Stock Market Wizards

Interviews with America’s Top Stock Traders

Book by Jack D. Schwager

Article and Review by GlobalMacroForex

Jack D. Schwager is known for getting the best candid and useful answers out of some of the top hedge fund managers in the business.  In this easy but informative read, he focuses on equities.  Some of the traders interviewed focus on a value-oriented approach, others use flaws in options pricing, there’s a 100% short seller, and some even have technical patterns.  This summary article covers only a handful of the many interviews and only a few points from each.  Let’s dig in…

Steve Watson

Steve Watson likes to buy stocks that are about to benefit from a catalyst.  It can’t just be a low P/E stock because it can just sit there or be cheap because it sucks.  There has to be a change in the market’s perception, which he calls a catalyst.  He gives the example of Windmere bought a Black & Decker division but overpaid.  He noticed the higher operating costs dragged down earnings, which made their shares sell-off.   Watson bought it cheap after when they announced they’d close down the unprofitable facilities, which he thought would be the catalyst to rocket the earnings up. 

To find the right company, he calls management, talks to their competitors, consumers, distributors, and even tries the product. If it’s a store chain, he’ll visit their stories.  He tries to figure out what the actual market thinks about the company, not what Wall St thinks.  Then compares these two perceptions.

Dana Galante

Dana Galante is a 100% short seller.  For her to short a company, she feels all 3 of these catalysts must be met:

-very high P/E

-a catalyst that makes the stock vulnerable over the near term

-an uptrend that has stalled or reversed”

One of the biggest red flags in a company (that would make a good short for her) is if they have high receivables.  This usually indicates they have some artificially inflated revenues by management recognizing revenue too early.

She gives the example of Pegasystems a software company that licensed software for a monthly fee.  However, they were recognizing 5 years of revenue right away just by discounting the future cash flows.  This isn’t standard practice and she knew right away it would be a good short when they changed their accountants.  Typically a change in accountants means the old auditors weren’t okay with certain assumptions.

Ahmet Okumus

Ahmet Okumus is a picky value investor.  He will go through periods of time with as little as 13% of his assets allocated and the rest in cash if he can’t find what he is looking for.  He never buys stocks that just made a new high, instead preferring a deep discount of 60% off their highs and a P/E under 12.  In addition, he likes it to be sold at or near the book value.  By only getting companies at such a deep discount, he sets himself up for a very high probability of gain and a very low level of risk.

Then when the shares decline, he usually buys more instead of cutting his losses.  One great way for him to do this is by selling out-of-the-money puts.  This allows him to scoop up the shares when

they decline in price while collecting the up-front premium.

John Bender

John Bender likes to trade options because they allow him to structure trades that profit from mispricings.  He says options are often mispriced because the Black-Scholes model uses a standard normal curve, and in the real world prices don’t have an equal chance of going up or down.  He gives a lot of examples of this.

One example comes from technical resistance when the price hits the support or resistance, it’s much more likely to go back into the trading band then rocket out of it. 

He also gives the example of stock market rallies (bubbles) like the tech market.  The rise itself feeds more buyers, which will send the prices higher or plummet down.  It’s not likely to be only down a tiny drop.  For example, he designed an options plan in 1998 for IBM that would profit small on an upswing, lose small on a small downswing, but profit largely on a huge move down.  When IBM went down 20%, he got a nice return.

Another example he gives of these sharp moves down is more likely than small moves down is in Gold.  It was trading at $405 and many commodities advisors were advocating it.  Bender thought if it went down, it would plummet since going below the $400 psychological level would debilitate these commodities advisors with tight stops.  However, at $400 was a support level.  So similar to IBM he designed a strategy to profit from large moves down, but take loses on small moves below $385.  It ended up dropped to $360 right away on Russia announcing it would sell gold.

Conclusion

There are many more interviews that were not covered at all in this brief summary article.  In addition, each of the interviews had way more useful information that we didn’t mention.  This book highlights the variety of investing styles that are possible and gives you many ideas about how to develop your own path.