The New Market Wizards: Conversations with America's Top Traders (28 page)

Given your very negative long-term view of the U.S. economy, are you holding a major long position in bonds?

I was long until late 1991. However, an attractive yield should be the last reason for buying bonds. In 1981 the public sold bonds heavily, giving up a 15 percent return for thirty years because they couldn’t resist 21 percent short-term yields. They weren’t thinking about the long term. Now, because money market rates are only 4.5 percent, the same poor public is back buying bonds, effectively lending money at 7.5 percent for thirty years to a government that’s running $400 billion deficits.

The current situation is just the inverse of 1981. In 1981 the public should have seen Volcker’s jacking up of short-term rates to 21 percent as a very positive move, which would bring down long-term inflation and push up bond and stock prices. Instead, they were lured by the high short-term yields. In contrast, now with the economy in decline, the deficit ballooning, and the administration and the Fed in a state of panic, the public should be wary about the risk in holding long-term bonds. Instead, the same people who sold their bonds in 1981 at 15 percent rates are now buying them back at 7.5 percent because they don’t have anything better to do with their money. Once again, they’re not focusing on the long term.

Your long-term performance has far surpassed the industry average. To what do you attribute your superior track record?

George Soros has a philosophy that I have also adopted: The way to build long-term returns is through preservation of capital and home runs. You can be far more aggressive when you’re making good profits. Many managers, once they’re up 30 or 40 percent, will book their year [i.e., trade very cautiously for the remainder of the year so as not to jeopardize the very good return that has already been realized]. The way to attain truly superior long-term returns is to grind it out until you’re up 30 or 40 percent, and then if you have the convictions, go for a 100 percent year. If you can put together a few near-100 percent years and avoid down years, then you can achieve really outstanding long-term returns.

What else have you learned from Soros?

I’ve learned many things from him, but perhaps the most significant is that it’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong. The few times that Soros has ever criticized me was when I was really right on a market and didn’t maximize the opportunity.

As an example, shortly after I had started working for Soros, I was very bearish on the dollar and put on a large short position against the Deutsche mark. The position had started going in my favor, and I felt rather proud of myself. Soros came into my office, and we talked about the trade.

“How big a position do you have?” he asked.

“One billion dollars,” I answered.

“You call that a position?” he said dismissingly. He encouraged me to double my position. I did, and the trade went dramatically further in our favor.

Soros has taught me that when you have tremendous conviction on a trade, you have to go for the jugular. It takes courage to be a pig. It takes courage to ride a profit with huge leverage. As far as Soros is concerned, when you’re right on something, you can’t own enough.

Although I was not at Soros Management at the time, I’ve heard that prior to the Plaza Accord meeting in the fall of 1985, other traders in the office had been piggybacking George and hence were long the yen going into the meeting. When the yen opened 800 points higher on Monday morning, these traders couldn’t believe the size of their gains and anxiously started taking profits. Supposedly, George came bolting out of the door, directing the other traders to stop selling the yen, telling them that he would assume their position. While these other traders were congratulating themselves for having taken the biggest profit in their lives, Soros was looking at the big picture: The government had just told him that the dollar was going to go down for the next year, so why shouldn’t he be a pig and buy more [yen]?

Soros is also the best loss taker I’ve ever seen. He doesn’t care whether he wins or loses on a trade. If a trade doesn’t work, he’s confident enough about his ability to win on other trades that he can easily walk away from the position. There are a lot of shoes on the shelf; wear only the ones that fit. If you’re extremely confident, taking a loss doesn’t bother you.

How do you handle the pressure of managing a multi
billion
dollar portfolio?

I’m a lot less nervous about it now than I was a few years ago. The wonderful thing about our business is that it’s liquid, and you can wipe the slate clean on any day. As long as I’m in control of the situation—that is, as long as I can cover my positions—there’s no reason to be nervous.

According to Druckenmiller, superior performance requires two key elements: preservation of capital and home runs. The first principle has been quite well publicized, but the second is far less appreciated. From a portfolio perspective, Druckenmiller is saying that in order to really excel, you must take full advantage of the situations when you are well ahead and running a hot hand. Those are the times to really press, not rest on your laurels. Great track records are made by avoiding losing years and managing to score a few high-double-digit-or triple-digit-gain years. On an individual trade basis, going for home runs means really applying leverage in those infrequent circumstances when you have tremendous confidence. As Druckenmiller puts it, “It takes courage to be a pig.”

Another important lesson to be drawn from this interview is that if you make a mistake, respond immediately! Druckenmiller made the incredible error of shifting from short to 130 percent long on the very day before the massive October 19, 1987, stock crash, yet he finished the month with a net gain. How? When he realized he was dead wrong, he liquidated his entire long position during the first hour of trading on October 19 and actually went short. Had he been less open-minded, defending his original position when confronted with contrary evidence, or had he procrastinated to see if the market would recover, he would have suffered a tremendous loss. Instead, he actually made a small profit. The ability to accept unpleasant truths (i.e., market action or events counter to one’s position) and respond decisively and without hesitation is the mark of a great trader.

Although Druckenmiller employs valuation analysis and believes it is important in gauging the extent of a potential future price move once the current market trend reverses, he emphasizes that this approach cannot be used for timing. The key tools Druckenmiller applies to timing the broad market are liquidity analysis and technical analysis.

In evaluating individual stocks, Druckenmiller recalls the advice of his first boss, who made him realize that the initial step in any analysis is determining the factors that make a particular stock go up or down. The specifics will vary for each market sector, and sometimes even within each sector.

Druckenmiller’s entire trading style runs counter to the orthodoxy of fund management. There is no logical reason why an investor (or fund manager) should be nearly fully invested in equities at all times. If an investor’s analysis points to the probability of an impending bear market, he or she should move entirely to cash and possibly even a net short position. Recall Druckenmiller’s frustration at being extremely bearish in mid-1981, absolutely correct in his forecast, and still losing money, because at the time, he was still wedded to the idea that a stock manager had to be net long at all times. There is little question that Druckenmiller’s long-term gains would have been dramatically lower and his equity drawdowns significantly wider if he restricted himself to the long side of the stock market. The flexibility of Druckenmiller’s style—going short as well as long and also diversifying into other major global markets (e.g., bonds and currencies)—is obviously a key element of his success. The queen in chess, which can move in all directions, is a far more powerful piece than the pawn, which can only move forward.

One basic market truth (or, perhaps more accurately, one basic truth about human nature) is that you can’t win if you have to win. Druckenmiller’s plunge into T-bill futures in a desperate attempt to save his firm from financial ruin provides a classic example. Even though he bought T-bill futures within one week of their all-time low (you can’t pick a trade much better than that), he lost all his money. The very need to win poisoned the trade—in this instance, through grossly excessive leverage and a lack of planning. The market is a stern master that seldom tolerates the carelessness associated with trades born of desperation.

THE ART OF BOTTOM-UP INVESTING

R
ichard H. Driehaus got hooked on the stock market as a kid, and his enthusiasm for the market has never flagged since. While still in his early teens, Driehaus discovered the folly of following the recommendations of financial columnists. As a result, he decided to educate himself by devouring all the stock newsletters and financial magazines he could find at the local branch library. It was during those childhood years that he began to develop the basic market philosophy that would serve as the core of his approach in his later years as a securities analyst and portfolio manager.

Upon college graduation, Driehaus set out to find a market-related job and landed a slot as a research analyst. Although he liked the job, he was frustrated by seeing his best recommendations ignored by the sales force. Driehaus got his first chance to manage money in 1970 while working in the institutional trading department at A. G. Becker. To his pleasant surprise, Driehaus discovered that his trading ideas were even better in practice than he dared to believe. In his three years as a manager at A. G. Becker, he was rated in the top 1 percent of all portfolio managers surveyed by Becker’s Fund Evaluation Service, the largest fund rating service at the time.

After leaving A. G. Becker, Driehaus worked as a director of research for Mullaney, Wells and Company, and then Jessup and Lamount, before starting his own firm in 1980. For the twelve-year period since 1980, Driehaus averaged an annual return in excess of 30 percent (net of brokerage and management fees), nearly double the S&P 500, return of 16.7 percent during the same period. The S&P 500, however, is not the appropriate benchmark, as Driehaus focuses on small cap (capitalization) stocks. In case you think that Driehaus’s superior performance is related to the better performance of the low cap stocks, note that the Russell 2000 index, which tracks the performance of the 1,001st through 3,000th largest U.S. companies (a group representative of the stocks in Driehaus’s portfolio), was up only 13.5 percent, compounded annually, during the same twelve-year period. One dollar invested in the Russell index in 1980 would have been worth $4.56 at the end of 1991; one dollar invested in Driehaus’s Small Cap Fund would have grown to $24.65 during the same time frame.

Although Driehaus’s flagship investment vehicle has been small cap stocks, he has broadened his scope to include other types of funds as well. He is particularly fond of the concept that underlies his Bull and Bear Partnership Fund. This fund seeks to remove the impact of the general stock market trend by approximately balancing long and short positions on an ongoing basis. In other words, the fund’s market directional exposure is near zero at all times, with performance entirely dependent on individual stock selection. In its first two years of operation, 1990 and 1991, this fund realized back-to-back annual returns of 67 percent and 62 percent (before a 20 percent profit incentive fee payout), with only three out of twenty-four months registering a loss (the largest being a mere 4 percent).

Over the years, philanthropy has become an increasingly important force in Driehaus’s life. In 1984, he started the Richard H. Driehaus Foundation with a $1 million contribution of TCBY (The Country’s Best Yogurt, originally This Can’t Be Yogurt) stock. He manages the foundation’s funds, distributing 5 percent of the total equity annually to a variety of charities. By the end of 1991, the foundation’s capitalization had grown to approximately $20 million.

I met Driehaus on one of his periodic jaunts to New York City for an art auction. The interview was conducted over a leisurely breakfast (apparently far too leisurely as far as the staff was concerned) in the cavernous dining room of a midtown hotel. Eventually, we moved on to continue the interview at a quiet lounge at a nearby hotel, where the dark, floor-to-ceiling wood-paneled walls and antique fixtures provided a century-old atmosphere.

When did you first become interested in the stock market?

When I was thirteen years old I decided to invest $1,000 saved up from my newspaper route in the stock market. My early investments, which were guided by financial columnist and broker recommendations, fared poorly. I had thought that if I followed the advice of professionals, I would make money. I found the experience very disheartening.

I decided to try to figure out what made stock prices move. I started going down to the local library on a regular basis and reading a variety of financial periodicals and newsletters. One letter that had a particularly strong impact on me was John Herold’s
America’s Fastest Growing Companies.

What appealed to you about that letter?

It was my favorite letter for two reasons. First, it showed me the success that could be achieved by buying growth stocks. Herold had stocks in his newsletter that he had recommended ten years earlier that were up tenfold and twentyfold. These were incredible moves to me. Second, Herold’s approach of focusing on earnings growth made a lot of sense to me. It seemed logical that if a company’s earnings were growing over a long period of time, its stock price had to go in the same direction. In his newsletter, Herold displayed charts that superimposed a stock’s price and its earnings over a ten-year period, with both graphs showing dramatic growth. These charts, which basically demonstrated that a stock’s price was in harmony with its long-term earnings growth, became a very powerful image to me.

Was your first job market related?

Yes. After college, I landed a job as a securities analyst for a small Midwestern brokerage firm. To my dismay, I discovered that many of my recommendations were never implemented in the customers’ portfolios.

Why was that?

Because the P/E multiples [the ratios of prices to earnings] were too high. Many of the best growth stocks have high multiples and are psychologically difficult to buy. If the brokers weren’t turned off by the high P/Es, their clients were. Also, I realized that many brokers weren’t portfolio managers but were primarily sales oriented. I found it very discouraging that many of my best recommendations were not being utilized.

After about two years, I left this company to join the institutional trading department of A. G. Becker, which at the time was a very strong force in the Midwestern brokerage business. I published my own in-house recommendation letter for the customers of that department. The company management began to notice that my recommendations were significantly outperforming the stocks in their other portfolios, as well as their own research recommendations. At the beginning of 1970, they gave me approximately $400,000 of the A. G. Becker Profit-Sharing Fund to personally manage. This was my first opportunity to implement my investment philosophy. I was elated.

Did you find that there were differences between actually managing money and simply making recommendations?

No, not really. However, the period when I started managing this account coincided with a bear market in stocks. Consequently, I had to suffer through some early, large losses. This is a good example of why you have to have faith in your approach in order to succeed. For example, one of the first stocks I bought was Bandag, which I purchased at $37. The stock first went down to $22, but then in the ensuing 1971–72 bull market, it went up tenfold.

Did you hold on to the stock for that entire move?

No, unfortunately, I didn’t. About a year later, I was on a business trip and I called my office to check on my stocks. I found out that Bandag was up $5 that day, reaching a new high of $47. I decided to take my profits, with the idea of buying the stock back later. Bandag then proceeded to continue to go straight up to a high of $240 over the next year. That experience taught me that it’s not that easy to buy back a good stock once you’ve sold it. It reinforced the idea that there’s great advantage and comfort to being a long-term investor.

Yet I understand that your average holding period tends to be significantly shorter than that of most other money managers. Why is that?

Although many of the equities in our portfolios are held for a very long period if they’re doing well, you have to be willing to turn over your portfolio more frequently than the conventional norm to get superior performance. I always look for the best potential performance at the
current
time. Even if I think that a stock I hold will go higher, if I believe another stock will do significantly better in the interim, I’ll switch.

In other words, you want the fastest horse, even if your first horse is still trotting in the right direction.

Yes, but even more importantly, I want to make sure I get off the horse if it starts heading in the wrong direction. Most people believe high turnover is risky, but I think just the opposite. High turnover reduces risk when it’s the result of taking a series of small losses in order to avoid larger losses. I don’t hold on to stocks with deteriorating fundamentals or price patterns. For me, this kind of turnover makes sense. It reduces risk; it doesn’t increase it.

How long did you stay with A. G. Becker?

I left in the fall of 1973 to become the research director for Mullaney, Wells and Company, a small regional brokerage firm.

Did they give you money to manage?

No, but A. G. Becker let me continue to manage the account I had traded for them. In addition to that, the woman who reconciled the trades in the A. G. Becker office had seen that I was good at picking stocks. She gave me $104,000 of her own money to manage, which constituted most of her liquid assets.

As I recall, late 1973 would have been a particularly poor time to start a stock account.

That’s right. The 1973–74 bear market was the worst decline since the 1930s.

Were you fully invested?

Yes.

Then I assume the account must have taken a fairly large hit.

At the worst point, I believe the $104,000 went down to under $60,000.

Did your client’s confidence ever flag?

That’s the beauty of it. Her confidence never wavered. She had the strength to stay in. In fact, she’s still with me today. I’ll always be grateful to her for sticking with me when I was young and unproven.

What is her account worth today?

The account is now up to $5.8 million—and that’s after taxes. This stuff really works!

Any trades stand out in your long trading history?

My largest position ever was Home Shopping Network [HSN], which I purchased in 1986. I heard about the stock from one of my analysts whom I had sent to a cable television conference several weeks before the company went public. As you probably know, Home Shopping Network sells low-priced merchandise—clothes, jewelry, and so on—over cable television. They had started this venture about a year before the offering, and in their first six months they had sold $64 million in merchandise and earned $7 million fully taxed. These were about the best results I had ever seen for a new company. Even better, the company still had incredible potential. At the time of the offering, they were reaching only a limited number of subscribers but were adding new subscribers very quickly. The cable systems liked the service because they got part of the profits, so it was easy for HSN to get picked up by new cable networks.

Did you buy the stock on the initial offering?

I wish I could have, but it was very hard to get stock on the deal. I believe we got only one hundred shares. The offering price was $18 per share and the first trade was in the low $40s. I bought most of my position in a range between the low $40s and low $50s.

Wasn’t it hard to buy the stock when it was up so much?

No, because the growth was tremendous, the company was making lots of money, and the potential at the time seemed open-ended. I actually felt very good buying stock at those levels. Within five months, the stock was at $100. During this time, the company continued to build its subscriber base and even purchased television stations to reach more viewers. The revenues and earnings remained very strong.

How long did you hold the stock?

By early 1987, the stock had reached $200. I sent my analyst down to Florida to an investor meeting hosted by the company. Although the management was very optimistic, at the meeting they admitted that almost all the growth was coming from new subscribers and that the growth in order rates from customers on existing cable systems was not that great. About this time, the stock had also started to break down technically. That was all I needed. I sold the stock aggressively and eliminated my entire position over the next few weeks.