The New Market Wizards: Conversations with America's Top Traders (29 page)

Any other examples of stock picks that exemplify your investment style?

A recent example is U.S. Surgical [USS]. Although by now USS has become an institutional favorite, I was fortunate to uncover this story in late 1989, before it really took off. At that time, USS didn’t yet have the great stock characteristics that it later showed in 1990 and 1991—accelerating sales and earnings, high relative strength, and institutional sponsorship. But it did have a very powerful, fundamental story. It had developed the best pipeline of noninvasive surgical products—an innovative sector that I thought would become the fastest growing medical market of the nineties. USS is probably a good example of what I try to do because the key to buying this stock was early recognition of the noninvasive surgery market. This new procedure was not heavily covered by Wall Street back in 1989. It didn’t have that much to do with what I call “left brain” (micro) factors, which would be growth rates, multiples, margins, and so on. This stock was a “right brain” (macro) story. You had to appreciate the potential of this market
before
the numbers came through so powerfully.

Danek Group [DNKG], a manufacturer of spinal implants, is another good example. I started buying DNKG as soon as it went public in May 1991. It had everything I look for in a growth stock: accelerating revenues and earnings and proprietary products in a rapidly expanding market. Even better, from a trading point of view, DNKG was a strong medical products company at a time when the market couldn’t wait to buy such issues. Anything healthcare-related was moving in 1991, and DNKG forcefully participated in this move, exploding from $19 to $43 during its first three months after going public. But then a rumor began circulating that DNKG was going to run into some trouble at the FDA. Although this news was unsubstantiated, the stock cracked from $43 to $34 in just a couple of days. This was my second largest position. Usually, I sell a portion of my position when there’s a problem—and trouble at the FDA certainly qualifies as a big problem. But in this case, I just didn’t believe the rumors, and medical stocks were in strong demand in the marketplace, so I stayed with my full position. This proved to be the right decision, as DNKG not only recovered but went on to hit new highs, exceeding $60 by the end of 1991.

In this instance, the key to making money in the stock was trading the position properly. Some portfolio management decisions are investment oriented and some are trading oriented. This was a trading decision. Also, I might have made a different decision if other factors were different. For example, if the market weren’t strong, or if the medical products group had been weakening, then I might have sold the entire position. There are a lot of different inputs that can affect a decision, and there are no universal decision rules.

Any other illustrative case histories?

Another interesting company was Blockbuster Entertainment [BV], which operates and franchises video rental stores. This is a franchise expansion story. I first learned of this company from a very bullish research report issued by a Texas brokerage firm. The estimated revenues and earnings growth rates left me a little skeptical at first, but the technical indicators were improving and the concept was unbelievable. The story had good credibility because the company was being launched by Wayne Huizenga, who was already a successful businessman. He was one of the founders and former chairman of Waste Management, another company in which I was an early investor after the company went public in the early 1970s.

The Blockbuster story started to appeal to me even more when the company made its next quarterly earnings announcement. The growth rates were impressive and made me believe that the street estimate I had frowned upon earlier was not only achievable but maybe even conservative. I instructed one of my analysts to increase his research efforts. Huizenga planned to continue opening company-owned and franchised video rental stores under the Blockbuster name. I learned that these were superstores that stocked thousands of videocassettes. I felt the concept would work because VCR sales were still growing quite substantially and Blockbuster’s main competition came from mom-and-pop video retailers that had a much smaller selection of videocassettes. We continued to increase our position in the stock over the next few months and made a lot of money, as the stock more than doubled.

In all these examples, it sounds like you bought the stock and the stock took off. Can you think of a major winner that first headed south after you bought it?

In the summer of 1984, a broker friend called me and said, “I have a good stock for you.”

“Okay, what is it?” I asked.

“This Can’t Be Yogurt [TCBY],” he answered.

“I don’t know,” I said. “I don’t really like yogurt.”

“No,” he said, “this yogurt really tastes good. Let me send you a prospectus.”

He sent over not only a prospectus but a sample of the product as well. The prospectus looked very interesting, showing about 70 to 80 percent growth in earnings, but perhaps even more importantly, I thought the product tasted great—just like ice cream. When the company went public, I bought a large amount of stock at the initial offering price of $7. After I bought it, the stock went down to $4[fr1/4]. At that point, I got a call from one of my clients, questioning the advisability of maintaining our large holding in the stock. The company’s earnings growth was so spectacular that I told him I thought the stock was still a buy.

Did you buy more?

As a matter of fact, I did, but I waited until the stock started to uptick.

Did you have any idea why the stock was going down?

I couldn’t figure it out. My best guess was that the market was so negative for small cap stocks that TCBY was probably just getting dragged down with the rest of the group.

What ultimately happened to the stock?

Eventually it went up to $200.

What was the catalyst that turned it around?

The environment changed. The market began to appreciate growth stocks. It was partly the company and partly the environment. There’s a saying, “You can’t make a harvest in the wintertime.” That was the situation initially. It was wintertime for small cap, high growth stocks. The market just wasn’t interested. Once this general attitude changed, the market focused on the company’s excellent earnings, and the stock took off.

Were there any situations in which you bought a stock very heavily because of good earnings growth and prices went down and never recovered?

Sure, that happens a lot. We probably have more losers than winners, but we cut our losses.

How do you decide where to cut your losses?

It could be a change in the fundamentals, such as a disappointing turn in earnings, or it could be due to the price action.

Wouldn’t negative price action have gotten you out of a stock like TCBY? Where do you draw the line?

It’s not purely deterministic; there’s an element of art involved. Ultimately, you have to balance your underlying faith in the company with the price action.

Was it then a matter of your confidence in the fundamentals for TCBY being so strong that it overrode everything else?

Exactly. It was a matter of my conviction on the stock.

What do you look for in terms of the price action?

I look at the total image. It’s more the visual impression than whether the stock breaks a particular point.

I take that to mean that you use charts.

Absolutely. Technical analysis is vital for success.

How long have you been using charts?

About twenty-five years. That probably says as much as anything about how helpful and reliable I have found them. They give you a very unemotional insight into a stock in an otherwise emotional market.

Do you always check the chart before you buy a stock?

Absolutely. I won’t buy a stock when it’s dropping even if I like the fundamentals. I have to see some stability in the price action before I buy the stock. Conversely, I might also use a stock’s chart to trigger the sale of a current holding. Again, the charts are a very unemotional way to view a stock’s behavior and potential.

Is it fair to say that you determine your trading ideas based on fundamental analysis but that you time your trade entry using technical analysis?

Generally speaking, that’s probably true. However, often the trigger for buying a stock is fundamental news. For example, recently I purchased a stock called Dataram Corporation following the release of a very positive earnings report. The company, which makes memory products for personal computers and workstations, reported quarterly earnings up from $.32 to $.75 and revenues up from $7 million to $11 million. The stock, which had closed at $26 3/8 on the previous day, shot up $4 on the news. We purchased twenty-five thousand shares at an average cost of $30 1/4.

Do you put a limit on the order in that type of situation?

Oh no! We would never have gotten filled. I felt very comfortable buying the stock, even after its large price move that day, because the numbers were very strong and the market was moving toward technology stocks anyway. We ultimately ended up purchasing almost 4 percent of this company at an average cost of $31 1/2. The stock now sells at $58.

Is it generally true that stocks that witness a huge, one-day move tend to keep going in the same direction over the near term?

That has been my observation over the years. If there’s a large move on significant news, either favorable or unfavorable, the stock will usually continue to move in that direction.

So you basically have to bite the bullet and buy the stock.

Yes, but it’s hard to do.

Were you always able to do that?

It’s taken time to get good at it.

Does a stock have to be stronger than the overall market in order for you to buy it?

Generally speaking, yes. I like to see the stock’s relative strength in the top 10 percent of the market, or at least the top 20 percent.

You implied earlier that you’ll often buy stocks with high P/E ratios. Does this imply that you believe P/E ratios are irrelevant?

The P/E ratio might show statistical significance for broad stock groups, but for the type of stocks we buy, it’s usually not a key variable. Stocks with long-term, high-growth potential often sell at higher multiples, particularly if they’re newer companies. The P/E ratio really measures investors’ emotions, which swing wildly from fear to greed, and is only significant at extremes.

Do you feel there’s an advantage to buying stocks that are not too heavily covered by the street?

Absolutely! There’s a definite market inefficiency there. Typically, the more the street covers a stock, the less opportunity there is.

What are the major misconceptions people have about the stock market?

They tend to confuse short-term volatility with long-term risk. The longer the time period, the lower the risk of holding equities. People focus too much on the short term—week-to-week and month-to-month price changes—and don’t pay enough attention to the long-term potential. They look at all movement as negative, whereas I look at movement as a constructive element. For many investors, the lack of sufficient exposure to high-returning, more volatile assets is their greatest risk. In my opinion, investment vehicles that provide the least short-term volatility often embody the greatest long-term risk. Without significant price movement, you can’t achieve superior gains.

One market paradigm that I take exception to is: Buy low and sell high. I believe that far more money is made buying high and selling at even higher prices. That means buying stocks that have already had good moves and have high relative strength—that is, stocks in demand by other investors. I would much rather invest in a stock that’s increasing in price and take the risk that it may begin to decline than invest in a stock that’s already in a decline and try to guess when it will turn around.

Finally, another major trap people fall into is trying to time the market. Since January 1980, the market has realized an average annual compounded return of 17 percent. If you were out of the market on the forty best days, which represent only 2 percent of the trading days, the return would drop to under 4 percent. The moral is that the penalty for being out of the market on the wrong days is severe—and human nature being what it is, those are exactly the days that most people are likely to be out of the market.