Stock Market Wizards

by Jack D. Schwager

  What differentiates you from the majority of traders who are a lot less successful?

  Discipline. I don’t think anyone is more disciplined than I am. When I put on a trade, I have a contingency plan for every possible outcome. I can’t think of any circumstance that would be an exception. If there were, I would have a plan for that too.

  What else?

  I trade for a living. When you have to earn a living every day from trading, finding a way to be consistent becomes a necessity.

  How do you know when you are wrong in a position?

  The stock goes down. That’s all you need to know.

  How much vacation time do you take a year?

  I don’t take vacations during trading days. I haven’t missed a day in the market in over ten years.

  Even when you’re sick?

  Even when I’m sick. I’ve traded through pneumonia. I’ve traded with a temperature of 105 degrees.

  What is your typical day like?

  I get into work around 8 A.M. and work till about 7 P.M. Then I take a few hours to eat and exercise, and go back to work from ten at night until one in the morning. Then I do it all over again. Sunday I usually work from midday into the night. Saturday I rest and recharge.

  No vacations, six-day workweeks, and fourteen-hour workdays. Don’t you ever feel the need to take a break?

  My desire to be the best trader is greater than my desire to take a break. I don’t like to get out of the swing.

  * * *

  Sure, I would have liked it better if Minervini had been more forthcoming with the specifics of how he selects stocks and times his trades, but I have to agree with him that the most important advice he can give—and does provide—relates to his trading philosophy. The main points of this doctrine include:

  Rigorously control your losses.

  Develop a method that fits your own personality, and master that one style.

  Do your own research, act on your own ideas, and don’t be influenced by anyone else’s opinion.

  Have a contingency plan for every possible event, which includes how to get back into a trade if you are stopped out and when to take profits if the trade goes in your direction.

  Maintain absolute discipline to your plan—no exceptions!

  Yes, I know, some of these points, such as discipline and loss control, have become clichés as trading advice. But this doesn’t make these principles any less important. Why do you think they became clichés? The fact is that discipline and loss control are the two factors that were most frequently mentioned as keys to trading success by the traders I interviewed, both in this book and its two predecessors. The problem is that traders and investors have heard this advice so often that they often fail to hear it at all—and that would be a crucial mistake.

  One exercise that Minervini did that proved extraordinarily helpful to him was to analyze his past trades. The insights of this analysis changed his trading style forever and helped him to make the transition from marginal performance to spectacular success. In his own case, Minervini found that by capping the maximum loss on his trades, he could dramatically increase his overall returns, even after allowing for winning trades that would have been eliminated by this rule. This discovery allowed him to make a lot more profit with much less aggravation. Other traders and investors may find that a similar comprehensive analysis of their past trades reveals patterns that point the way to improve their own performance.

  Interestingly, the methodology that Minervini eventually developed was precisely the opposite of his instinctive approach as a novice, which was buying low-priced stocks that were making new lows. Success required not merely the adaptability to modify his initial approach, but also the flexibility to acknowledge that his original ideas were completely wrong. The lesson is that early failure does not preclude long-term success, as long as one is receptive to change.

  * * *

  Update on Mark Minervini

  Minervini’s 5½ -year personal account track record at the time of the original interview (a 220 percent average annual compounded return) would have been difficult to maintain even under the best of circumstances. Minervini would be the first to admit that he is unlikely to generate outsized returns during a major bear market. Given his methodology, which is focused on early identification of potential superior performing companies, Minervini’s trading reflects a definite long-side bias. When he is bearish on the market, he tends to spend a lot of time at or near the sidelines, protecting capital and waiting for a more opportune investment environment—a stance that, as he discusses in this update, has been less than popular with some of his investors. Not surprisingly, Minervini’s fund, which was launched in January 2000, three months before the market top, has spent significant portions of the subsequent 2¾ years in or near cash. The track record reflects this predominant capital preservation mode: Since the start of the bear market (April 2000) Minervini is up only a modest 3 percent (compared with contemporaneous cumulative declines of 45 percent in the S&P 500 and 75 percent in the Nasdaq).

  At the time of our last interview, you were just beginning to manage other people’s money through a fund. What has that experience been like?

  I found there were conflicts between my style of investing and institutional investors’ concepts about investing.

  What kind of conflicts?

  My style of investing is to make large bets in concentrated positions and manage risk by using tight stops and closely monitoring the fundamentals of the companies in the portfolio. I have complete confidence in being aggressive when I feel it is warranted and staying out of the market for as long as I feel necessary when the investment environment is unfavorable. There were conflicts on both scores: Institutional investors don’t want you to be highly concentrated, and they don’t like the idea of being fully in cash.

  If the market goes up during the month, and you’re in cash, they’ll say, “My other funds are up. My stocks are up. The Dow is up. What are you doing in cash?” If the market goes down a lot in a month and you were in cash, they’ll want to know why you didn’t have short positions on.

  I’m not going to put on short positions for the sake of being short. I’m looking for a specific setup in a stock or the market in order to go short. If that setup doesn’t occur, I won’t go short. That doesn’t mean the market won’t go down. The type of sell signal I look for tends to occur when a market is rolling over from a top, not after it has been in a long slide, as is currently the case. You have to stay in your own area of confidence. For example, one of Warren Buffett’s best friend’s is Bill Gates. Yet Warren Buffett has never bought a single share of Microsoft because he considers the stock to be outside his area of confidence.

  Also, my philosophy has always been to stay out of the market as much as possible. The less time I am in the market, the less risk I am taking. If dictated by market conditions, I’d rather make X percent having significant market exposure in only three months of the year than make the same amount while being in the market all the time.

  Certain investors won’t have the confidence level in my approach that I have and will very quickly question my strategy if I am in cash when the market is moving. If investors don’t feel you are managing money the way they believe it should be managed, they’ll redeem their investment. It’s really quite ironic because they are hiring you for your advice. It’s like going to a doctor and telling him how to treat you. But that is what happens in the investment world.

  You were doing so well trading your own account, with no one to answer to. What was your motivation to get into managed money?

  It was the challenge of moving beyond just trading my own money. I have always admired people such as Steve Cohen of SAC and Lee Ainslee of Maverick who have built organizations that employ many traders and manage large sums of money.

  The net exposure in your Quantech fund is strongly skewed to the long side. How have you managed to be net profitable being net long in a steadily declining market?r />
  An important part of success in the markets is knowing when to stay out of the game. Part of your strategy may be when not to apply your strategy. The Quantech fund has been in cash or nearly so for significant periods during its 2½-year life span, which has almost entirely coincided with the bear market. On rare occasions, the fund may even be modestly net short. For example, I was short the Dow index on September 11, by coincidence, of course.

  Why were you short then?

  It’s amazing how the market seems to discount future events. I was short the Dow, and I was getting ready to go long defense stocks when the World Trade Center was hit. The only reason I didn’t go long the defense stocks was because I was so bearish on the stock market. Imagine if I had been both short the Dow and long defense stocks; I think I would have had a visit from the FBI. The defense stocks were rallying, and the market was rolling over before the attack on the World Trade Center. I don’t mean to suggest that the market was discounting the terrorist attack, but it is incredible that those two trades—short the stock market and long defense stocks—were the exact trades showing up most strongly in my technical work before September 11.

  When we first did the interview you had never experienced a multiyear bear market. Have you learned any new trading lessons from the bear market of the past two years?

  My strategy has not changed one iota. If anything, the bear market has only reinforced my conviction about staying out when the conditions for a trade are not there. In the long run, companies that generate cash flow and earnings, grow rapidly, and have new products or services are going to be rewarded. Of course I wait until the market action demonstrates that it recognizes those positive fundamentals because ultimately perception is all that matters.

  Are you saying that your methodology has remained completely unchanged?

  Yes. I will, however, revise my models to incorporate new information. For example, every year, I analyze all the stocks that were the best performers in the preceding year to refine the fundamental and technical profile I use to identify the stocks that are likely to be the biggest winners in the future.

  Any thoughts about the recent accounting scandals?

  Even though the U.S. accounting system may be the best one in the world, the very first word in the term GAAP (generally accepted accounting principles) tells you something is wrong. There shouldn’t be any generalities in math. There should be specific ways to report. Those specifics may need to be tailored by sector—a retail company might have different guidelines than an insurance company—but within sectors, companies shouldn’t have much latitude in deciding how to report their numbers. How can a company as complex as General Electric, which probably has hundreds of divisions and revenues that rival the GDP of many countries, come within one penny of their earnings estimates every quarter? Most companies are operating fully within the law. It’s not that they’re breaking the law; they’re just taking advantage of it. Hopefully, recent events will lead to some improvements.

  What’s your very long-term market view?

  Although the current price plunge will probably lead to a sharp rally on the first significant bullish surprise, I don’t believe we are likely to see the re-emergence of a sustained uptrend like the one in the 1990s. One of the factors that contributed to the bull market of the 1990s was the psychological and economic boost provided by the fall of communism at the end of the 1980s. Now I see the threat of going back into a Cold War type situation, but with terrorism replacing communism.

  What advice would you have for investors at this juncture?

  The same advice I have always had. You need to realize that, ultimately, a stock is virtually 100 percent perception, and therefore prices can go anywhere. Most of the Internet companies were worth nothing, but they reached these incredible prices on perception. Think of the wealth that was made and lost in these stocks purely as a function of perception.

  * * *

  STEVE LESCARBEAU

  The Ultimate Trading System

  Steve Lescarbeau’s systems are the next best thing to a daily subscription to tomorrow’s Wall Street Journal. Lescarbeau invests in mutual funds. His goal is to hold them while they are going up and to be in a money market fund while they are going down. He times these asset transfers with such precision that he more than triples the average annual returns of the funds he invests in while sidestepping the bulk of their periodic downturns.

  During the five years he has traded, Lescarbeau has realized an average annual compounded return of over 70 percent. As impressive as this may be, what is truly remarkable about his track record is that this high return has been achieved with extraordinary risk control: His worst equity decline from a month-end peak to a subsequent month-end low was a minuscule 3 percent. His consistency is also astounding: He has been profitable in 91 percent of all months, and his annual return has exceeded 50 percent every year.

  For reasons he explains in the interview, Steve Lescarbeau is almost paranoid about revealing any details about his trading systems. He is also not interested in raising any money to manage. Why then did Lescarbeau even agree to do this interview? First, I assured Lescarbeau that he would see this chapter and have the opportunity to approve it before it was printed. Second—and this is just my guess—by his own account, Lescarbeau’s initial research direction was inspired by the Gil Blake interview in my book The New Market Wizards. Perhaps agreeing to this interview was a courtesy granted for having provided this indirect aid to his own career.

  Lescarbeau doesn’t let up. Even though he has created some incredibly effective trading systems, he continues his research to find even better systems. His drive is not restricted merely to the markets; when he was in sales, he was consistently the top salesman in his company. Lescarbeau even approaches his leisure activities with intensity. He doesn’t merely go for a bicycle ride; he goes for a hundred-mile bicycle ride—at least he did until he blew out his knee by doing excessive repetitions, at too high a setting, on a weight-training machine.

  Lescarbeau works alone at his home in a small rural town outside of Albany, New York. The interview was started and completed in Lescarbeau’s home office, a corner room with dark wood paneling, floor-to-ceiling bookcases, and windows overlooking his lawn. The middle portion of the interview was conducted over a buffet lunch at a local Italian restaurant, at which we were the only diners (due to the lateness of the hour for lunch, not the quality of the food).

  * * *

  How did you first get interested in the stock market?

  I got involved in the financial services industry in 1983, working for a mutual fund company. To be perfectly candid, I switched into this field because I thought it was the place I could make the most amount of money as a sales kind of guy. I had a degree in chemistry from Boston University, which helped, but no training whatsoever on the financial side.

  How do you go from chemistry to the sale of financial investments?

  As a plug to BU, my degree in chemistry has been extremely helpful. I think that a physical science degree is as good as if not better than a financial degree because it trains you to be analytical. If there is anything I am really good at, it’s being a researcher. I’m not a particularly good trader. When I got out of school, I was sick and tired of studying, and I just wanted to make money. I got a job in sales using my chemistry background.

  You didn’t try to get a job directly in chemistry?

  No, chemists don’t make any money, but salesmen do.

  Didn’t you figure that out in college?

  Yes, when I was a senior [he laughs].

  What were you selling?

  Filtration systems to the pharmaceutical and electronic industries. It was very high-tech stuff. I was very good at selling. I was number one in sales for three years in a row.

  How did you develop the talent for sales?

  I’m just a willful person.

  How did you go from selling filtration systems to selling financial investments?

&n
bsp; When I won the salesman-of-the-year award, one of the prizes was a trip to La Costa, California. I remember driving down the Monterey Peninsula, seeing all these phenomenal houses, and thinking that I would never make the kind of money to be able to afford a similar house if I stayed with my firm. That’s when I decided to leave and do something where I could make more money. I looked into two fields—medical delivery and financial services—because the incomes were unlimited for a salesperson. In 1983, I took a job as a regional sales manager at a mutual fund company.

  Did you have any experience in financial markets?

  None whatsoever. In fact, when I won the salesman-of-the-year award at my previous job, they also gave me a hundred shares of stock. I didn’t even know what it was. I guess you can’t be much more ignorant of the market than that.

  How did the new job work out?

  I loved the job and did very well over the next few years. However, because of limitations that the company placed on me, I realized that if I wanted to take the next step, I would have to do something different.

  I decided to become a stockbroker. I was interviewed and hired by Shearson Lehman Brothers. While I was there, I met Tim Holk, who was in managed futures—an area I knew absolutely nothing about. Tim had raised some retail money for Commodities Corporation. [At the time, Commodities Corporation had a group of in-house traders who managed the firm’s proprietary funds as well as outside investor funds. Two of the traders I interviewed in Market Wizards—Michael Marcus and Bruce Kovner—achieved their early success at Commodities Corporation.] One day, I went down with Tim to meet with some traders at Commodities Corporation. After that meeting, I told Tim, “Screw the retail money; let’s go after institutional money.”