Stock Market Wizards

by Jack D. Schwager

  In those days, although we had terminals, we didn’t have computers. Everything was done by hand. I posted his trades while he was trading.

  Did you find yourself trying to anticipate market direction?

  I don’t really remember, but I was never really obsessed with the market, like a lot of the people that you have written about. I like the market, and I think it’s exciting and challenging, but I don’t go home and think about it.

  What was your first job out of college?

  I worked for Kingston Capital, a large institutional money management firm. I started out doing back office and administrative work. Eventually, I was promoted to the role of trader, and I did all the trading for the office, which managed one billion dollars.

  By trader, I assume you mean being responsible for order entry as opposed to having any decision-making responsibility?

  That’s right, I just put in the orders.

  What was the next step in your career progression?

  In 1985, Kingston was taken over in a merger. The acquiring firm changed everyone’s job description. They told me I couldn’t do the trading anymore because it all had to be done out of New York. They wanted me to move into an administrative role, which would have been a step back for me.

  Henry Skiff, the former manager of the Kingston branch office, went through an analogous experience. He was shifted to a structured job that he couldn’t stand. He and another employee left Kingston after the merger to form their own institutional money management firm. Henry offered me a job as a trader and researcher. Although Henry was a difficult person to work for, I liked the other person, and I didn’t want to go back to an administrative position.

  I left with Henry and helped him start the office for his new firm. I did research and trading for him for two years. Although it was a good experience, I realized my future was limited, since Henry was not willing to give up much control over the portfolio. Around the time I decided that I had to leave, my husband got a good job offer in another city, and we decided to move. I found a job at Atacama Investment, which at the time was an institutional money management firm. I started out as a portfolio manager, comanaging their small cap fund [a fund that invests in companies with small capitalization], which had a couple of billion dollars in assets.

  Had you had any experience before?

  Not picking stocks.

  Then how did you get a job as a portfolio manager?

  I originally started out interviewing for a trading job. But the woman who had been managing the portfolio, Jane, was on maternity leave. She only had about six months’ experience herself, and they needed someone to fill the slot. Mark Hannigan, who ran Atacama, believed that anyone could do that job. He called us “monkeys.” He would tell us, “I could get any monkey to sit in that chair and do what you do.” He also used to tell me that I think too much, which really annoyed me.

  Mark’s philosophy was that if a stock’s price was going up on the chart, earnings were growing by 25 percent or more, and if a brokerage house was recommending it, you would buy it. There was minimal fundamental analysis and no consideration of the quality of earnings or management. This is the origin of why I ended up trading on the short side of the market.

  Did being a woman help you get the job because you were replacing another woman?

  No, I probably got the job because they could pay me a lot less.

  How little did they pay you?

  My starting salary was twenty-five thousand dollars a year.

  What happened to Jane?

  After two months, she returned from maternity leave, and we worked together. She was a perennial bull. Everything was great. She was always ready to buy any stock. I was the only one who ever thought we should wait a minute before buying a stock or suggested getting out of a stock we owned before it blew up.

  Were you and Jane working as coequals, or was she your boss because she was there before?

  We were comanagers. I actually had more experience than she did, but she joined the company six months earlier. We worked as a team. Either one of us could put a stock in the portfolio.

  Was it a problem having to comanage money with another person?

  Not really, since neither one of us had much experience. I would pick a stock and say, “Look at this,” and Jane would say, “Yeah, that looks good; let’s buy 100,000.” The real problem was the trading desk. Once we gave them a buy order, we had no control over the position. The trade could be filled several points higher, or days later, and there was nothing we could do about it.

  Do you mean that literally? How could there be such a long delay in a trade being filled?

  Because the trader for the company was front-running orders [placing orders in his own account in front of much larger client or firm orders to personally profit from the market impact of the larger order he was about the place]. If a stock we wanted to buy traded 100,000 shares that day and we didn’t get one share, he would say, “Sorry, but I tried.” Since I was a trader, I knew enough to check time-and-sales [an electronic log of all trades and the exact time they were executed]. If you questioned him, however, he would just rip you in front of everybody. (We all worked in one large room.)

  Rip you in what way?

  He would scream at me, “You don’t know anything about fucking trading. Just go back and sit at your desk.”

  Did you realize he was crooked back then, or did you just find out later?

  He was the highest-paid person there. He was probably making several hundred thousand dollars a year. But he lived well beyond even his salary. He had a huge house, and he was always taking limousines everywhere. Everyone suspected that something was going on. It turns out that there was; it all came out years later when the SEC investigated and barred him from the industry.

  It’s rather ironic that as a trader who was merely responsible for entering orders, he was making ten times what you were making as the portfolio manager. I assume this is fairly unusual.

  Yes, it is. Normally, the traders always make much less.

  When did you get your first inclination to start shorting stocks?

  I sat close to Jim Levitt, who ran Atacama’s hedge fund. I was very interested in what he was doing because of his success in running the fund.

  Was Jim a mentor for you on the short side?

  Yes he was, because he had a knack for seeing reality through the Wall Street hype. I jokingly blame him for my decision to go on the short side of the business. When things are going badly, I’ll call him up and tell him it’s all his fault.

  What appealed to you about the short side vis-à-vis the long side?

  I felt the short side was more of a challenge. You really had to know what you were doing. Here I was, just a peon going up against all these analysts who were recommending the stock and all the managers who were buying it. When I was right, it was a great feeling. I felt as if I had really earned the money, instead of just blindly buying a stock because it was going up. It was a bit like being a detective and discovering something no one else had found out.

  When did you start shorting stocks?

  In 1990 after Jim Levitt left Atacama to form his own fund because he was frustrated by the firm’s restrictions in running a hedge fund.

  What restrictions?

  The environment wasn’t very conducive to running a hedge fund. One of the rules was that you couldn’t short any stock that the company owned. Since the firm held at least a thousand different stocks at any time, the universe of potential shorts was drastically limited. They also had a very negative attitude toward the idea of shorting any stocks.

  When Jim Levitt quit, I was on vacation in Lake Tahoe. Mark called me and told me that I would be taking over the hedge fund because Jim had left the firm. Mark’s philosophy was that anyone could short stocks. He ran computer screens ranking stocks based on relative strength [price change in the stock relative to the broad market index] and earnings growth. He would then buy the stocks at the top of the
list and sell the stocks at the bottom of the list. The problem was that by the time stocks were at the bottom of his list, they were usually strong value candidates. Essentially you ended up long growth stocks and short value stocks—that approach doesn’t work too often. But he had never been a hedge fund manager, and he thought that was the way you do it.

  Did you use his methodology?

  No, I really didn’t.

  How were you picking your shorts then?

  I looked for companies that I anticipated would have decreases in earnings, instead of shorting stocks that had already witnessed decreases in earnings.

  How did you anticipate when a company was going to have decreased earnings?

  A lot of it was top down. For example, the year I took over the hedge fund, oil prices had skyrocketed because of the Gulf War. It was a simple call to anticipate that the economy and cyclical stocks would weaken.

  Why did you leave Atacama?

  In 1993 Atacama transformed their business from an institutional money management firm to a mutual fund company. Also, both my husband and I wanted to move back to San Francisco. I spoke to a number of hedge funds in the area, but none of them were interested in giving up control of part of their portfolio to me, and I didn’t want to go back to working as just an analyst after having been a portfolio manager.

  With some reluctance, I had dinner with Henry Skiff. It was the first time I had seen him in five years. He said all the right things. He assured me that he had changed, and he agreed with everything I said. He had formed a small partnership with about one million dollars. He told me I could grow it into a hedge fund, run it any way I wanted, and get a percent of the fees.

  What, exactly, was it about Henry that you didn’t like when you had worked with him five years earlier?

  I didn’t have a whole lot of respect for him as a portfolio manager. I’ll tell you one story that is a perfect example. During the time I worked for him, junk bonds had become very popular. Henry had a friend at a brokerage firm who offered to give him a large account if he could manage a junk bond portfolio. We had no clue. Henry gave us all a book about junk bonds and told us to read it over the weekend. The following Monday we began trading junk bonds; Henry was the manager, and I was the trader. The book had said that the default rate was 1 percent, which turned out to be completely bogus. The whole thing ended up blowing up and going away. Also, although I didn’t find out about it until years later, Henry had embellished his academic credentials in the firm’s marketing documents, falsely claiming undergraduate and Ph.D. degrees from prestigious universities.

  Anyway, Henry convinced me that rejoining him was a great opportunity. He offered to give me a large raise over what I had been making. He even offered to pay for my move. I figured the job would give me a way to move back to San Francisco and that if it didn’t work out I could always find another job. Henry had a great marketing guy, and we grew the fund to $90 million. But Henry hadn’t changed; he second-guessed everything I did.

  Henry would see a stock go up five dollars and get all excited and say, “Hey Dana, why don’t you buy XYZ.” He wouldn’t even have any idea what the company did. I would buy the stock because he wanted me to. The next day the order would be on the trade blotter, and he would ask me, “Hey, Dana, what is this XYZ stock?” That was another experience that turned me off to the long side of stocks.

  There was tremendous turnover at the firm because Henry treated his staff so poorly. We had a meeting every morning where the managers talked about the stocks in their portfolio. Henry would just rip the managers apart. One of his employees, a man in his fifties, committed suicide. Henry would tear the confidence out of people, and this poor guy just didn’t have it in him to take it. I had worked with him for a while, and he was a broken man. I can’t say he killed himself because of the job, but I wouldn’t be surprised if it was a factor.

  Was Henry critical with you as well?

  He was constantly second-guessing me and arguing with me every time I put on a trade he didn’t agree with.

  Then how much independence did you have?

  I had independence as long as I was doing well, but every time the market rallied, he wanted me to cover all my shorts. We fought a lot because I didn’t give in. One thing I did is that if Henry insisted I buy a stock, I would buy it, but then immediately short another stock against it. That way I would negate any effect he was trying to have on the portfolio. I did well, but after two years, I couldn’t take it anymore and quit.

  Did you start your own firm after you left Henry the second time?

  No. After I quit, I was hired by Peter Boyd, who had a hedge fund that had reached $200 million at its peak. He told me that he’d heard a lot of good things about me and was going to give me a portion of his fund to manage. He said that I could run it any way I wanted. I told him that I thought I could add the most value by trading strictly on the short side because that was something he didn’t do. He started me out with $10 million and gave me complete discretion. It was great for me because it was like having my own business without any of the administrative headaches.

  Everything was fine for the first two years, but in the third year, the fund started to experience very large redemptions because of poor performance. Boyd had to take the money from me because his own portfolio wasn’t very liquid. He had lost the money by buying huge OEX put positions, which expired worthless only days later. [He bought options that would make large profits if the market went down sharply but would expire as worthless otherwise.]

  It almost sounds as if he was gambling with the portfolio.

  It sure appeared to be gambling. Looking back, it seemed that he tried to hide these losses by marking up the prices on privately held stock in his portfolio. He had complete discretion on pricing these positions.

  How was he able to value these positions wherever he wanted to?

  Because they were privately held companies; there was no publicly traded stock.

  Is it legal to price privately held stocks with such broad discretion?

  Yes. In respect to private companies, the general partner is given that discretion in the hedge fund disclosure document. The auditors also bought off on these numbers every year. He would tell them what he thought these companies were worth and why, and they would accept his valuations. They were these twenty-two-year-old auditors just out of college, and he was the hedge fund manager making $20 million a year; they weren’t about to question him.

  Another hedge fund manager I interviewed who also does a lot of short selling said that the value of audits on a scale of 0 to 100 was zero. Do you agree?

  Yes.

  Even if it’s a leading accounting firm?

  Oh yeah.

  How could hedge fund investors be aware whether a manager was mispricing stocks in the portfolio?

  The quarterly performance statements are required to show what percent of the portfolio consists of privately held deals. His performance was so good for so long that people didn’t question it.

  What percent of his portfolio consisted of private deals?

  In the beginning it was about 10 percent, but as he lost more and more money, the portion of the portfolio in privately held companies continued to grow. By the end, privately held stocks accounted for a major portion of the portfolio, and he was largely left with a bunch of nearly worthless paper.

  It sounds as if he was gambling in the options market and hiding his losses by marking up his private deals. Wouldn’t the truth come out when investors redeemed their money and received back much less than the reported net asset value?

  Although I’m not sure, I believe the first investors to redeem received the full amount, but as more investors redeemed their funds, the true magnitude of the losses became apparent.

  Did you know what he was doing at the time?

  I knew about the option losses, but no one knew about the private deals. They were off the balance sheet.

  It sounds as if you worked with q
uite a host of characters. You didn’t do too well picking your bosses.

  Yes, I know. You think that wouldn’t be a good sign, but…

  How did you start your own firm?

  I had one account that I had met through Peter. He hired me to run a short-only portfolio. That was the account I took with me to get started.

  What year was this?

  1997.

  Your track record shows your performance back to 1994.

  To generate the early years of my track record, I extracted the short trades for the period until I started trading the short-only portfolio.

  Do you use charts at all?

  I use them for market timing. I think that is one of the things that has saved me over the years. If, for example, the stock I am short collapses to support, I will probably get out.

  How do you to define support?

  Price areas that have witnessed a lot of buying in the past—points at which prices consolidated before moving higher. Some dedicated shorts will still hold on to their positions, but I will usually cover. I’ll figure the market has already gone down 50 percent. Maybe it will go down another 10 or 20 percent, but that is not my game. I look for stocks that are high relative to their value.

  That is an example of how you use charts for profit taking. Do you also use charts to limit losses?

  When a chart breaks out to a new high, unless I have some really compelling information, I just get out of the way.

  How long a period do you look back to determine new highs? If a stock makes a one-year high but is still below its two-year high, do you get out?

  No, I am only concerned about stocks making new all-time highs.

  Have you always avoided being short a stock that made new highs, or have you been caught sometimes?

  No, I have been caught sometimes.

  Can you give me an example.

  One stock I was short this year, Sanchez Computer Associates, went from $32 to $80 in one day.

  In one day?

  It’s a company that makes back-office and transaction processing software for banks. Most of their clients are in underdeveloped countries and don’t have their own systems. The business was slowing down, and the Street cut its annual earnings estimate from 75 cents a share to 50 cents. The stock was still trading at $25 at the time, and as a short, that news sounded great to me. I thought the stock would go a lot lower. Shortly afterward, the company announced that they would start an on-line banking software service. This was at a time when the on-line banking stocks were going ballistic.