Won’t CFOs tend to paint a rosy picture of their company?
Of course. You can’t go strictly by what they say. CFOs are only human, and they will tend to exaggerate how well their company is doing. But we also speak to distributors, customers, and competitors. If we are going to own something, we’re going to talk not only to the company, but also to the people selling and using their products.
What did you teach your research people about doing phone interviews?
You want the other person to be on your side. Don’t ever tell a CFO he is wrong or try to tell him how to run his business. If you do, he probably won’t take your phone call the next time. You also have to ask questions the right way. You don’t want to ask a CFO a direct question such as, “What are earnings going to be this quarter?” because, obviously, he can’t tell you. But if instead you ask him about how his company will be affected by a product his competitor is putting out, you may well get some useful information. We are detectives. We are trying to find out information that is not widely dispersed and then put all the pieces together to get an edge.
What else do you look for when you buy a stock?
A low price and the prospect for imminent change are the two key components. Beyond that, it also helps if there is insider buying by management, which confirms prospects for an improvement in the company outlook.
Is insider buying something that you look at regularly?
Yeah, but I’d rather not put that in print.
Why not?
Because I don’t want to give away secrets.
But insider buying is not exactly a secret. In fact, it came up in a number of other interviews I did for this book.
Over the course of the two times in my career that I looked for a job on Wall Street, I must have interviewed with as many as eighty firms. I was amazed by how many hedge fund managers used charts and sell-side information [brokerage research] but didn’t use insider buying. In fact, I had a lot of managers tell me that using insider buying was stupid [he laughs].
Stock investing is not an exact science. The greater the number of useful things you can look at, the greater you increase your odds. The odds are better that we will make correct investment decisions if we talk to a company than if we don’t talk to them. Similarly, if we focus on companies with insider buying, it doesn’t mean that these stocks will go up, but it certainly improves our odds.
Do you also mean to imply that you don’t use charts or Wall Street research?
I never looked at a chart for 99 percent of the stocks I bought for our funds.
Is the reason you don’t use charts because you tried using them but couldn’t find any value or because you never explored this avenue of research?
Too many people use charts. If too many people are using an approach, I feel that I can’t get a competitive edge.
What about brokerage research? Is that also something you never use?
I will look at analysts’ earnings estimates because part of my job is to find out whether a company is doing better or worse than people perceive. But I have never called a sell-side analyst to ask for an opinion. Don’t get me wrong; there are some great analysts out there. But it really comes down to my philosophy: It’s much more valuable to do your own research so that you can make your own decisions about when to get in and out.
If I buy a company because of an analyst’s recommendation, and the stock suddenly drops 20 percent, I’m going to be dependent on that analyst for information. If I call the analyst and he says, “Everything is fine,” and then try to call the CFO of the company, he may well not return my call because he doesn’t know who I am. In the meantime, he’s talking to ten other people with whom he has built a relationship. If I was the guy who built the relationship with the company, maybe I would be the first person the CFO called back.
Another aspect is that sell-side research tends to be biased; it is driven by investment banking relationships. If a brokerage firm earns several million dollars doing an underwriting for a stock, it is very difficult for an analyst of that firm to issue anything other than a buy rating, even if he believes the company has significant problems. Some of my research analysts have good friends who are sell-side analysts and have seen them pressured to recommend stocks they didn’t like.
Let’s say a stock is trading in the 8 to 12 P/E range and you like the fundamentals. How do you decide when to buy it? Obviously, you’re not using any technical analysis for timing, since you don’t even look at charts.
You need a catalyst that will make the stock go higher.
Give me an example of a catalyst that prompted you to buy a stock.
A current example is Amerigon. Two weeks ago, they put out a press release announcing a five-year agreement with Ford Motors to manufacture ventilated car seats. The press release didn’t contain much information about the size of the contract. But by talking not only to the company but also to someone at Ford, we know the contract is huge. We also know that they’re working on similar agreements with the other car manufactures.
What is another example of a catalyst?
A change that will lead to a dynamic improvement in margins. Another one of our long positions is Windmere, which is a manufacturer of personal care products, such as hair dryers. Last year, they bought a division of Black & Decker and overpaid for it. The high operating costs of the acquired division acted as a drag on their earnings. We bought the stock recently when we learned that the company planned to close down some of these unprofitable facilities—an action that will bring their costs down and lead to better-than-expected earnings in coming quarters.
Any other examples of a catalyst?
Sometimes the catalyst can be a new product. One of our biggest winners last year was LTXX, a semiconductor company. They had come out with a new product, and by talking to their customers, we knew the sales were going to be very good. Wall Street didn’t know about it because the sales of this new product hadn’t shown up in earnings reports. When the earnings starting showing up above expectations, the stock took off.
If you buy a stock and it moves higher, when do you decide to liquidate the position?
Too early [he laughs]. We are always rotating our stocks. If we buy a stock at ten times earnings and it goes up, usually by the time it gets to twenty times earnings, we are out of it. We will rotate the money down to another stock with similar qualities so that we can keep the risk/reward of the portfolio as low as possible. LTXX is a good example. We started buying the stock around $5 and got out when it went up to $15, even though our earnings projections for the stock were still positive. Today the stock is trading at $45. That’s fairly typical. But that same trait of liquidating stocks too early has also helped us during market declines because we’re not long the stocks with the high price/earnings ratios that get hit hardest in a market correction.
If you buy a stock and it just sits there, at what point do you decide to get out?
If it looks like dead money and what I originally thought would happen is not happening, then it’s probably better to just move on.
In other words, you liquidate once it becomes clear that the reasons you went in are no longer valid?
Or because I have a better idea. We’re working with a finite amount of money. Consequently, it’s important to stay invested in your best ideas.
How many positions do you have at one time?
Over a hundred. We won’t let any single position get very large. Our largest holding will be about 3 percent of assets, and even that is rare.
For shorts, our maximum position will be half that large.
What is your balance between long and short positions?
Our total exposure will normally range between about 20 and 50 percent net long, although it could be even lower if I get very bearish on the market. Right now we’re about 80 percent long and 40 percent short, which is fairly typical. We’ve always kept a pretty good-size short position and will continue to do so. Part of the reason for th
at is that I am a perennial bear.
A perennial bear in the greatest bull market in history—that doesn’t like a beneficial trait. Why do you have a bearish bias?
Thank goodness we’ve been able to make money anyway. I have felt this way for a while, but certainly now [March 2000], I think we are seeing a mania in certain sectors, such as the Internet and technology. Valuations are up there in the ozone layer. It is no different from the market manias we’ve seen in the past: the Russian market a few years ago, the Japanese market during the 1980s, the real estate market in the 1970s, even the Dutch tulip craze in the seventeenth century. Right now, when everyone’s golf buddy is making money buying these stocks, there’s a lot of peer pressure to follow the group. You have a locomotive while prices are going up, but the problem is, what happens when the locomotive stops and reverses direction, as it invariably will.
Are we near a top or will the top form three years from now? I can’t answer that question. All I can do is control the factors over which I have an influence. I can control the number of CFOs and customers we talk to each day, but I can’t determine what the market is going to do.
Isn’t it difficult to talk to the CFOs of companies you are shorting? I imagine they wouldn’t be too eager to talk to managers who are selling their stock.
We don’t really talk to CFOs on the short side anymore.
Because of the access problem?
No, because we got talked out of some of our best short positions. In earlier years, there were a number of times when I changed my mind about selling a stock because a CFO assured me that everything was fine, and then the stock tanked. If we are considering a stock on the short side, we spend a lot of time talking to customers, suppliers, and competitors.
How do you select your short positions?
We certainly look for the higher-priced stocks—companies trading at thirty to forty times earnings, or stocks that have no earnings. Within that group, we seek to identify those companies with a flawed business plan.
Give me an example of a flawed business plan.
My favorite theme for a short is a one-product company because if that product fails, they have nothing else to fall back on. It’s also much easier to check out sales for a one-product company. A perfect example is Milestone Scientific. The company manufactured a product that was supposed to be a painless alternative to dental novocaine shots. It sounded like a great idea, and originally we started looking at the stock as a buy prospect. One of our analysts went to a dentistry trade show and collected a bunch of business cards from attending dentists. The primary Wall Street analyst covering the stock assumed every dental office would be buying five of these instruments, and he projected unbelievably huge earnings.
I visited the company in New Jersey. There were three people sitting in rented offices who were outsourcing everything. We started calling dentists and found the product didn’t work as well as advertised; it wasn’t entirely painless, and it also took longer than novocaine to take effect. Another crucial element was that the company sold the product with a money-back guarantee. They booked all their shipments as revenues and left themselves out on a limb in terms of product returns.
We also talked to the manufacturer to whom the company was outsourcing their production and found out the number of units actually shipped as well as their future production plans. We could see that the orders were slowing down dramatically on the manufacturing side. The differences between reality and the Wall Street research report were about as far apart as I have ever seen.
What ultimately happened to the stock?
It went down below one dollar.
Wasn’t it difficult to get the manufacturer to talk to you in that type of situation, let alone give you all that detailed information?
If you call, there’s at least a chance the person will talk to you. One of things I tell my analysts is, “Make the calls. Maybe they won’t talk to you, but I guarantee that if you don’t call, they won’t talk to you.” In this case, the manufacturer was very helpful at the start, but then they wised up to what we were doing and stopped taking our calls. But by then, we had all the information we needed.
What do you say when you call a manufacturer in this type of situation?
I tell him the truth. I tell him that I am a fund manager and am doing research on the company and the industry. In some cases, when we call a company, we ask them to provide us with the names of some of their top customers to help us evaluate their product.
Does giving you this information sometimes work against the company because their customers don’t like them as much as they believe?
When I first started doing this I thought that contacting customers supplied by a company would be like talking to references on a résumé—they would only say complimentary things. I was amazed when this frequently proved not to be the case. I have often wondered whether a company had any idea what their customers really thought about them. Sometimes we have found our best information this way.
Any other examples of how you pick your short positions?
A good example is Balance Bars. You could walk into any GNC store and see shelves loaded with competitive products and the price of Balance Bar items marked down. Yet the stock was trading at a multiple of thirty-five times earnings; it should have been trading at ten times earnings.
That sounds a lot like Peter Lynch talking about getting trading ideas by going to the mall with his family.
Peter Lynch has probably inspired me more than anyone else. I read his book One Up on Wall Street at least ten times. One question I ask people I interview is whether they’ve read his book. If they haven’t, it tells me they are not as serious about the stock market as they claim to be.
What aspect of the book do you personally find so valuable?
The message that it is critical to do your own research rather than depending on Wall Street research.
What type of research?
Talking to companies and customers.
But the ordinary investor can’t call up companies.
The ordinary investor may not be able to call up the company CFO, but as Lynch advises, the nonprofessional can call the investor relations office and still get valuable information by asking the right questions. The gist of Lynch’s advice to the ordinary investor is: Invest in what you know—the company you work for (assuming it is doing well), companies in the same industry, or companies that make a product you can touch and feel. His point is that people would be much better off investing in companies they understand than listening to their broker and investing in companies they know nothing about. One part of Peter Lynch’s philosophy is that if you can’t summarize the reasons why you own a stock in four sentences, you probably shouldn’t own it.
Did you ever meet Peter Lynch?
I never met him, but I interviewed at Fidelity on several occasions. I was obsessed with getting a job there because I wanted to be the next Peter Lynch and eventually run the Magellan fund. The last time I interviewed with Fidelity, which was right before I took the job at Friess Associates, I got as far as meeting with Jeff Vinik [Lynch’s initial successor as manager of the Magellan fund]. He asked me only two questions, which will stick in my mind forever. First, he asked, “What is the bond rate?” I was a stock guy who never paid attention to the bond market. I subsequently learned that Vinik pays very close attention to interest rates because he trades a lot of bonds. His second question was, “You’re twenty-nine years old; what took you so long?” The interview was over in less than five minutes.
Do you, like Peter Lynch, get trading ideas by going to the mall?
All the time. I love going to malls. Investing is not as complicated as people make it out to be. Sometimes it just requires common sense. Anyone can go to the mall and see that a store like Bombay is empty and the Gap is filled with people. If you go to four or five malls and see the same thing, there is a reason for it. Bombay hasn’t had the right products to make people want to buy their stuff for
years, whereas the Gap is continually changing with the times and getting in fresh inventories that meet their customers’ needs.
Does that imply that you bought the Gap and shorted Bombay?
We don’t trade the Gap because we only trade small cap stocks. We have been short Bombay from time to time.
What are examples of trades that were largely inspired by mall visits?
Last Christmas I went to Men’s Wearhouse because I needed a suit. I hated the clothes, and I noticed the store was virtually empty. We did some additional research to confirm the trade, but we ended up shorting the stock.
How about on the long side?
One stock we bought is Claire’s. I noticed that the store always seemed to be mobbed with teenagers. We also liked their financials and found their management very forthcoming.
We were talking about companies with flawed business plans. Any other examples?
Enamalon. The company’s single product was a toothpaste that supposedly did a better job of whitening teeth. If they didn’t spend a lot of money on promotion and advertising, they would never get a toe-hold in the highly competitive toothpaste market. On the other hand, if they did spend enough to get widespread consumer recognition, they would burn through most of their capital. It was a no-win situation from the start. The other problem was that the product cost a lot more than ordinary toothpaste but didn’t work any better. We had everyone in our office try it, and only one person liked it.
You said the name of the company was Enamalon? I never heard of the toothpaste.
Exactly, that’s my point.
What happened to the stock?
The last time I checked, it was trading for one dollar.
It sounds like an important element in your decision to short this stock was to have everyone in the office sample their product. Any other examples of short ideas that were derived by “consumer research”?
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