The New Market Wizards: Conversations with America's Top Traders (30 page)

What are the traits of the people who are successful in this business?

They’re open-minded and flexible. They’re also risk takers, because they believe in what they’re doing.

I understand that you have several people at your firm trading their own small funds. Did you train these people?

Yes, none of them had any previous experience in the business before starting with us. There are three people involved, and they’re all doing very well.

I guess that means that you believe successful trading can be taught?

It can be taught as long as the person has an open mind. I like to say that the mind is like a parachute—it’s only good when it’s open. Of course, each person must still develop an individual philosophy and tailor basic trading concepts to his or her own personality.

How did you fare during the October 1987 crash?

We had a very tough month. The Small Cap Fund was down 34 percent. Fortunately, the fund was up 46 percent coming into October. We finished the year down 3 percent. About one week before the crash, I sensed something significantly negative was going to happen in the market.

How did you realize that?

Buying had dried up, there was a sense of fear in the market, and I was also worried about the burgeoning use of portfolio insurance. Because of my concern about the increased risk exposure in the market, I had a substantial portion of my portfolio up for sale on the Thursday and Friday before the crash. Unfortunately, I wasn’t able to liquidate as much stock as I wanted to.

You were unable to liquidate your position because the tone of the market was so bad?

The atmosphere was horrible.

When we were talking about entering orders on extreme price moves, you mentioned the necessity of using market orders instead of limit orders, which are unlikely to get filled in such situations. If you felt that strongly, why did you use limit orders instead of market orders in this case?

We
were
trying to sell the stocks at the market. However, many of the issues we hold are very thin and the size we wanted to sell was just too large relative to what the market could handle. For example, one stock we held was nominally trading at $36 bid/$38 offered, and while we were willing to sell our entire thirty-thousand-share position at $34, there were no bids of any size even well below the market.

Did you come in on Monday, October 19, knowing that it was going to be a very bad day?

Yes, but I had no idea how extreme it would be.

Were you still trying to sell stock that day?

We managed to sell some.

Did you stop trying to sell as the day wore on?

After a while the break was so severe that it didn’t seem to make any sense to try to sell unless the financial world was coming to an end.

Could you describe your emotions on that day?

I was actually very calm. I felt detached—as if I had transcended the situation. I almost had a sense of observing myself and everything that was going on.

After the smoke cleared on October 19, you must have realized that you had just lost one-third of your wealth in one day’s time. [Driehaus keeps almost all his money in his own funds.] Is there a feeling that goes with that?

Yes, get it back! [He laughs loudly.] Actually, I had lost much more than that in 1973–74.

Did that help?

Yes, it did help. It showed me that you could survive that type of break. I had the confidence that I could make it back and the commitment to do it. As Nietzsche said, “What does not destroy me, makes me stronger.”

I get the impression that you really don’t suffer any major market-related stress, even in extreme situations such as the October 1987 crash. Is that because you believe that things will work out in the end?

I believe that’s exactly right.

When did you get that degree of confidence?

I believed in my investment philosophy from the very beginning, but I acquired the true confidence when I applied this philosophy to the fund I managed at A. G. Becker and found that I had placed in the top 1 percent of all funds surveyed. I couldn’t believe how well the approach worked. My confidence in this trading philosophy has never wavered.

You’ve been a portfolio manager for nearly twenty years, during which time you outperformed the industry averages by a wide margin with enviable consistency. What do you consider the key to your sustained success over such a long period?

The essential element is having a core philosophy. Without a core philosophy you’re not going to be able to hold on to your positions or stick with your trading plan during really difficult times. You must fully understand, strongly believe in, and be totally committed to your trading philosophy. In order to achieve that mental state, you have to do a great deal of independent research. A trading philosophy is something that cannot just be transferred from one person to another; it’s something that you have to acquire yourself through time and effort.

Any final advice?

If you reach high, you just might amaze yourself.

Driehaus’s basic philosophy is that price follows growth and that the key to superb performance in the stock market is picking the companies with the best potential earnings growth. Everything else is secondary. Interestingly, the high growth stocks that meet Driehaus’s criteria often sell at extremely high P/E ratios. Driehaus contends that the so-called prudent approach of buying only stocks with average to below-average P/Es will automatically eliminate many of the best performers. The stocks that Driehaus tends to buy are also often companies that are not followed by, or only lightly followed by, industry analysts, a characteristic that Driehaus believes leads to greater inefficiencies and hence greater profit opportunities.

Driehaus’s stock selection ideas are fundamentally based. However, to confirm his selection and to aid in the timing of purchases, Driehaus is a great believer in technical analysis. With rare exception, before he buys a stock, Driehaus wants to see its price rising and high relative strength (i.e., a stock that is performing significantly stronger than the broad market). These technical characteristics mean that when Driehaus buys a stock, it is frequently near its recent high. He believes that fortunes are made by jumping on board the strongest fundamental and technical performers, not by picking bargains.

Most investors would find the typical stock in Driehaus’s portfolio hard to buy. Think of a broker espousing the same strategy in a telephone solicitation. “Hello, Mr. Smith. I have a real interesting stock for you to consider.”
(Pause)
“What is the P/E ratio? Well, it’s 60 to 1.”
(Pause)
“How far is it from its low? Well, it’s making new highs. Mr. Smith? Hello? Mr. Smith?”

Driehaus’s method provides yet another example of the principle that successful strategies often require doing what most people find instinctively uncomfortable. Quite simply, the natural inclination of most people toward comfortable approaches (e.g., buying stocks that are near their lows, buying stocks with low P/Es) is one of the reasons the vast majority of investors experience such poor results.

Another example in which Driehaus’s ability to do what is uncomfortable enhances his profitability is his willingness to buy a stock on extreme strength following a significant bullish news item. In such situations, most investors will wait for a reaction that never comes, or at the very least will place a price limit on their buy order. Driehaus realizes that if the news is sufficiently significant, the only way to buy the stock is to buy the stock. Any more cautious approach is likely to result in missing the move. In similar fashion, Driehaus is also willing to immediately liquidate a holding, even on a sharp one-day decline, if he feels a negative news item has changed the outlook for the stock. The rule is: Do what is right, not what is comfortable.

Another important point to emphasize is that a small percentage of huge winners account for the bulk of Driehaus’s superior performance. You don’t have to be right the majority of the time, but you do have to take advantage of the situations when you are right. Achieving this dictate requires two essential elements: taking larger positions when one has a high degree of confidence (e.g., Home Shopping Network was Driehaus’s largest position ever) and holding such positions long enough to realize most of the potential. The latter condition means avoiding the temptation to take profits after a stock has doubled or even tripled, if the fundamental and technical conditions still point to continued higher prices. The steely patience necessary to hold such positions to fruition is one of the attributes that distinguishes the Market Wizards from less skilled traders. Even though Driehaus and Druckenmiller employ dramatically different approaches, “home run” trades are an essential ingredient to the success of each.

Perhaps Driehaus’s most fundamental piece of advice is that in order to succeed in the market (any market), you must develop your own philosophy. Carefully researching and rigorously verifying a trading philosophy is essential to developing the confidence necessary to stay the course during the difficult times—and there will always be such times, even for the most successful approaches.

THE MASTER OF CONSISTENCY

G
il Blake calls his management company Twenty Plus. This name ties into the logo on his business card and stationery, which shows a probability curve with a +20 percent return falling two standard deviations to the left of the mean. For those not statistically inclined, the implication is that he has a 95 percent probability of realizing an annual return of at least 20 percent. The sketch of the probability curve does not extend to a 0 percent return, let alone into negative returns—which says a great deal about Blake’s confidence.

Blake’s confidence is obviously not misplaced. In the twelve years since he began trading, he had averaged a 45 percent annual return. Although this is an impressive figure, the most striking element of Blake’s performance is his consistency. True to his logo, he has never had a year with a return below 20 percent. In fact, his worst performance was a 24 percent gain in 1984. But even in that subpar year, Blake had a consolation—he made money in all twelve months! To really appreciate Blake’s consistency, you have to look at his monthly returns. An amazing 134 months (ninety-six percent) in his 139-month track record were either breakeven or profitable. He even had one streak of 65 months without a loss—a feat that would qualify him as the Joe DiMaggio of trading (Joe’s streak ended at 56).

Blake’s confidence in his approach also permeates his unique fee arrangement. He charges his clients 25 percent of total annual profits, but—and here’s the unusual part—he also agrees to pay 25 percent of any losses and 100 percent of losses incurred in a new account during the first twelve months. Obviously, he has not had to pay out on these guarantees yet.

By now you probably want to know where to send your check. Save your stamp. Blake stopped accepting client funds five years ago. He has made only two exceptions since then; both times for close friends.

Blake is a mutual fund timer. Generally speaking, mutual fund timers attempt to enhance the yield return on a stock or bond fund by switching into a money market fund whenever conditions are deemed unfavorable. In Blake’s case, he doesn’t merely switch back and forth between a single mutual fund and a money market fund but also makes the additional decision of which sector in a group of sector funds provides the best opportunity on a given day. Blake uses purely technical models to generate signals for the optimum daily investment strategy. His holding period tends to be very short, typically ranging between one and four days. By using this methodology, Blake has been able to show consistent monthly profits even in those months when the funds in which he invested registered significant declines.

Blake prides himself on being a Wall Street outsider. After graduating from Cornell, he served three years as a naval officer on a nuclear submarine. He subsequently attended the Wharton Business School, graduating with highest honors. Following business school, Blake spent three years as an accountant with Price Waterhouse and nine years as chief financial officer for Fairfield Optical. During this entire time, he had no serious thoughts about trading. Indeed, he still generally believed in the truth of the random walk theory, which he had been dutifully taught in school. (This theory basically implies that trying to beat the markets is a futile endeavor.)

Blake’s life changed when he strolled into his friend’s office one day and was presented with some evidence of nonrandom market behavior that he assumed must have been a fluke. In doing the research to prove this point, he instead convinced himself that there were indeed substantial pockets of nonrandom behavior in the markets that provided unbelievable profit opportunities. Thus, fifteen years after graduating from college, Gil Blake became a trader.

Are great traders born or made? In Blake’s case, the following note from his nursery school teacher, which his mother proudly saved, provides some insights:

I interviewed Blake at his suburban Massachusetts home on a Saturday afternoon during the peak of the fall season. I arrived there shortly after lunchtime. Thoughtfully, assuming that I would not have eaten, he had picked up sandwiches. I found Blake to be very low-key and unassuming. He seemed genuinely flattered that I considered him worthy enough to be included in a book of top traders. In terms of return relative to risk, Blake has few, if any, peers, but you would never guess that from his demeanor.

You became a mutual fund timer long before it became popular. What was your original inspiration?

Well, I really owe it to a friend. I remember the day as if it were yesterday. I wandered into a colleague’s office, and he said, “Hey, Gil, take a look at these numbers.” He had invested in a municipal bond fund to take advantage of the prevailing high interest rates, which at the time were about 10 to 11 percent tax free. Although he was getting a high interest rate, he discovered that his total return was actually declining rapidly because of the steady attrition in the net asset value [NAV].

He handed me a sheet with about a month’s worth of numbers, and I noticed that the trend was very persistent: the NAV had declined for approximately twenty-two consecutive days. He said, “Fidelity allows you to switch into a cash fund at any time at no charge. Why couldn’t I just switch out of the fund into cash when it started to go down and then switch back into the fund when it started to go back up?”

My reaction was, “Nick, I don’t think the markets work that way. Have you ever read
A Random Walk Down Wall Street?
” I pooh-poohed his idea. I said, “The problem is that you don’t have enough data. Get some more data, and I bet that you’ll find this is not something you could make any money on over the long run.”

He did get more data, and, amazingly, the persistency of trends seemed to hold up. I quickly became convinced that there was definitely something nonrandom about the behavior of municipal bond funds.

How did you perceive that nonrandomness?

In fact, it was the simplest approach that proved the best. We called it the “one penny” rule. In the two years’ worth of data we had obtained, we found that there was approximately an 83 percent probability that any uptick or downtick day would be followed by a day with a price move in the same direction. In the spring of 1980, I began to trade Fidelity’s municipal bond fund in my own account based on this observation.

And that worked?

Yes, it worked exceedingly well.

That’s almost hard to believe. I know that in the bond market, switching a position each time there’s a daily price change in the opposite direction is a disastrous strategy.

That may well be true. However, you have to keep in mind two things. First, there were no transaction costs involved in switching in and out of the fund. Second, there seemed to be some sort of smoothing process operating in the NAV numbers of the municipal bond fund. For example, there was one three-month period around early 1981 when there were virtually no upticks in the NAV of the fund—the days were all either down or flat—while at the same time, the bonds were certainly having some uptick days. In fact, this price behavior was exhibited by virtually all municipal bond funds.

How can you explain that?

I don’t know the answer. Maybe someone can explain it to me some day.

Of course, you couldn’t directly profit during the declining periods, since you obviously can’t go short a fund.

That’s right, during those periods we were in cash.

Given that you could be only long or flat and the bond market was collapsing, were you still able to come out ahead?

When I started in March 1980, the NAV of the fund was approximately $10.50. By the end of 1981, the NAV had steadily eroded to about $5.65—a drop of nearly 50 percent. Nevertheless, using the above method, I was able to achieve gains in excess of 20 percent per year, not counting interest income, which added another 10 percent. The odds appeared to be so favorable that I started to seriously think about how I could get more funds to trade. I ended up taking out four successive second mortgages over a three-year period, which I was able to do because housing prices in the Northeast were rising at a fast clip.

Weren’t you at all reticent about doing that?

No, because the odds were so favorable. Of course, I had to overcome the conventional wisdom. If you tell someone that you’re taking out a second mortgage to trade, the response is hardly supportive. After a while, I just stopped mentioning this detail to others.

If it took only a one-day change in the direction of the NAV value in order for you to get a signal, it sounds like you would be switching an incredible number of times during the year.

Actually, it only worked out to about twenty or thirty times per year, because the trends were so persistent.

Wasn’t there any limit to the amount of times that you could switch? Even twenty to thirty times per year sounds like a high number.

Fidelity’s guideline was four switches per year, but they didn’t enforce that rule. In fact, I even discussed the excess switching with them, and they said, “Just don’t abuse it too much.”

I asked, “What if I make twenty or thirty trades per year?” The reaction was, “Well, don’t tell too many people about it.” My impression was that the rule was there as a fallback provision but that they didn’t worry too much about it—at least they didn’t in the beginning.

As the years went by, I got an occasional letter from Fidelity stating: “It has come to our attention that you are switching more than four times a year, and we would appreciate your cooperating with the guideline.”

Did you just ignore these letters?

No. I would use the municipal bond fund for four trades, then the high-yield municipal bond fund for four trades, and then the limited-term municipal bond fund for four trades, and so on.

So, technically, you did adhere to the four-trades-per-year-rule; you merely switched to different funds.

That’s right.

I assume that, nowadays, the NAV must change direction much more frequently.

That’s right. The next step in my evolution as a trader began when that pattern started to go away—as most of these things eventually do.

The probabilities of a price change in the same direction as the previous day started dropping?

To some extent, but, more importantly, the high volatility started to disappear. During 1979 to early 1984, the volatility in these funds averaged approximately one-quarter to one-half of a percent per day. The daily volatility eventually dropped to only about one-tenth to two-tenths of a percent. Also, the reliability or persistency of the prices dropped from 80 percent to below 70 percent.

What happened when the reliability of the trend persistence and the volatility in the bond funds both started to decline precipitously? Was the method still profitable?

Yes, but the potential annual return in municipal bond funds began to look like about 20 percent.

And that was not good enough?

I really wanted to look for something better. I thought that if I were able to find profitable inefficiencies in municipal bond funds, then it was possible that similar opportunities could be found in equity funds. From the fall of 1984 through the spring of 1985, I practically lived at the local library, extracting years of data on perhaps a hundred mutual funds off the microfilm machine. I was looking for another needle in a haystack.

I found that there were tradable patterns in equity funds but that the prospective returns were only around 20 to 25 percent per year. Even with higher volatility, the daily price persistency of about 60 percent was just not high enough. Through most of this research, I had ignored the Fidelity sector funds, because they charged a $50 fee per switch. I couldn’t see paying this charge when there were so many funds that had no switch fee at all.

Two insights really contributed to a breakthrough. First, I had found early on that commodity-related funds (such as the gold and oil sectors) seemed to work better than more broadly based funds. Second, I discovered separately that the technology, oil, and utility indexes were each significantly less random than a broad market index. I went back to examine the sector funds and was just amazed by what I found. I couldn’t believe that I had ignored sectors during my earlier research. I had almost missed it.