Stock Market Wizards

by Jack D. Schwager

  * * *

  MICHAEL MASTERS

  Swimming Through the Markets

  Five years ago, Masters was an unemployed stockbroker; today, he is one of the largest stock traders in the country. Masters, an Atlanta-based fund manager, got his start in the business as a broker, but he never liked it. After five years and growing frustration, he virtually forced his own firing. With no other qualifications than desire and confidence, Masters decided to start his own fund. He raised his start-up capital by selling ten 1-percent shares in his new company at $7,000 per share (an astoundingly fortuitous investment for his initial backers).

  In 1995, he launched the Marlin fund, a name that reflects his love of sportsfishing. During the five years he has managed the hedge fund, Masters has achieved the extremely rare combination of lofty returns and low risk: an average annual compounded return of 86 percent, with only three losing months—the worst a relatively minuscule 3 percent decline. As of April 2000, assets under management had grown past the half-billion-dollar mark, reflecting the combined influence of huge returns and a steady influx of new investors. Total assets would have been even larger, but Masters had decided to close his fund to new investment, reflecting his concern that excessive asset growth could impede performance.

  Although its plus-one-half-billion-dollar asset base places Masters Capital Management among the larger hedge funds, the figure drastically understates the firm’s trading activity. Because of Masters’s extremely high turnover of positions—far more rapid than the industry average—the firm’s level of transactions rivals that of the country’s largest hedge funds and mutual funds.

  During trading hours Masters’s concentration on the market is intense and all-inclusive. To avoid any interruptions or distractions, he locks himself in the trading room with the company’s trader, Tom Peil. The firm’s research analysts know the computer lock combination and can gain entry if they have sufficiently urgent market information. With rare exception, Masters will not accept any phone calls during market hours. “He is so completely absorbed watching the market,” says Peil, “that when an important call does come in, I can yell at him repeatedly to pick up the phone, and he won’t hear me until I scream something ludicrous like ‘purple dragons!’”

  Masters is affectionately known as “the big sloppy” by his staff, a nickname that reflects both his size (six foot five) and the copious amounts of food he eats at his desk, leaving a wake of leftovers and dirty paper plates. One of Masters’s idiosyncrasies is that he is so used to using a keyboard to navigate the computer screen—a habit that dates back to the premouse days when DOS reigned supreme—that he still refuses to use a mouse except when it is absolutely necessary. “Mike’s keyboard clattering is a constant throughout the day,” says Peil. “We joke that when Mike’s time comes, they will have to bury him with his keyboard.”

  Although he quips about Masters’s quirks, Peil’s admiration for him comes through very strongly. Peil, a veteran of brokerage firm trading desks, was enjoying his retirement, trading his own account, when he met Masters. He was so struck with Masters’s character and talent that he came out of retirement to join the firm as a trader. When I asked Peil what he found so impressive about Masters, he cited three factors, two of which were synonymous with honesty: “First, his integrity; second, his morality; and third, his determination to succeed.”

  Masters is an openly religious man. During our conversations, he referred to the importance of his belief in God to his life in general, and his trading in particular. “Believing in a higher power gives me the strength to deal with the losses that are an inevitable part of this business. For example, I lost millions of dollars today, which would have been difficult to handle otherwise.” Although Masters didn’t mention it himself, I learned that he tithes his income. He also works at a Christian mission regularly.

  Since I was arriving in Atlanta in the evening and had to catch a connecting flight the next morning, Masters and I decided to conduct the interview over dinner. Masters suggested a favorite restaurant of his: Bacchanalia. The food was superb, and if you are ever in Atlanta, I can heartily recommend it, with one caveat: cabdrivers apparently can’t find the place. My cab from the airport got lost, and for all I know the first two cabs the restaurant called to pick me up are still circling Atlanta.

  * * *

  How did you first get interested in the stock market?

  My dad traded for a living back in the 1970s. When I was about eleven or twelve, I became curious about what he did and asked him a lot of questions. He gave me a book to read, When to Sell Stocks by Justin Mammis. Note that the title of the book wasn’t When to Buy Stocks, but When to Sell Stocks. My dad’s focus was mainly on short selling.

  How did your dad do in the markets?

  He did well enough to support a family for five or six years.

  What happened after that?

  He went back to school to earn an M.B.A. and then established a consulting business.

  Did you learn anything about the markets from your dad?

  Definitely. He taught me the importance of taking profits, which I have incorporated into our strategy.

  Taking profits in what sense?

  The idea that a profit isn’t real until it is realized.

  The other big influence for me were my uncles, Uncle Louie and Uncle Larry, who both traded stocks. When I was little, we would have family gatherings. Uncle Louie would be seated on one side, Uncle Larry on the other, and my dad across the table, and they would all be talking about the stock market. I was the only son, and I thought that’s what men did. When I got into the business, Uncle Louie and Uncle Larry were accounts of mine, and I learned a lot from them.

  What did they teach you?

  The importance of discipline. If you have a loss, get out.

  Did you go to college with the intention of becoming a money manager?

  No, I went to college with the intention of becoming a doctor. Actually, I went to the University of Tennessee because I had a swimming scholarship. That experience helped a lot. There is no way I could be doing what I am today without that background.

  How so?

  Getting used to the pain. We did some crazy sets in training. We would swim as much as twenty thousand or twenty-five thousand meters a day. The coach would come over and say, “Okay, we’re going to do a hundred 200s” [a hundred repeats of 200-yard intervals], and your heart would sink. You just knew it was going to hurt.

  How far did you get in your swimming career?

  I was a collegiate all-American in the sprint freestyle.

  What does all-American imply?

  It means that you are in the top eight in the NCAA championships.

  Did you try out for the Olympics?

  I went to the Olympic trials, but I didn’t make it. I came down with the mumps the summer before the trials, and I didn’t have enough time to get back into peak condition. I would, however, have ranked high enough the year before to have made the team.

  Did you try out at the next Olympic trials?

  Swimming is not a real profitable sport. I would have been twenty-six by the time of the next trials. I could have hung around, but I had been swimming a long time, and I’d had enough of it.

  Do you still swim?

  I swim a little bit, but not as much as I should. I just don’t have the time.

  How did you make the transition from being premed to being a trader?

  When I got through organic chemistry, I realized that I didn’t have any passion for going to medical school.

  Why did you want to become a doctor in the first place?

  When I was ten years old, I had a really bad accident and ended up in the hospital for many weeks. As a kid, I was impressed by watching the doctors in the hospital, and I thought it would be a good occupation. I liked the idea that the job combined both science and helping people.

  What kind of accident?

  I ran into a plate glass window. We had sliding
doors out to our pool. One day I was running back into the house, and I thought I had left the doors open, but they were closed. I ran right into the glass and it shattered, cutting me all over. The cut in my leg went all the way through to my femur and severed my tendons. I don’t know if you noticed, but I still have a limp. I had to relearn how to walk. Actually, that is how I first became involved in swimming; it was part of the therapy.

  Your mom must have kept the windows very clean.

  Yes she did. But after the accident she always made sure to have tape across the glass doors.

  What changed your mind about becoming a doctor? There had to be more to it than not liking organic chemistry.

  After two or three years in college, I realized that I really didn’t have any desire to become a doctor; I was only on that track because of a goal I had as a ten-year-old. I took some finance courses, which I really enjoyed, including an investment course that was tremendous, and I switched my major.

  What did you learn in that investment course?

  The typical valuation theories—the Graham & Dodd–type stuff [a classic investment text].

  Do you use that type of analysis in your own trading?

  I don’t use it much, but it’s a good background to have. I think it’s very useful just so that you can measure other investors’ perceptions of what is important.

  What part of the academic background might still find its way into your current approach?

  Portfolio theory. The conventional theory is that you should diversify your portfolio so that you can remove the unsystematic, or company specific, risk. That way, if a company blows up, you don’t get hurt by it. But that also means that you end up tracking the index. If your goal is to outperform the index, using that type of strategy makes it very difficult to succeed. We stand portfolio theory on its head. We actually try to take unsystematic risk by being in stocks when the unsystematic risk is high relative to the systematic risk (that is, at times when the stock’s price movement will be more influenced by company-specific events as opposed to directional movements of the stock market as a whole).

  What did you do after you graduated college?

  I decided to go to business school, which allows you to put off the decision of doing anything for another couple of years. I applied to Emory, which is a local school, and I didn’t bother applying anywhere else. I was told by the admission officer that they’d love to have me, but I didn’t have the work experience, which I found out was one of the entry requirements at Emory at the time. The only work experience I had was mowing lawns and summer jobs at a steel mill, which didn’t exactly qualify.

  I decided to get work experience by applying for a job in the brokerage industry. There was a fellow who lived near me who worked at a brokerage firm and thought I was industrious because he had seen me mowing lawns in the neighborhood. Also, he had played college football, and he liked the idea that I had been a college athlete as well. He told me that he would give me a shot as a broker, even though I didn’t have the typical profile.

  What is the typical profile?

  Sales experience.

  Did they have a training course?

  Yes, two weeks on how to sell.

  What happened after the training course?

  I was given a list of people to cold-call.

  Was that difficult to do?

  It was real difficult to do. I also did cold-call visits with one of the other trainees. We knocked on doors in the neighborhood, trying to get people to open accounts. One time we went into a grocery store, and it turned out that the owner’s brother-in-law had lost all his money in the stock market. The grocery owner chased us out of his store, swinging a big loaf of bread at us, and yelling, “I don’t want to talk to you brokers. Get out of here!” [He laughs lengthily at the recollection.]

  I guess you were lucky it wasn’t a hardware store. What percent of your cold calls were you able to convert into accounts?

  About 1 percent. After I had been in the business for a while, I figured out that I wanted to be on the managing side, not the selling side. The company, however, wanted you to sell financial products. If you were a broker who wanted to manage money, they looked at you as if you had two heads.

  Were you successful as a broker?

  I was able to survive, which I guess is somewhat successful. One of the problems I had with my company was that I thought their commission structure was too high. So I just changed it.

  Did you have approval to do that?

  I didn’t.

  You just unilaterally lowered commissions?

  Yes, because the commissions were just too high to trade.

  So you realized even then that paying full commissions would make trading a losing game?

  Absolutely. If the clients are not going to win, they are not going to stay with you.

  How did your company react to your lowering commissions?

  They were upset when they found out about it.

  By how much did you reduce commissions?

  About 90 percent. Of course, now you have discount brokerage, but it was different then.

  What did you know at the time that was right, and what did you know that was wrong?

  I learned that if I thought ahead about events, I usually made money, but if I waited until events happened, I would lose. For example, I remember situations where a company reported positive earnings, but the stock sold off because the news had already been discounted. That was a good lesson for me.

  When did you make the transition from a broker to a fund manager?

  I reached a point where the trading in my own account was becoming reliably profitable, and I felt I was ready to go out on my own. But the actual move was a forced issue.

  Forced issue in what sense?

  I was fired. I had a number of discretionary accounts that were below the firm’s minimum. The office manager said, “You can’t trade these accounts below the company minimum.”

  I said, “Yes I can.”

  He said, “No you can’t. You’re out of here!”

  It was something that I psychologically really wanted to happen. I guess I just needed a good kick in the ass to make the transition. I wasn’t comfortable being a broker anymore.

  Why is that?

  Because anytime you’re trying to make money for both the firm and the client, there is a built-in conflict. I wanted to manage money on a performance basis because I thought it was far cleaner. I had some ethical problems with the brokerage business.

  Such as?

  There are subtle pressures for you to push stocks the firm is underwriting and to sell mutual funds with whom the firm has a relationship, even though they may be lower-rated funds.

  What if you try to sell other mutual funds?

  You may get a lower commission on the sale, and in some cases you may not get any commission at all.

  What happened after you got fired?

  I spoke to my dad about what I should do, and he suggested that I should try going out on my own. Although I liked the idea of having my income based on my performance, I was concerned about whether anyone would be interested in having me manage their money when my only experience was being a broker.

  What made you believe that you could be a successful money manager?

  Except for my dad and my wife, Suzanne, everyone said that you couldn’t trade successfully and advised me against trying to do it. Your books [Market Wizards and The New Market Wizards] were actually very helpful because they showed me that it was possible. Just knowing that was very important. I realized that if somebody could make money trading, so could I. Also, the fact that I had competed successfully at the highest levels of swimming gave me confidence that I could excel in this business as well.

  But what was that confidence based on? Were you getting trading results anything like those you are getting now?

  For years, I had done only slightly better than breakeven in my own account. But my trading results were just beginning to im
prove significantly when I was fired.

  What changed?

  I started focusing on catalysts. One thing that helped me tremendously was writing the software for my trading ideas. My father wrote a lot of software for his food service consulting business, and he advised me, “If you really want to know something, you should write software for it.”

  What did you put in your model?

  All types of inputs, but I found that the catalysts outweighed everything else. As a result, the model ended up focusing almost completely on the catalysts.

  What exactly do you mean by catalysts?

  A catalyst is an event or an upcoming event that has the potential to trigger a stock price move by changing the market’s perception about a company.

  Isn’t a catalyst by definition a one-time event? How do you model one-time events?

  Most catalysts are repetitive events—earnings are reported four times a year; retail companies report same-store sales monthly; airline companies report load factors monthly, and so on.

  How do you use an event such as an earnings report to make trading decisions?

  There have been lots of academic studies to show that stocks with positive earnings surprises tend to outperform the market, but the margin of improvement is relatively moderate. Frequently, you may find that when you buy a stock after a positive earnings surprise, you are buying it near a price peak because the earnings surprise was already discounted.

  How could it be discounted if it was a “surprise”?

  We are talking about two different things. An “earnings surprise” is defined by academics and Wall Street as a number that is above or below the consensus estimate by some minimum margin. Whether an earnings surprise is discounted or not, however, depends on the price trend before the report’s release. For example, if a stock goes up 10 points in a flat market during the week prior to the earnings report, and earnings are reported as only a nickel better than the consensus, it may be a “surprise” in terms of the academic definition, but it’s probably already discounted.