Many of the indicators that have worked reliably for decades have ceased working in the current bear market, leaving many professional market participants looking foolish. The problem is that most of us have not seen a comparable stock market in our lifetimes. Very few of us have lived through the aftermath of the bursting of a market bubble. The closest analogy would the 1930s in the United States or the 1990s in Japan.
Do you mean to suggest that the current bear market could be as protracted as those extreme examples?
The analogy is not totally appropriate insofar as the current U.S. economy is far sounder than the U.S. economy of the 1930s or the Japanese economy during the past ten to fifteen years. But one reason to think this way is that I don’t believe the current stock market malaise will come to a permanent end until memories of the 1990s bull market are completely erased. There are still too many people ready to try to pick bottoms and buy tech stocks.
If you just look at some of these tech companies on the basis of their fundamentals—negative earnings, huge debt, high valuations—there would no conceivable reason to go near them. Yet many people are still jumping in any time these stocks begin to rebound. Why? Because they still have the memory of how these stocks went from $10 to $200 in the late 1990s. It is reminiscent of the typewriter companies with the advent of the computer. Investors had been so taken, for so long, with the dominance of the typewriter, that even as it became clear that the PC revolution had started, people were still willing to buy Smith Corona all the way down to zero. The same kind of general dynamic seems to have taken hold in the technology and speculative portions of the current market.
As another example, you couldn’t get a more frightening, destabilizing event than what occurred on September 11. Yet the market failed to remotely approach the extreme levels it had seen many times in the past, particularly in times of crisis. I found that amazing; it made me realize that it would take a long time for this process to unwind itself. Every time one of these rallies fails and the market falls to new lows, as was the case with the recent breaking of the September 2001 lows, it disenchants more and more people. But the absence of extremes suggests this process still has to be repeated before the bear market comes to an end.
By extremes, do you mean extreme low valuations?
Yes, certainly valuation levels in September 2001, and even the lower lows in July 2002, were well above levels seen at past market bottoms, but I am also talking about measures of extreme emotion, such as downside volume versus upside volume. In this context, the levels seen in the aftermath of September 11 and the July 2002 lows were nowhere near other past extremes, which is one of the main reasons why I believe we are going to see more unwinding of the excesses of the 1990s. Nevertheless, if the market is going to have a strong three-month rally, I want to participate in that rebound regardless of my long-term viewpoint.
How do you distinguish between a market that is beginning an intermediate rally and one that is just witnessing a one-week pop?
From a technical perspective, I would look for lots of trendlines being broken and stocks moving up on volume. Also I approach the market one stock at a time, one day at a time. I don’t just say now is a good time to play for a three-month upmove and load up on long positions. If a stock’s fundamentals look sound, the stock and sector are acting well technically, and the general market tone is improving, I may put on a position and stay with it as long as these factors don’t deteriorate significantly.
Do you always use stops?
Yes.
Why didn’t that help in 2001?
I was using stops, but I had one horrendous month—February—in which my entire portfolio got stopped out twice. Leading companies had gone down 50 to 70 percent, so I bought a basket of these stocks, which then promptly proceeded to go down another 10 percent, stopping me out. I tried the same set of trades later in the month, and was stopped out again. I now use risk controls at the portfolio level in addition to stops on individual stocks. If the portfolio is down 5 percent in any month, I will pare down the exposure, and if it declines by 10 percent, I will go completely to cash.
Besides the failure to focus sufficiently on risk at the portfolio level, what has been the worst mistake you have made since your return to trading?
Not appreciating how drastically a bear market can change the balance between return and risk. For example, say you like a pharmaceutical company because you have done thorough research that leads you to believe there is an 80 percent probability that the FDA will approve their drug application. In the current bear market environment, even if you are right about the odds, the trade may be a bad bet because the stock might go up only 5 percent with a favorable ruling, but go down 50 percent with an unfavorable ruling.
What is the most important lesson you have learned from your difficult experience in 2001?
The importance of only trading with an edge—not to trade when there is no trade.
Are you trading less now?
Yes, radically less. I’ve re-examined my trading at my prior hedge funds and found that during those periods in which my turnover was the highest, I never made any real progress. When I look back at those times, I realize they were the same periods when my emotions were running at their highest. Too much emotion tends to lead to too much turnover and bad decisions. Although I still like to be spontaneous, I now put myself through more mental drills before I decide to put on a trade.
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STEVE WATSON
Dialing for Dollars
Steve Watson has never had a problem taking risks. He fondly recalls the childhood summer ritual of catching snakes with his cousin in the Ozark Mountains. When he was eleven, he and his cousin thought it would be “fun” to move up from capturing nonpoisonous snakes to the poisonous variety. They found two large water moccasins. After pinning each snake down with a long branch and grabbing it tightly just below the head, they decided it would be a good idea to carry their quarry back to the family cabin, approximately a mile downriver, to proudly show their fathers what they had caught. After sloshing through the shallow river for about half a mile, with the snakes wrapped around their arms and their hands tiring from the tight grip needed to keep the snakes’ heads immobile, they had some second thoughts. “Maybe this wasn’t such a good idea,” they agreed. Finally, unable to maintain their grips for much longer, they hurled the snakes into the water and darted in the opposite direction. In comparison, buying and shorting stocks must seem pretty tame.
Watson has also been willing to take risks in his career. Two years after becoming a broker, he faced the growing realization that he had chosen the wrong path toward fulfilling his goal to trade stocks, so he quit and set off for New York. He did so without the comfort of any business contacts, job leads, or supportive résumé. In fact, there was absolutely no logical reason for Steve Watson to succeed in his quest—other than his determination. Several years later, he quit a secure job with a major fund to start his own hedge fund. He launched his new business without even enough money to rent office space.
When it comes to trading, however, Watson is willing to accept risk but not to take risks. “You have to be willing to accept a certain level of risk,” Watson says, “or else you will never pull the trigger.” But he believes in keeping the risk under firm control. His net long position is typically less than 50 percent of assets, often significantly less. Since starting his fund four and a half years ago his worst drawdown from an equity peak to a subsequent low has been just under 4 percent—the same level as his average monthly return after deducting fees. In terms of return to risk, this performance places him at the very top tier of fund managers.
One of the major lessons that I have learned by conducting the interviews for the Market Wizard books is that, invariably, successful traders end up using a methodology that fits their personality. Watson has chosen an approach that is heavily dependent on communicating with and getting information from other people, a style that is a good match for h
is easygoing manner. Asked whether he found it difficult to get people who were often complete strangers to take the time to speak with him, Watson said, “My father is one of the nicest people you could ever hope to meet. One thing he taught me was, ‘Don’t treat anyone differently than you would your best friends.’ I find if you approach people with that attitude, most of the time they will try to help you out.”
I met with Watson in a conference room at his firm’s Manhattan office. He was relaxed and friendly, and spoke with an accent that reflected his Arkansas origins.
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When did you first get interested in the stock market?
I came from a family that never read The Wall Street Journal, never bought a share of stock, and never invested in mutual funds. I didn’t know anything about the stock market until I was in college. When I attended the University of Arkansas, I took an investment course that sparked my interest.
What about the course intrigued you?
Doing research on a stock. As a main project for the course, we were required to pick a stock and write a report on it. My group picked a local utility company that was experiencing some trouble. We did our analysis and came to the conclusion that it was a terrible company. We were all prepared to trash the stock in our presentation.
The day before the presentation, someone in our group came up with the bright idea of going to the local brokerage office and seeing what they said about the stock. The brokerage firm had this beautiful glossy report on the company, which was filled with all sorts of positive commentary and concluded with a recommendation to buy the stock. Here we were, a group of undergraduate students taking an elementary investment course, and we thought that since these guys get paid to do this for a living, we must be wrong. We completely transformed our report so that it reached a positive conclusion, even though it was the exact opposite of what we believed.
The next day, we gave our presentation, and the professor just tore it apart. “This is a terrible company!” he exclaimed, citing a list of reasons to support his conclusion—all of which had been in our original report. Of course, we couldn’t say anything [he laughs].
What ultimately happened to the stock?
It went down. That’s when I learned my first and most important lesson about the stock market: Stick to your own beliefs.
Did that course clinch your decision to pursue a career in the stock market?
Yes. After I graduated, I moved to Dallas, which was the only big city I had ever visited, to look for a job as a stockbroker. I thought being a stockbroker meant that you got to manage other people’s money and play the stock market all day long. I quickly found out that it was more of a sales job, and quite frankly, I’m a terrible salesperson. I picked up my largest client because his own broker wouldn’t answer the phone on the day of the October 1987 stock market crash—he couldn’t face talking to his customers—and I was the only one his client could reach.
After I was there for about two years, I remember calling up my dad and saying, “I don’t like being a stockbroker. All I do is cold-call people all day, trying to sell them stuff they probably don’t need in the first place.” Verbalizing my feelings helped me decide to quit. I knew I really wanted to be a money manager. I moved to New York City to find a job more closely aligned with my goal.
Had you been successful picking stocks as a broker?
No, I had been very unsuccessful.
What then gave you the confidence that you could manage money successfully?
I didn’t expect to get a job managing money on day one. I just wanted to break into the business. Once I decide I am going to do something, I become determined to succeed, regardless of the obstacles. If I didn’t have that attitude, I never would have made it.
When I arrived in New York, I didn’t have any contacts, and my résumé—a 2.7 GPA from Arkansas University—and two years’ experience as a stockbroker were certainly not going to impress anyone. I couldn’t compete against people who had gone to Harvard and interned at Goldman Sachs. Therefore, I had to do it the hard way. I went to work for an insurance company, doing credit analysis, essentially to pay the bills, but also to gain some analytical experience. I also applied to business school at NYU but couldn’t get in. I enrolled at Fordham University for a semester, received good grades, and then transferred.
After I graduated, I interviewed with about forty different hedge fund managers, which was very helpful, because it gave me a feeling for what other people were doing. I landed a job at Bankers Trust working in the small cap department [group that invested in stocks with small capitalization]. Even though I was new to the game, the reason I was hired was that I knew small cap stocks better than anyone else. I can’t tell you how many nights I stayed up until 3 A.M., flipping through stocks on the Bloomberg. At that point, I probably knew something about every exchange-listed stock under the $300 million market cap level.
Why had you decided to focus on small cap stocks?
Small caps have always been a love for me because I can’t get an edge on stocks like Microsoft or Intel. I can’t call up the CFOs of those companies. In college, even though I didn’t have a job, I would call up CFOs, tell them that I was doing a project on their company, and ask them questions. I had stacks of company reports filling up my apartment.
What were your responsibilities at Bankers Trust?
I worked as Bill Newman’s right-hand person for one of the firm’s two small cap funds. He gave me tremendous leeway. If I liked an idea, he let me go with it. It was almost as if I were a portfolio manager because he rarely turned down one of my stock picks. Unfortunately, he left the firm three months after I joined. I didn’t get along with his replacement—our investment philosophies clashed.
In what way?
My new boss—who, incidentally, was one of the worst stock pickers I have ever seen—was a momentum player who believed in buying high P/E stocks [stocks trading at large multiples of their earnings] that were moving up rapidly, whereas I believed in buying value stocks and doing a lot of detailed research on a company. I left about a half year later, and after another extensive Wall Street job search found a job with Friess Associates, which ran the Brandywine Fund.
What job were you hired for?
Officially, I was hired as a consultant because I worked in a satellite office. At the time, the firm’s main branch was located in Wilmington, Delaware, and I worked in Manhattan. The way Friess operated was that everyone was both a research analyst and portfolio manager. They used what they called “a-pig-at-the-trough” approach. If you found a stock that you liked and wanted to buy, you had to convince one of the other people to liquidate one of their holdings to make room in the portfolio, just like one pig has to push another pig out of the way if he wants to get a spot at the trough.
How long were you there?
About two years.
Why did you leave?
The assets of the fund were growing rapidly. I love small cap stocks. But the assets of the fund were getting too large to bother with small cap stocks, and the fund’s focus shifted almost exclusively to mid cap and large cap stocks, which made it harder to get a hold of the CFOs and ask questions. Also, as the assets grew, the number of analysts increased. When there are fifteen analysts, your performance doesn’t have too much impact on the fund. I wanted to be in a situation where I had control over the performance. I decided to leave to start my own fund.
Where did you get the money to start your fund?
At the time, I only had about $20,000 to my name. I went to a few CFOs to whom I had given stock tips for their own personal accounts—recommendations that had worked out very well for them. I only raised $700,000 in assets; I’m the worst salesman in the world. But that was enough to start the fund.
How did you cover your operating expenses?
I was extremely lucky. Ed McGuinn, the man from whom I was renting office space at the time, wanted to help me get started. He knew I couldn’t afford to rent space o
n my own, so he let me have the use of a small office for free. It was the smallest office I had ever seen—about 12 feet by 5—but I was extremely grateful. He even paid the monthly fee for my Bloomberg.
I noticed that in your first year as a fund manager, your net exposure was considerably higher, probably double what it has been since then. Why is that?
I had a different risk/reward perspective the first year because I was managing less than $1 million. I allowed my net exposure to get up to 70 to 80 percent and individual positions to get as high as 5 or 6 percent of assets. As a result, we had triple-digit returns that year.
How do you select the stocks you buy?
We have two funds: the microfund, which invests in companies with a market capitalization of under $350 million, and a small cap fund that invests in companies with a capitalization of $350 million to $1.5 billion. In both funds, we begin by looking for companies that are relatively cheap—trading between eight to twelve times earnings. Within this group, we try to identify those companies for which investors’ perceptions are about to change. Typically, these may be companies that are having some trouble now, but their business is about to turn around. We try to find out that information before everyone else does.
How do you do that?
We make a lot of phone calls. The difference between our firm and most other hedge funds is that talking to companies is our primary focus. I have two people who spend three-quarters of their time booking calls with company management and five research people who spend virtually their entire day calling companies and talking to CFOs.
In this business, you can’t wait for a new product to come out and be successful. By that time, you will have to pay three times as much for the stock. We are trying to add value by doing our own research. If you are buying stocks that are washed out—stocks that are trading at only eight to twelve times earnings—any significant change can dramatically impact the stock price.
Stock Market Wizards Page 5