I’m a “don’t pass” player. That means I bet against the shooters. The odds are the same whether you bet with or against the shooters, but most people bet with the shooters, the people rolling the dice. I bet against them, because I don’t want to be associated with the guy in the blue double-knit leisure suit with the gold medallion hanging out of his open shirt or the fat bleached blonde who’s bursting out of her sequined minidress and spitting on the dice before every roll. I’m hoping they’ll crap out before they make their point. That means that everyone at the table, even the stickmen, who survive on tips and want everyone winning and happy, hate me. That doesn’t bother me a bit. At the craps table or in the trading pit, the losers always hate the winners.
Playing craps at Vegas has taught me three rules that I find indispensable in trading. The first rule is, DIVORCE YOUR EGO FROM THE GAME. Don’t get emotionally involved. While you’re playing against the shooter, it’s nothing personal. If you let your ego into the game, the temptation is to double up when Doubleknit wins a few bets, to hang tough so you can get even fast with Sequins. I’ve found this behavior to be self-destructive and a sure way to go tapioca. You have to be unemotional, like the house. The house never takes anything personally.
The second rule is, MANAGE YOUR MONEY. The minute I arrive at the casino, I go to the cashier’s cage and get a safe-deposit box for my money. I put all but a few hundred dollars in the box. If I lose that, I have to go back to the box to get more. Having to go back to the box does two things: it makes me physically leave the table, which automatically breaks my losing streak, and it gives me time to relax and consider what I want to do next. It’s like splashing cold water on my face. The same holds true for trading: keep money in a separate account that your broker can’t get to unless you expressly transfer it into your trading account. That way, you can’t get swept up in the excitement of the moment and shoot your whole wad.
The third rule is, CHANGE TABLES AFTER A WINNING STREAK. The luckier you’ve been, the surer it is that your luck is going to change. Changing tables is not easy, especially if you’re doing well. Human nature tells you that if you’re making money at one table, stay there and make some more. But the best thing you can do is to pick up your winnings, go back to the box, and deposit everything except for a few hundred bucks. Periodically leaving the table with your winnings is the only way you can avoid getting ground down by the house’s edge. Then, if you still feel lucky, you still have your concentration, and if you still want to play, go find a new table and hope you get hot again.
This kind of mental discipline may not make you a winner in the market, but if you don’t have it, you’re sure to be a loser.
4
The Great Pyramid
In early 1970, when I graduated from Columbia Business School, I knew that I wanted to be in the stock market. I figured that there were three ways I could get into the game. I could become an investment banker, a trader, or a securities analyst. I knew that I wasn’t cut out to be an investment banker. Investment bankers were smooth operators who made fortunes by creating entities, underwriting stock offerings, and keeping big pieces of the action, but I didn’t have the experience, the capital, or the polish to become an investment banker. I didn’t want to be a trader because in those days, traders were just middlemen. They got orders from their clients and phoned them down to the floor. I decided I wanted to be a securities analyst. That’s what appealed to me and best fit my personality.
When I was in the first grade, the teacher asked each of us what we wanted to be when we grew up. I said, “a detective.” Here I was, a smart kid from a good Jewish home, but I didn’t want to be a doctor or a lawyer, I wanted to be a detective. My parents must have wondered where they’d gone wrong, but I knew even then that I liked to analyze things, and that’s what securities analysts did. They analyzed companies, interviewed managements, and wrote reports. They got to travel all over the country, and I liked to travel.
In the spring of 1970, the economy was in a recession. For the Class of ’70, jobs on Wall Street were hard to find, but that hadn’t stopped me. I was a hustler and I was selling my favorite product, me. At the beginning of the year, when I was finishing up at Columbia, I started cold calling everybody. Like a detective, I investigated leads, got names of research directors, called them up. They’d say, “We’re not hiring anybody, let alone some kid who doesn’t know anything. Don’t you know there’s a recession going on?”
“Well, somebody must have given you your first break,” I’d say. I always got them with that line. Usually it was enough to keep the conversation going. Then I’d try to get an appointment, because even if the contact didn’t pay off right away, it might pay off later on. I ended up with six job offers.
I went with Kuhn Loeb. Kuhn Loeb was owned by the Schiff family and was an old-line, well-respected Jewish firm. Jack Favia was the head of research and Jack offered me $16,000, which was a princely sum back in 1970. Jack assigned me to Abe Bronchtein, an MIT graduate who was the drug analyst for Kuhn Loeb. Abe was my mentor. He followed the pharmaceuticals and he assigned me to the drug chains, the Rite Aids, the Revcos, the Eckerds. That’s how I got into health care.
In addition to the drug chains, Abe exposed me to other companies that were in health care. One of my early assignments was to help him look at a company called Four Seasons Nursing Centers. Medicare had just come in a few years before and nursing home stocks were going crazy. They had become the new rage. Four Seasons was run by a promoter named Jack Clark, and Jack Clark had come to New York to pitch Four Seasons stock to Wall Street analysts. Abe and I met him for a power breakfast in his suite at the Regency Hotel on Park Avenue between 61st and 62nd Streets. Jack Clark was a “dude,” a real smooth operator. The first thing I noticed when I walked into his suite was Jack Clark’s alligator shoes. I’d never in my life seen anything so beautiful as those alligator shoes. It was like the light had come out of the sky.
Now, no rational person on this earth would pay $1,500 to walk down the street in a depreciating asset. But I kept staring at Jack Clark’s feet and thinking, Alligator shoes, that’s for me. I’m gonna have to get me some of those someday. I don’t remember a thing about the interview. All I remember was Jack Clark’s alligator shoes. It was just the shoes, baby. No wonder nobody wants to hire anybody under twenty-five fresh out of business school.
A few weeks later, Abe and I flew out to Joliet, Illinois, to do due diligence on Four Seasons. Abe wanted to see one of the nursing homes. Sure enough, it was a brand-new nursing home, but as we found out later on, Four Seasons’s earnings weren’t coming from the operation of the nursing homes. They were coming from the construction side of the business. Jack Clark was a crook. What he was doing was building nursing homes, inflating the construction profits, and representing those profits as operating earnings from the nursing homes. That way, the stock would trade at a high multiple as a “concept stock.” As everyone learned with the S&L crisis fifteen years later, you can make big profits in construction if you inflate the price. On April 27, 1970, trading in Four Seasons stock was halted. Four Seasons was a fraud, and Jack Clark and his beautiful alligator shoes ended up going to prison.
The hot concept that came after nursing homes was hospital management. Unlike Four Seasons and some of the other nursing home companies, hospital management was no Ponzi scheme. These were legitimate businesses run by businessmen who saw the huge opportunities being presented by Medicare and Medicaid.
I saw this embryonic industry that was allied with the health care field and I started following it. The big ball started rolling. Hospital management became my primary area of expertise. I was a young analyst following a young industry, and this was my first exposure to real wheeler-dealers. Before I knew it, I was one of the players in their game. I wrote favorable reports about their companies, I recommended their stocks, I got Kuhn Loeb to sponsor a big institutional luncheon in New York at the City Midday Club where all the boys flew in on t
heir private planes and I was the moderator. I’d sit with them at the head table and introduce them to the institutional clients. “David Jones is a graduate of Yale and Yale Law School and he and Wendell Cherry, the new owner of the Kentucky Colonels, have made Extendacare one of the fastest-growing companies in America,” I’d gush. “In just two short years, Dr. Tom Frist and Jack Massey have taken Hospital Corporation of America to the pinnacle of the industry,” I’d trumpet. “Bernie Korman and Bob Goldsamt were the first to see the potential in consolidating hospital management, and thanks to their leadership, American Medicorp has been a pioneer in this explosive field,” I’d boast.
It was a real dog and pony show and I was a central part of the act. The stocks were soaring. The more I ingratiated myself with management, the greater the chance that I could attract some big investment banking fees for my firm, and, ultimately, for myself. Investment banking was where the real big money was; to get a shot at it, I needed to be friendly and positive to these potential clients anytime I could. Big ball, please roll my way!
In the spring of 1972, I’d been at Kuhn Loeb two years. My salary was up to $30,000 and I was jetting all over the country, big-shotting it up with my friends from Amherst, analyzing the drug chains, and promoting hospital management companies. Then one day at a luncheon for Columbia B-School alumni, I bumped into a classmate. He’d taken a job at The Great Pyramid.
In those days there were a lot of boutique firms, small brokerage firms that were noted for their hot securities analysts. The Great Pyramid was one of them. It had a glow, an aura, a karma, a charisma. My friend told me that The Great Pyramid was looking for more analysts and that he could get me an interview. Getting an interview with The Great Pyramid was like getting a tryout with the Dallas Cowboys. “Shit, yeah, go ahead,” I said.
The Great Pyramid was on the thirty-third floor of one of the new stainless-steel towers adjoining Battery Park, overlooking the harbor right where the Staten Island Ferry came in. I had a great interview. I met with the head of the entire institutional department and the partner in charge of institutional research. They offered me $50,000 to come over to The Great Pyramid. So I did.
The Great Pyramid was quickly becoming one of the most impressive edifices on Wall Street. At the top were King Khufu and King Khafre. Khufu and Khafre were the gods, the Pharaohs who were building this financial wonder, and like the great kings of ancient Egypt, they were loading their chambers full of treasures and precious objects.
The Great Pyramid was in a dazzling new building and also overlooked the Statue of Liberty. There was some irony here, because the Pyramid was full of people whose parents and grandparents had fled the pogroms of Eastern Europe and Russia and had first viewed the Statue of Liberty from the other side. The parents and grandparents settled in Brooklyn and the Bronx, but now their children and grandchildren had forgotten where they were from. They were scrambling up New York’s social ladder and acting like their families had come over on the Mayflower. They were joining country clubs, sending their kids to private schools, summering in the Hamptons, patronizing charities, buying boxes at Lincoln Center, sipping wine at the Guggenheim, and munching cheese at the Metropolitan Museum of Art.
Immediately under Khufu and Khafre was the High Priest who was in charge of the Pyramid’s entire institutional sales and research effort. It was the High Priest who’d sold me on coming to the Pyramid. On the next level, directly below the Priest, was the Prophet. The Prophet was the head of research and technically he was my boss, but as soon as I got to the Pyramid, I learned that the High Priest and the Prophet weren’t going to be mentors to me like Favia and Bronchtein had been at Kuhn Loeb. The Great Pyramid wasn’t like Kuhn Loeb.
The Prophet had thirty analysts, including me, under him. His job as director of research was to have meetings with the analysts, keep abreast of what reports they were working on, review their work, brief the High Priest, and ensure that research reports were disseminated to clients, the rest of the investment community, and the public in an equitable manner. The Prophet had reorganized the research group into three subgroups of ten analysts each and put a senior analyst in charge of each subgroup. Now the Prophet didn’t have to go to meetings. He could send Papyrus to meetings instead.
Papyrus was the associate director of research in charge of my subgroup. Papyrus wasn’t much older than I was, but already he was a legend on Wall Street. He covered the airline industry, and in those days, airlines were indeed highflyers. But highflyers often went down as fast as they went up, and on occasion a Papyrus recommendation crashed and took a bunch of the Pyramid’s retail brokers and their clients down with it. The big joke around the Pyramid was that Papyrus had lost more luggage than Allegheny.
Hiero Glyphics was also in my subgroup, and there were some jokes about him, too. Hiero had recommended Polaroid at $170. He couldn’t see how Polaroid with all of its patents on instant photography could ever stop selling more and more film and making more and more money. He was convinced that Polaroid was going to earn $4, then $8, then $16, then $83. According to Glyphics, there was going to be a Polaroid camera in your brain and up your ass and they were all going to be taking instant pictures forever. When Hiero’s projected earnings failed to develop, it produced a bleak picture for the Pyramid’s brokers and their clients.
The Sphinx was another member of the group. Sphinx was an accountant who liked to analyze young companies with fast-growing earnings. It was important for research groups to have an accounting sleuth like Sphinx because the figures presented in a company’s annual report, especially a young company in a new industry, could be very misleading. The disclaimers issued by the independent accounting firms that certified the financial statements in annual reports always said something like,
Our examination of these statements was made in accordance with generally accepted accounting principles, and in our opinion, the accompanying balance sheet, statement of income and retained earnings present fairly the financial position of this company.
What these disclaimers really should have said was something like,
We’ve gone through the figures that management gave us, but you gotta realize that generally accepted accounting principles leave a hell of a lot of leeway to dick around with earnings. Plus, this company is paying us a boatload of money to certify these numbers, and if we don’t, they’ll find another independent auditor that will.
That’s why every annual report has page upon page of notes in tiny print backing up the financial statements. While these notes are too small and too confusing for most stockholders to digest, they are a veritable smorgasbord for an accountant like the Sphinx. He’d spread the annual report out in front of him, tie on his green eyeshade, and dig in. Once consumed, the notes gave him a real taste for the company. The inventories were stale, left on the shelves too long. The depreciation was overdone. The cost of goods sold was a bit understated. The receivables could use a pinch of discounting. The goodwill had gone bad.
By Labor Day 1972, I’d been at The Great Pyramid for three months. I was still analyzing the hospital management industry, and I was still bullish. Due to Medicare and Medicaid, money was pouring into health care, and thanks to their consolidation of the industry, the hospital management companies were poised to get a large share of it. I was gazing out at the Staten Island Ferry thinking how cool I was to be a hot young stud riding a hot young industry when the Sphinx waddled into my office.
As the Pyramid’s accounting sleuth, Sphinx had a hunting license to take a shot at any company or industry where he felt that the accounting presented a good target. When he hit one, he’d go to the analyst who handled that industry and tell him what he’d found. Sphinx parked his portly posterior in a chair and smiled smugly. He had that gleam in his eye that an accountant gets when he’s tracked down a debit posing as a credit.
“Marty,” Sphinx said, “I’ve been looking at the hospital management companies and I think the earnings might be fulla shit.”
He went on to tell me that the fastest-growing source of revenue for the health management industry was Medicare and Medicaid charges, but that those charges were just estimates of receivables based on customary billing rates. The actual reimbursements from the government were based on audits, and those audits frequently were two or three years behind. The Sphinx thought that the companies were recording their receivables in an overly optimistic manner, thereby inflating their earnings.
“Very interesting,” I said, shifting uncomfortably in my chair. I was the Pyramid’s lead analyst for the hospital management industry. Telling me that my boys were playing with their receivables was like telling the head cheerleader that his back-field might be messing around with the local bookies.
“Marty,” the Sphinx went on, “the receivables are only part of the story. The real problem is that these companies are selling at thirty to forty times earnings because they’re hot stocks with fast-growing earnings, but that ain’t right. With all the Medicaid and Medicare money going into health care, the government’s gonna tighten up on these existing programs. They’re gonna eventually raise the standards, which will increase the costs, and they’re gonna lower the payments, which will shoot the profit margins all to hell. These companies shouldn’t be selling at high multiples. This is gonna be a utility rate of return business.”
It never occurred to me to ask myself what the Sphinx knew about government regulation. Sphinx was older and more respected than I was, and when he talked, it was good to listen. Instead of telling him not to worry, that my boys were wired and could handle any government attempts at regulation, I got concerned. I started asking myself what I was missing. Maybe I’d gotten too close to the industry, maybe I wasn’t looking at it objectively. I decided that rather than being a cheerleader for the hospital management companies, I’d better start working on a report that would dig into the problems facing the industry, especially government regulation, and then project what effect these problems might have on future earnings.
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