Why is it ridiculous?
Because different market participants will do research of varying quality. The market price will reflect the average assessment of all investors. If you can do research that most other people do not, you might be able to discover something that most of the rest of the market doesn’t know and benefit from that knowledge. There are a lot of things that I know about my companies that most other investors don’t. Therefore, my evaluation of these companies is not going to be the same as theirs. Why then should a stock always trade at the right price level?
When you buy a stock, do you know where you want to get out before you get in?
Certainly. I always have a target price at which I will get out, assuming the fundamentals haven’t changed. If the fundamentals get stronger, however, I might raise my target.
What is this target based on? Is it some specified percent gain?
Yes, a percent gain.
What percent?
It depends how cheaply I buy the stock, but on average 20 to 25 percent.
What you are doing sounds like the exact opposite of Peter Lynch, who says you should go for a “ten-bagger” [buy stocks that you think can increase tenfold]; you’re not even going for a double, or even close to it.
I never go for home runs. That’s why I should do well in a bear market.
I assume that when you sell a stock, you look to buy it back when it dips.
Certainly, as long as the fundamentals don’t change.
But don’t you often find yourself taking a moderate profit on a stock, and then the stock never dips enough to give you a chance to repurchase it?
That happens a lot of time, but I don’t worry about it. My main goal is not to lose money. If you can make money consistently, you will do just fine.
Most of your trading history has been with a small amount of money. Now that you have started a fund and are doing well, that amount will increase dramatically. How will trading much larger sums of money affect your approach?
It won’t change anything. The stocks I buy are all well-known names with lots of liquidity. This is deliberate. When I first started, my attitude was that I had to think big. Therefore I made sure to adopt a style that could be used with much larger sums of money.
The period during which you have traded has coincided with one of the greatest bull markets in history. What happens to your approach if we go into a major bear market?
I hope we get a bear market. All the momentum players will get killed; all the Internet players will get killed; all the growth players will get killed; the value players, however, will do okay. The companies that I buy are already in bear markets. They are trading at five to six times earnings. They don’t have room to go much lower. Remember, the stocks that I buy are already down 60 to 70 percent from their highs.
Okay, I could see why you would lose a lot less in a bear market than investors using other approaches. But if the S&P index comes off 20 or 30 percent, I would assume that your stocks would go down as well.
That’s fine, I’ll just hold. I know the value of my companies. I don’t second-guess myself when I make an investment. A lot of other money managers have rules about getting out of their stocks if they go down by some specified amount, say 7 percent or 10 percent. They have to do that because they are not sure about what they are buying. I do tremendous research on any stock that I buy, and I know how much it is worth. In fact, if a stock I buy goes down 10 percent and the fundamentals haven’t changed, I might well buy more.
But if you never use any stop-loss points, what happens if a company you buy goes bankrupt? How much of an impact would an event like that have on your portfolio?
It will never happen. I don’t buy any companies that have even a remote chance of going bankrupt. I buy companies that have a good balance sheet, a high book value, consistent business track records, good management, and large insider buying ownership. These are not the type of companies that go bankrupt.
How do you know when you are wrong in a position?
If the fundamentals change and the stock no longer meets my criteria for holding it at the current price.
What if the price is going against you, but the fundamentals haven’t changed?
Then I will just buy more.
How many different stock positions do you typically hold at one time?
About ten. Simple logic: My top ten ideas will always perform better than my top hundred.
What is the maximum amount of your portfolio that you would allocate to a single stock?
At this point, the maximum I would hold on any single stock is about 30 percent of the portfolio. It used to be as high as 70 percent.
That sounds like an extremely large maximum position on one stock. What happens if you are wrong on that trade?
I make sure that I know the fundamentals and that I am not wrong.
But there may be some reason for a stock going down that you don’t know about.
No.
How can you say no for sure?
Because I know the companies I buy. For example, if I buy Viasoft at $7, a company that has $5 per share in cash and no debt, what is my downside—$2?
What is your approach on the short side?
I look for stocks that are trading at a huge multiple to earnings. However, after my experience with Internet stocks last year, I’ve added a rule that there has to be a catalyst. Now, regardless of how extremely overvalued a stock may be, I won’t sell it until there has been a catalyst for change.
So another mistake you made in shorting Amazon and Schwab last year, besides selling into a mania, was selling without a catalyst.
Exactly. Even though those stocks may be overvalued, the direction of the fundamentals is still strong. Although Amazon is not making any money, they continue to grow their revenues and meet their sales targets. As long as this is the case, the market is not going to sell the stock off sharply.
It seems it would be very difficult for you to apply your methodology to the short side. On the long side, you are buying stocks that have already declined sharply and are trading at prices that represent strong value. In other words, you are buying at a point where your risk exposure is relatively low. In contrast, when you are shorting a stock, no matter how high you sell it at, there is always an open-ended risk, which is the exact opposite of your buying approach. How can you even approach the short side?
I make sure that the fundamentals are broken before I go short. Even if Schwab today were trading at a hundred times earning, I wouldn’t short it as long as the trend in the fundamentals was still improving. I would wait for the fundamentals to start deteriorating.
But you might get another mania that drives the stock higher, even though the fundamentals are deteriorating.
Once the fundamentals get broken, market manias get broken as well. For example, there was a mania in Iomega a few years ago. Once the fundamentals started to break down, the mania ended.
But how do you deal with the problem of unlimited risk?
All my longs are long-term investments, but my shorts are usually short-term precisely because of the danger of unlimited risk.
How would you rate the quality of Wall Street research?
Not very good.
For what reason?
Most analysts don’t have a logical reason why a stock should be at a given price. As long as the company does well, they don’t care what the price is. Typically, if a stock reaches their target, they will just raise the target, even though the fundamentals haven’t changed.
We have seen an incredible bull market during the 1990s. Is the magnitude of this advance justified by the fundamentals?
For two reasons I think we are witnessing the biggest financial mania ever in the stock market. First, the stock market price/earnings ratio is at a record high level. Second, the average profit margin of companies is at its highest level ever.
What do you mean by profit margin?
The amount of profit per sales. For
example, if the profit margin is 20, it means the company is making $20 in profits for every $100 in sales.
Why then is a high profit margin a negative?
Because there is virtually no room for further improvement.
What do you read?
Everything, including financial newspapers and magazines, tons of company reports, and all sorts of trade journals. The trade periodicals I read depend on my existing and prospective positions. For example, last year I owned a company that was making products for urinary disorders, so I read Urinary Times.
What is the specific checklist you use before buying a stock?
The stock must meet the following criteria:
1. The company has a good track record in terms of growing their earnings per share, revenues per share, and cash flow per share.
2. The company has an attractive book value [the theoretical value of a share if all the company’s assets were liquidated and its liabilities paid off] and a high return on equity.
3. The stock is down sharply, often trading near its recent low. But this weakness has to be due to a short-term reason while the long-term fundamentals still remain sound.
4. There is significant insider buying or ownership.
5. Sometimes a company having a new management team with a good track record of turning companies around may provide an additional reason to buy the stock.
What are the trading rules you live by?
Do your research and be sure you know the companies that you are buying.
Buy low.
Be disciplined, and don’t get emotionally involved.
What are your goals?
My goal is to be the best money manager in the industry. After the fund reaches its ten-year anniversary, I hope to have the best track record for the prior ten years, nine years, all the way down to five years. Anything shorter than five years could indicate someone who is just lucky or using a style that is temporarily in favor with the market.
* * *
Okumus has developed a trading style that assures he will miss 80 to 90 percent of the winning stocks he identifies and typically realize only a small portion of the advance in the stocks he does buy. He also brags that he has never owned a stock that has made a new high. These hardly sound like characteristics of a great trading approach. Yet these seeming flaws are actually essential elements of his success. Okumus has only one overriding goal: to select individual trades that will have a very high probability of gain and a very low level of risk. To achieve this goal he has to be willing to forgo many winners and leave lots of money on the table. This is fine with Okumus. His approach has resulted in over 90 percent profitable trades and a triple-digit average annual return.
Okumus’s bread-and-butter trade is buying a stock with sound fundamentals at a bargain price. He looks for stocks with good growth in earnings, revenues, and cash flow, and significant insider buying or ownership. Strong fundamentals, however, are only half the picture. A stock must also be very attractively priced. Typically, the stocks Okumus buys have declined 60 percent or more off their highs and are trading at price/earnings ratios under 12. He also prefers to buy stocks with prices as close as possible to book value. Very few stocks meet Okumus’s combination of fundamental and price criteria. The majority of the stocks that fulfill his fundamental requirements never decline to his buying price. Out of the universe of ten thousand stocks Okumus surveys, he holds only about ten in his portfolio at any given time.
One element of market success frequently cited by Market Wizards, both in this volume and its two predecessors, is the age-old trading adage: Cut your losses short. Yet Okumus’s methodology seems to fly in the face of this conventional wisdom. Okumus does not believe in liquidating a stock position because it shows a loss. In fact, if a stock he buys moves lower, he may even buy more. How can Okumus be successful by doing the exact opposite of what so many other great traders advise?
There is no paradox. There are many roads to trading success, although none are particularly easy to find or to stay on. Cutting losses is important only because it is a means of risk control. While all successful traders incorporate risk control into their methodology, not all use cutting losses to achieve risk control. Okumus attains risk control by using an extremely restrictive stock selection process: He buys only financially sound companies that have already declined by well over 50 percent from their highs. He has extreme confidence that the stocks he buys have very low risk at the time he buys them. To achieve this degree of certainty, Okumus passes up many profitable trading opportunities. But because he is so rigorous in his stock selection, he is able to achieve risk control without employing the principle of cutting losses short.
One technique Okumus uses to enhance his performance is the sale of out-of-the-money puts on stocks he wishes to own. He sells puts at a strike price at which he would buy the stock anyway. In this way, he at least makes some profit if the stock fails to decline to his buying point and reduces his cost for the stock by the option premium received if it does reach his purchase price.
Okumus is very disciplined and patient. If there are very few stocks that meet his highly selective conditions, he will wait until such opportunities arise. For example, at the end of the second quarter in 1999, Okumus was only 13 percent invested because, as he stated at the time, “There are no bargains around. I’m not risking the money I’m investing until I find stocks that are very cheap.”
* * *
Update on Ahmet Okumus
Okumus managed to keep rolling along during the first two calendar years of the bear market, with his flagship fund scoring impressive gains of 49 percent in 2000 and 31 percent in 2001. In 2002, however, Okumus hit a speed bump. Okumus’s fund finished September at the low point of a drawdown and down over 40 for the year to date—the same percentage decline as the devastated Nasdaq index and a loss significantly larger than the 29 percent decline in the S&P 500. Even with this huge loss, Okumus remained miles ahead of the indexes in cumulative terms: since inception (August 1997), his fund was up 218 percent compared with declines of 14 percent in the S&P 500 and 26 percent in Nasdaq composite.
Okumus’s large losses in 2002 stemmed from two causes. First, he turned bullish for reasons discussed in this follow-up and increased his net long exposure above 100 percent at a time when the equity markets continued to plummet. Second, his analysis indicated that the best bargains were in the technology sector, which is where Okumus concentrated his holdings, and this sector was particularly hard hit during the 2002 decline. At the time this follow-up interview was conducted (August 2002), Okumus was down 21 percent year-to-date—a loss that would nearly double by the end of the following month (the time of this writing).
Okumus buys stocks that he considers to be deeply undervalued. As long as the fundamentals don’t change, he will hold these positions regardless of how much prices decline. This approach is both the reason why he experiences periodic large drawdowns as well as the reason why these declines have been followed by huge rebounds. Since its inception in 1997, Okumus’s flagship fund has experienced three prior large drawdowns: two equal to 20 percent and one equal to a gargantuan 53 percent. In all three cases, the fund recovered to new highs within two months of the end of the drawdown. Will Okumus repeat with a quick, huge rebound for a fourth time? The answer should be known by the time this book is in print, but I wouldn’t bet against him. [Late item: By the time these pages were being proofread one month later, Okumus had recovered the entire year’s loss.]
I believe you recently have gone the most net long you have been in some time. Is that right?
That’s right, we are the most net long we’ve been since the summer of 1998.
What is your motivation?
Cheap valuations and insider buying. In technology, we are seeing the largest amount of insider buying in thirteen years. For example, in Sun Microsystems, insiders were sellers for ten years. They stopped selling two quarters ago and bought some shares last quarter. Just yes
terday, there was a news item that the chief technology officer bought one million shares!
Have you changed your methodology at all during the bear market?
No, it’s exactly the same. We invest just like a businessman buying an asset. If we buy something that’s worth $20 at $9, it could go to $6, but as long as we correctly assess the value, we should end up making money.
How much money are you managing now?
Over $500 million.
That’s quite a dramatic increase since we did our original interview. At that time, your portfolio was very concentrated. Given the large growth in assets under management, I assume you can’t be anywhere near as concentrated as you used to be.
We used to have about ten positions; now it’s closer to twenty, including both longs and shorts. The bulk of our assets, however, are still in the top ten positions.
So you are still very concentrated.
As I said, we haven’t changed anything.
Although the fundamentals of the companies you hold appear very sound—as you previously phrased it, you are buying $20 of value for $9—isn’t there a possibility that the fundamentals you are basing your valuations on could be misleading because of questionable, or even deceptive, accounting? And since you run a very concentrated portfolio, isn’t there the risk that a single event of corporate misrepresentation could have a large negative impact on performance?
No, because we don’t buy companies with debt. All of the companies that have been involved in recent scandals have been companies with a ton of debt. They create off balance sheet items or book expenses in the wrong places to hide their debt. Also, insider buying is typically a feature of most of our long-side holdings. How many insiders do you know who buy their company stock before committing a fraud?
You never buy companies with debt?
Never say never. But we buy companies with debt less than 10 percent of the time, and in those cases they have less than 30 percent debt to equity.
How many people do you have in the organization now?
Stock Market Wizards Page 18