This is the second part of the summary of "Hedge Fund Market Wizards" by Jack Schwager.
The first part is here:
Steve Clark. Steve Clark is another trader whose track record exhibits very low volatility. He survived (I would even say thrived) 2007–2008. When volatility in financial markets started to rise in 2007, his hedge fund, Omni Partners LLP, exited directional bets. They employed all their money in risk arbitrage trades with short duration. Clark believed that this type of trade didn’t depend on market volatility. The trade was not a free lunch of course. There was a possibility that in case of a large market distress, the prime brokers would increase margin requirements which would result in forced liquidations on the trades. By buying out-of-money out options and shorting out-of-money calls, he hedged against the risk of a big market decline.
Clark also emphasizes the importance of position size. If your size is too big, it is very likely your trading decision will be more irrational; emotions rather than analytical thinking will drive your trading. And how to know if your position size is too large? Clark believes that “if you wake up thinking about it”, then it probably is.
By the way, position size doesn’t imply that a trader should always trade small. If you have a strong conviction in the trade, and also a big risk / reward ratio, then you can get positioned with a large size. His Fiat trade in 2003 is a pertinent example. When the market began to recover from the bear market, Fiat stock price was falling. However, the main reason was not fundamental but the announcement that Deutsche Bank will get rid of its industrial holdings including Fiat. Since a large seller (Deutsche Bank) was selling its rights, they were too cheap which implied a good return potential.
Michael Taylor. Taylor made his fortune in emerging markets, namely Eastern Europe markets. In his view, in emerging markets stock selection is more important than macro analysis. During the meetings with the company management one can develop a good understanding of the company’s business and its business plans while in macro outlook many variables are difficult to predict. However, Taylor still thinks one should consider macro situation when investing in a company. Conducive macro environment, a long-term trend and a company with strong fundamentals are the things he is looking for when he decides to invest in the company. A long position in Russian mobile companies in 1999–2005 is an example he gives. This was the period when increasing oil prices led to a stronger Russian economy. Ordinary Russians had more money now; and this expressed itself in the mobile phones market whose penetration rate was 25 percent at that time. This was a favorable secular trend. Also, the companies were managed well with transparent accounting disclosures.
I liked (which doesn’t mean I agree 100% with him) Taylor’s view of low-beta companies. He believes that investing in boring, low-beta companies is a big mistake. If the market falls 40 percent, low-beta share prices will decrease 20 percent. Though this is better than the market fall, holding cash would be preferable. And if the market goes up, let’s say 30 percent, low-beta stocks will increase 15 percent. This is what Taylor calls “negatively asymmetric returns”. The same is true for emerging market sovereign bonds. In the best case, you will get your money back with some coupon payments. But if the country defaults on its debt, you’ll lose all your investment.
Thomas Claugus. Claugus’s is the most ‘human’ interview in the book in my opinion. He talks about his personal angst which also affected his trading career. However, in this article I will not describe his feelings but about how he chooses the stocks, especially the idea of optionality.
Claugus believes that the market tends to underrate the future revenue potential of the companies. He gives an example of oil companies whose current productions are reflected in the share price but the exploration programs are not. This is what Claugus calls “free optionality”. He pays the fair value based on current business but gains a chance to benefit from anticipated enhancement of the business. His experience is that if the company will benefit from ongoing programs in more than a year away, its value will not be reflected in share price.
Though the idea of free optionality is mostly related to cash flow, occasionally you can do better by focusing on asset value rather than cash flow. Claugus mentiones Paramount Resources which purchases land with the potential for oil and gas exploration. After finding places which can be favorable for exploration, the company leases the land. When oil companies begin to explore the neighborhood area, Paramount sells its land. Claugus notes that one should not look at Paramount through cash flow analysis because they don’t develop anything but rather purchase and lease the land. The proper way to look at their business is to find out which land they have acquired and what it is worth.
Joe Vidich. A former market maker, Joe Vidich shares some observations of how intraday price action may be helpful in short-term trading. For example, in bull markets, “prices open up lower, and then go up for the rest of the day.” The opposite is true in bear markets: prices open up higher, and then they fall during the rest of the day. The reason is that in bull markets there will always be traders who want to short the new highs, and they will sell the next day’s opening. Another short-term pattern that holds true in his views is that if there is bad news before the opening but the market dismisses the bearish news and doesn’t trade down too much, it implies that smart money (let’s say big traders) is not willing to sell, and you can buy the dip.
I found Vidich’s views on stop loss interesting. He believes that using a stop order is a bad idea because if you do that, the result of the trade will depend on only one price. As he puts it, stop loss is “an outrageously poor way” to control your risk. However, you can (and should) use mental stop-loss. If the asset price has fallen 10 percent, you should review your position and figure out why it is down so much but it doesn’t imply that you should immediately sell at that point.
He also notes how stop orders of other participants can be used as an entry point. If a stock’s low was 20 during the past 12 months, we can reasonably expect that there’ll be many stop orders just below 20. If the stock falls to 20, not only stop-losses will be hit but the stock will be down a bit more because at those levels there will not be big buyers. To put buy orders one-half point below 20 is a good idea, Vidich says.
Kevin Daly. Daly has realized an exceptional return from 1999, when he launched his fund, to 2010. Cumulative gross return during this period was more than 870 percent while maximum drawdown was only 10.3 percent. And we should not forget that he achieved these results when equity indices didn’t perform well, to put it mildly: investors putting their money into S&P 500 would realize -9 (minus nine) percent return. The most pertinent benchmark index for Daly, Russell 2000, returned 68 percent in that decade.
If you thought that in this unfavorable market environment Daly achieved his remarkable return by shorting stocks, you would be wrong. Daly occasionally shorts the market; a single-digit fraction of assets under management was involved in shorting.
So how Daly, almost a long-only investor has performed so well in markets which were flat at best? Mostly by staying out of the markets when there are no opportunities. It doesn’t make sense to commit your capital if there is no good use for it. He stayed on the sidelines remaining in cash over two years during the bear market of 2000–2002.
Daly is a value investor. I liked his opinion on how to avoid a value trap. He believes that if the business cannot increase its cash flow, however cheap it may seem, he will not invest in them. These businesses, which Daly calls “melting ice cubes”, are not able to increase their intrinsic value. He shows newspapers, yellow pages, and video rentals as examples. As a value investor, your job is to find a company that trades at discount to its intrinsic value.
Jimmy Balodimas. Balodimas is a nonconformist type of trader. He doesn’t conform to the conventional truths of trading. He will go long during the downtrend, and sell during the uptrend. He breaks accepted “cut your losses and let your profits run” wisdom by increasing his losing positions and cutting his winners.
He is often successful in anticipating bottoms and tops. What confused Schwager (and me too) was Balodimas’s approach. Though Balodimas is too early to the trends and is successful to catch the beginning of the trend, he tends to leave his winning positions. He didn’t ride the downtrend fully in the 2000–2002 bear market. As he himself puts it, “I am not a milker”.
Balodimas himself explains his dissident character in an interesting way. Schwager calls him “a natural short” to which Balodimas replies that actually being long seems unnatural to him because there is a marketing campaign that attracts people to hold stocks. “It’s an energy that can’t always be maintained.”
Even though it seems that Balodimas’s trading approach is an innate talent and he always traded the way he traded, he also adapts to the changes in markets. Increase in institutional traders’ participation in markets was followed by decreasing volatility in price action of equities. The smooth moves implied pullbacks of less magnitude. Now Balodimas couldn’t afford to be too early into the trends. He changed his approach by trading small in the beginning of the trend and only increasing his position size when market change gave him confidence that things will change in his favor.
Joel Greenblatt. Greenblatt is one of the most successful money managers. His Gotham Capital returned 50 percent gross average annual return from 1985 through 1994 when Greenblatt shut the fund down. Since asset size of the fund began to harm the performance, he decided to close Gotham Capital and return investor money.
Greenblatt is a value and special situations investor. In his interview (and also in his book “You can be Stock Market Genius”) he gives some examples of how he exploited special situations to achieve excellent returns. In another book immodestly called “The Little Book That Beats the Market”, describes a quantitative approach on how to select cheap and good companies. During more than 20 years of backtesting period, the approach which Greenblatt calls “Magic Formula” achieved annual return almost twice that of S&P 500 — the index return was 9.5 percent while Magic Formula returned 19.7 percent!
Greenblatt mentioned the increased participation of institutions in the financial markets and expounds on how it enhanced the role of value investing. Since money managers are monitored for the performance during a short time period, they are not willing to wait for many years to perform. Clients will ‘punish’ managers for poor performance over a short interval by withdrawing their money. This makes valuation metrics even more important because they require patience to work over years. This is actually Greenblatt’s three lessons on value investing: 1) Value investing does work. 2) Sometimes it doesn’t work. 3) Point 2 is the reason why Point 1 is true.
