’t become a great basketball player because he wanted to do product endorsements. Van Gogh didn’t become a great painter because he dreamed that one day his paintings would sell for $50 million.

  Was your passion for the market related to the opportunity to make a lot of money?

  Initially I might have been attracted to the stock market because of the money, but once I got involved, making money was not the issue.

  What was the issue?

  The issue was winning. The issue was being the best at something. My goal is to be the best trader in the world. If you’re the best, you don’t have to worry about money; it comes flying through the window.

  What did you learn from your experience in losing all your money?

  I realized that no one was going to do it for me; I had to do it for myself. My broker still got a commission, but I was sitting there broke. Incidentally, although I didn’t realize it then, I now fully believe that losing all of your money is one of the best things that can happen to a beginning trader.

  Why?

  Because it teaches you respect for the market. It is much better to learn the lesson that you can lose everything when you don’t have that much money than to learn the same lesson later on.

  I guess that implies you are not an advocate of paper trading for beginners.

  Absolutely. I think paper trading is the worst thing you can do. If you are a beginner, trade with an amount of money that is small enough so that you can afford to lose it, but large enough so that you will feel the pain if you do. Otherwise, you’re fooling yourself. I have news for you: If you go from paper trading to real trading, you’re going to make totally different decisions because you’re not used to being subjected to the emotional pressure. Nothing is the same. It’s like shadowboxing and then getting in the ring with a professional boxer. What do you think is going to happen? You’re going to crawl up into a turtle position and get the crap beat out of you because you’re not used to really getting hit. The most important thing to becoming a good trader is to trade.

  How did you make the transition from failure to success?

  My results were transformed when I understood that what counts isn’t how often you’re right, but how much you profit on your winning trades versus how much you lose on your losing trades. On average, I’m only profitable about 50 percent of the time, but I make much more when I’m right than I lose when I’m wrong.

  I meant at the very beginning. How did you go from losing all your money following a broker’s tip to developing your own successful methodology?

  It was a slow, gradual process that took years of research and trading experience. I also read just about every book I could find on the markets and successful individuals. Out of the hundreds of books that I read, there were probably no more than ten that had a major influence on me. However, I don’t think there is any such thing as a bad book. Even if you only get one sentence out of a book, it’s still worthwhile. Sometimes, one sentence can even change your life.

  Okay, tell me a sentence that changed your life.

  “The fruits of your success will be in direct ratio to the honesty and sincerity of your own effort in keeping your own records, doing your own thinking
, and reaching your own conclusions.” In other words, take 100 percent responsibility for your results.

  Which book is this quote taken from?

  How to Trade in Stocks by Jesse Livermore.

  What other lessons did you get out of that book?

  There were many important messages. The basic message is not to have a rigid opinion; the market is never wrong. He also talked about the need for patience, not only in waiting for the right moment to enter a position, but also in riding a gain in a winning position. The message that really hit home with me was the importance of protecting your profits, not just your principal.

  What changed for you after reading Livermore’s book?

  I was astonished at how relevant the book still was to today’s market. It inspired me to go back and look at the stocks of the early 1900s and even earlier. I found that there is really nothing different in the markets. I was amazed at how many of Livermore’s observations matched my own.

  Such as?

  The importance of money management.

  Of course, Livermore himself didn’t exactly excel in that department. [Livermore made and lost several fortunes. He ultimately committed suicide after wiping out one too many times.]

  On a day-to-day basis Livermore did cut his losses. Unfortunately, from time to time he would let his urge to gamble get the better of him. That urge is what destroys many traders.

  What else helped you become a successful trader?

  Playing poker. I think that anyone who wants to be a trader should learn how to play poker.

  Can you elaborate on that?

  The first time I seriously watched a poker game in a casino I noticed that the average winning hand was over $50, but that it only cost you 50 cents to see the first three cards. I couldn’t believe that for half a buck I could get a pretty good idea of my chances of winning a hundred times that amount. If I folded fifty times and won only once, I would still win twice as much as I lost. Those seemed like terrific odds to me. That’s how I got started playing poker. My strategy was to play only super-high-probability hands.