Thursday, May 8, 2014

Knifes, Cold Streaks, and Investment Process


I took a knife skills class recently in which the instructor taught us how to use 8 inch cooking knives to break down vegetables to cook.  This guy could dice carrots with his eyes closed. How do you do this without cutting off your fingers?  

Process.

Every single time you start to cook, you hone your knife first.  Every time.  There is no mental dialogue of "Well, maybe the knife is still pretty sharp because I didn't use it that much last time."  No.  You hone your knife EVERY time.  You hold the knife the same way, the right way, every time.  You have your other hand in a certain posture so you are less likely to cut off a finger.  The instructor often had to cut up 60 lbs. of onions in minutes.  Process.

I was involved in this conversation recently:

Trader: "Well, when you're hot, you're hot, when you're not, you're not."
Me: "What do you mean?"

I was thinking he meant the fact that I went from up 9% this year to down 9% over the course of two months, after being up 51% last year, without using leverage.

Trader: "You sold XYZ stock yesterday and now it's up 8% today.  Everyone gets cold streaks."

This is a man who doesn't understand investing at its most fundamental level.  I sold XYZ stock because it hit my stop-loss discipline the day before.  Then, the stock beat earnings and happened to go up the following day.

Did I make a mistake?

No, absolutely not, because I followed my discipline.

I DO NOT GET HOT.  And I don't get cold either.
I follow my process, my discipline.

What is discipline?    Discipline is breaking down your rifle and cleaning it perfectly EVERY DAY, not just the day you expect to see combat.

Discipline is not: "Well, I always sell when my stock is down 20% from my entry point except when I think it still has good fundamentals."  Process is not: "I am on a hot streak because the stock went up more than expected, even though I bought ahead of earnings and it could have gone either way."  Discipline is realizing when you have made money for the wrong reason.

My investment style may go in and out of favor.  EVERY style goes in and out of favor; no style works in all market environments.  But I know, having done this for almost 20 years, and ten of those years with an actual process and discipline, that my method works. (For me.)

The seminal insight in Schwager's "The Market Wizards", one of the best investment books ever written, is that process and discipline matter more than anything.  He interviews a dozen different traders with a dozen different styles and they have only one common element: disciplined process.  The famous "Turtles" were completely that!  The traders that did the best were the ones that were able to blindly follow the discipline, regardless of their emotions.

I often see people on twitter, like a certain famous short-seller, tweet his winning trades.  It goes something like this: "I shorted TSLA at 200 and now I'm covering at 185."  Sometimes they double down, sometimes they don't. No process.  Just randomness.

When people see me about trying to get hired as a hedge fund analyst, especially new MBAs, they always tell me about their investment successes.  "I bought ABC widget Co. at $8 and it went to $16!"  Or "In my PA, my return was 28% last year."  Fine.  Now tell me your process.  That is all I really care about.  I want to know your discipline.  I want to know how you will be able to repeat your performance.  More important, I want to know what you are going to do when you are wrong, when the stock goes against you.

Process is everything.  When I first started at Merrill Lynch, years ago, we used to do HUGE mailings.  We would mail out 5000 letters to invite people to seminars.  I would enlist the help of   admin staff and even college interns.  We folded, stuffed, and labeled 5000 envelopes and took them to the post office.  You know what?  Even in a mindless task, there is always a better, smarter way to complete it.  I could tell a lot about the people just by how they stuffed envelopes.  The smart people were always looking for a more efficient, uniform way to do it.

I went to the Ira Sohn conference recently; I go to a lot of these conferences.  Most people mistakenly think that the value of the conference is the investment ideas.  They can't wait to find out the symbol of whatever Mr. Bigshot Hedgefunder is pitching.  There are armies of people at these events liveblogging and tweeting the stocks pitched, which of course, move right away.

They are missing the whole point.  The reason I go is to learn how these super investors think. Do you really think you are getting their freshest, best idea?  In fact, most of the time, I leave the conference without a single actionable idea.  But what I see is process.  Discipline.  How much work these people do.  How they do it.  How they pitch a stock.  What they look at.  Bill Ackman is a perfect example of this, with his detailed slideshows.  Process.

And when the market gets volatile, the ONLY thing you have is your process.

I don't want to cut off my finger because my knife isn't sharp. When someone is shooting at me, I do not appreciate when my rifle jams because it's dirty.  And I sure as hell am not on a hot streak just because my investment style is in favor at the moment.

Here's a mantra I will share with you:

I do not get hot.  And I don't get cold either.  I FOLLOW MY PROCESS.

Thursday, April 24, 2014

Two Grenades.  In which I throw two grenades square into the public square of conventional wisdom.

Value investors don't usually like tech stocks.  They like durable businesses. Technology shifts quickly; once dominant franchises are utterly destroyed in months.  (Blackberry, Nokia, MySpace, AOL Online, Dell computer, Kodak, the list is long.)

So when a tech stock finally gets "cheap," with a lot of cash flow and cash piling up on the balance sheet, value investors are tempted to buy them.

I am going to argue two positions.

1. Successful tech stock investing is done when the stocks are dear, not when they are cheap.
2. Tech companies should not get credit for huge piles of cash on their balance sheets.

Let me take the second argument first.

Apple has had billions of dollars in cash on their balance sheet over the last decade as the company has become a success, first with the iPod 13 years ago, and then with the iPhone seven years ago.  Seems like just yesterday that Steve Jobs was introducing this special iPod with internet access; now iPhones are a requirement of daily life.

Tim Cook, CEO of Apple, just said that outgoing CFO P. Oppenheimer was one of the greatest ever, having amassed a perfect ten year record of always meeting guidance.  How did he do it?  By sandbagging guidance so ridiculously low every quarter that it was useless for analysts.

What else did the CFO do that was disastrous?  Instead of using the excess cash to buy back stock when it was $100 per share, and even $200, $300 per share, he let it pile up.  What did he earn on that cash?  Nothing.  This was during the period of lowest interest rates in our lifetimes.

It was the functional equivalent of Apple requiring stacks of $100 bills under every software engineer's desk instead of table legs, to hold up their desk.  It was if the HQ of Apple was built out of c-notes instead of brick.

A company that sits on cash for a decade is implying that they NEED that cash to do business.  Even casinos don't keep this much cash laying around.  And how attractive are businesses that require billions of dollar in cash to operate?  Not very.  Ask Warren Buffett about this.

Definition of a good business:  a business that takes very little capital to create tremendous profits.

So I know what you're thinking- "well, Apple stock did pretty well all that time."  Sure, they did.  But they peaked at $702 almost 2 years ago and are still 20% below that level while the S&P is up about 30%.  Imagine what Apple stock would be trading at now, if the CFO had dollar-cost averaged that cash in along the way, like individuals are supposed to do with stock market investments?  The math is simple- the stock would be double the price it is at today.

There are countless examples of tech companies that are successful, pile up cash, and instead of admitting that they don't need that much to operate, blow it on bad acquisitions.  So at least Apple didn't do this.

So CFO Oppenheimer is not a complete value destroyer, only partially one.  So not a thief, just incompetent.

So tech companies DO NOT get credit for cash.  You CANNOT say "well, AAPL stock is trading at 8x p/e ex the cash."  That's like saying a company is trading 8x p/e ex all the needed capital equipment they need to run the business.

Let me use one last analogy.  If you were going to open a frozen yogurt shop in NYC and you needed a business loan, and got one for $20k and made $100k in annual profits, that would be a pretty nice little business.  If I ran the exact same business, but instead I needed $120k business loan, because I wanted to keep $100k in the safe just to feel better, and did the same $100k in profit, I think we could agree that would be a terrible business.

TECH COMPANIES DO NOT GET CREDIT FOR CASH.

OK back to the first principle: quite simply, you can't make big money in cheap tech stocks.

The list is long.  In every single super growth story in tech, the stock was trading at a high multiple during the growth phase, and then once the multiple was cheap or the same as the S&P, the stock no longer went up.  CSCO, MSFT, AAPL, GOOG, ORCL, TSLA, AMZN; the list is long.

I'm not saying you have to buy dream pie in the sky tech stocks to make money.  But to make the real money, the big, long term, stock up 500% over a few years money, you have to buy the stocks when they are at above market average multiples.

Buying "cheap" tech?  Well, you can do it for a trade, I'm sure.  But then if you are trading ups and downs within trading ranges, just trade commodities and save yourself the work of listening to conference calls.

BUYING CHEAP TECH DOESN'T WORK.

Tech stocks become cheap because the growth prospects are gone and they are market or GDP growers.  AAPL grew revenue by 4.7% last quarter.  The multiple is 12.  When it was still growing 60% per year it had a 45 p/e.

Yes you can find exceptions- of course!  But in general, do not get lured in to buying cheap tech thinking it will work.  You can make market-like returns, but you will never make huge returns buying cheap tech stocks.

Many investors mistakenly buy broken cheap old tech like IBM or CSCO because they remember the glory days when everyone was making double their money every couple of years in the stocks.  If you were not invited to the wedding, don't go to the funeral!

As a tech investor, I must be paid for risk.  Tech stocks will ALWAYS be riskier than other stocks because their franchises are rarely durable.  Rock solid platforms become obsolete.  Who would have dreamed Microsoft Windows would not be the dominant computing franchise?  Who would have imagined that a web site started in a dorm room would have a billion users and be threatening TV for ad space?  Who would have thought 2 Stanford grad school students would create a web site that would destroy the newspaper industry?

Tech investors need to be aboard huge, insanely successful enterprises. Examples from the past are DELL, CSCO, MSFT, AAPL and recently TSLA and FB.  Bigger risk, must have bigger potential reward.

I invite your comments, gripes and rumors.

Thursday, February 27, 2014

Good Things Happening.

I'm amazed at the contempt for this bull market.

I offer for your contemplation a list of good things.

Please offer your feedback and comments to me on twitter.

My twitter is @dasan.

Thank you.

Good things happening:
·         China and Taiwan talking, defusing tensions
·         New Fed chair is boring and steady; good transition 
·         Employment getting better- down to 6.6%
·         Rates in Italy and Spain low.  Euro crisis over.  Italy 10-year pre-crisis lows
·         Greece stable
·         Japan Nikkei up a lot last year- Japan has real economic change
·         Gas and oil production high in the US. Prices reasonable
·         Middle East calming: even Iran talks
·         China slowing but not collapsing- takes pressure off commodity prices
·         House passed a budget deal to avoid standoff
·         House prices in US have rallied enough to help consumer and bank balance sheets
·         There is a 50% chance of a budget surplus in the US in 2016
·         Supply and demand for stocks is favorable: only 3665 companies in the Wilshire 5000- net decline in listed stocks- was 8k, now 5k, not many IPOs last few years
·         Very modest inflation in commodities and consumer products such as clothing
·         High-profile people in finance are arguing the market is overvalued (Shiller, Klarman)
·         Number of people quitting their jobs is up , 1.8% quit rate, Sept 09 low was 1.2%, which indicates loosening job market and increased confidence
·         M&A is picking up as companies are more willing to use their cash for growth
·         CAPEX projections by companies in most industries are up due to increased confidence




Thursday, January 16, 2014

The 180 Rule and shorting stocks.

This little essay is not to show how smart I am or to try to tell you how to trade stocks.  It is written for my favorite audience:  myself.  I decided to share it with you in case you have better ideas that you would like to share with me.  I also thought maybe, just possibly, you might benefit from my thoughts on the subject of shorting stocks, and my own creation, “The 180 Rule.”

What is a 180?

As a kid, I had almost no athletic ability whatsoever.  Too small for football, too short for basketball, too lazy for track, I stuck to what would today be called “X Games.”  I skied, surfed and most of all, skateboarded.  I had a cool plasticky board with double kick tails, called a Freeformer.  When you are skating along, and you completely turn 180 degrees in the opposite direction, you have performed “A 180.”  At least that’s what we called it.

So back to stocks for a moment.  There are two basic types of stock market portfolio managers out there today. Long-only, and long-short.  Long-only means the PM is trying to pick good stocks in his sector or market-cap weighting, to “beat the market.”  In actuality, most long-only funds are thinly veiled index funds.  Think of the Fidelity or American Capital mutual funds.  The biggest bets they make are to be slightly off in their weightings on a stock versus their benchmark.  They charge customers a management fee of 1-2% and that’s it.  If they make great returns by riding out a bull market and picking slightly better weightings than the index, then they benefit by advertising those returns and attracting more assets.  They actually have very little “skin in the game.”  It’s OPM (other people’s money) and they don’t get an incentive fee for doing well.  They DO NOT short stocks.  Their job: kind of easy. (Now I’m sure somebody reading this is getting offended right now, but you know I’m right.)

So what about equity/long short fund PMs?  They have a different whole game.  They charge a management fee PLUS they get 20% of the gains they make for their customers.  They have much more concentrated positions, and most important, they SHORT STOCKS.  Or at least they are supposed to – a lot of the lazy PMs simply are long-only funds in drag- they just short index ETFs against their longs and call it a hedge.

What is so great about shorting stocks?  Let’s think about this for a minute.  If I think I can beat the market through buying stocks that will outperform the general market, why can’t I also, while doing my research, find stocks that will underperform? In EVERY market, even 2013’s bull market, there are stocks that go down.  Industries, especially in technology, are affected by change and fortunes of companies rise and fall.

So isn’t isn't a lot of my research wasted if all I can do when I find a company that will decline is say “well, I just won’t buy that one?”  Also, think about this.  Let’s think about an ideal world in which during my research, I find 10 stocks I really like and 10 stocks that should underperform the market, or even drop.  Imagine how cool it would be to be long 10 and short 10 in equal proportion, so that I would have ZERO exposure to the vagaries of the overall market?  I could wake up blissfully ignorant of the level of the S&P, and just watch as my longs went up and my shorts went down.  What is my return on capital in this perfect scenario?  Almost infinite.

Or look at it another way.  I have $100 million to invest for my clients and I can’t take on any leverage, by policy.  I find my longs and now I’m stuck.  Wait a minute, I can still increase returns!  I can basically short as much as I want.  Any short idea that I find is essentially “Free capital” because it is opposite to my longs and does not give me more (net) exposure to the market.

I typically run 100% long, 35% short, to net out at 65% net long.  So in theory, I have less exposure to the market as a whole, but can make money both ways.  And I have!  Even in 2013, stocks like DLR, RAX, and IBM plummeted while the overall tech market went up.
So what’s the catch?

SHORTING STOCKS IS HARD.

That’s the catch.  It’s hard.

Most people, especially long-only people, do NOT know how to short stocks.

Shorting a stock is not the opposite of finding a good long.  You may want to long a stock with a low P/E but you most definitely cannot only short a stock because the stock has a high P/E.  Just ask investors in TSLA, NFLX, and AMZN how well shorting high P/E (high growth) stocks worked out for them.

A quick guide (10 ideas) on shorting stocks.
1. Don’t short on valuation alone.  Death, this approach.
2. Crowded shorts are subject to short squeezes.
3. When a short works, your position gets smaller so you have to press it.
4. When a short goes against you, your position gets bigger so you get punished more and more.
5. Accounting frauds are good shorts, but you still need sangfroid because they can go on for a long time before they blow up.
6. Smarmy managements can do a lot of things to mess with shorts, such as buybacks, puffery, raising the dividends, putting out bogus press releases, and reporting poor quality earnings.
7. Tech obsolescence shorts are great but sometimes take longer to play out than you think.
8. Whenever the market is up big with massive breadth, the long-only guys will buy the heck out of your shorts and you will underperform that day.
9. My favorite shorts are accounting issues, tech secular shifts which cause obsolescence, and bad managements.
10. You are always fighting the crowd when you are short because all of Wall Street is set up to make stocks go up and to tout them and to make up reasons why you’re wrong.

So what is the 180 Rule?

This one is so easy to explain that it will seem logically obvious to you.  You may wonder why everyone isn’t doing it.  So here it is:

“When I fundamentally change my thesis on a stock because of new information, which makes me decide to sell my stock, I should consider shorting it as well.”

Let’s dig further.  I own ACME Cool Tech Gadget Co. and I have been making money on the stock.  My thesis is that ACME has a great market position and that their new Gadget is going to be obscenely profitable or whatever.  Then, all of sudden comes some facts that prove to me that I’m wrong.  I am NOT talking about the stock dropping for no reason or for some other reason.  This is a key point.  If my thesis is intact and the stock drops, I may have to revisit my thesis, but this is not what I am talking about.  I mean, I have new information which makes me think, gosh, you know, I may be wrong here and I think I’ll sell ACME.  Fine.  Most people.  Wait, 99.9% of people at this point just sell the stock, book profits and smile.

Then, the next few days when the stock drops, they lean back and smile.  They might even have a glass of champagne or two.  Three months later, when the stock is way down and it is obvious that they were right, they are happier yet.

BIG MISTAKE.

If the PM sells ACME because they think it will go down, why didn’t they also short it?  Then they would make money on both sides.  Imagine the annual rate of return if a PM did this at least once in a while.  This is a critical rule for amping up performance.  Why doesn’t everyone do it?

BECAUSE IT’S HARD, THAT’S WHY.

It’s mentally so difficult to be so cerebrally flexible that no one does it.  A day ago, you loved this stock.  You had good feelings about it, nice warm emotions.  You know a lot about it.  You might like the products.  Maybe you met the management and they are a bunch of nice guys.  Hell, you even made money on ACME.  “ACME stock sure has been good to me.”  DISASTER.  Do you see how emotional you are?

“When the facts change, I change my mind.  What do you do, sir?” said John Maynard Keynes.

It is so hard emotionally to do this 180 that no one does it.

When I went back and analyzed my trading records over a few years, I would have dramatically improved my performance had I followed the 180 rule every time.

Does it always work? Of course, not.  No trading always works.  Only 55% of my trades were winners in 2013, even during a raging bull market.  So you still have to follow your stop-loss discipline.  There is no magic to this rule.

But know this:  you are not playing The Game to your fullest ability if you don’t follow the 180 Rule.

Notice how the rule says “consider” shorting?  I don’t always want to do it.  Here are some reasons why.  If ACME stock has gone from a 6% to a 12% position because I was lucky and brilliant and got the story right, I will usually cut the position back.  This is not a case of the 180 rule.  I’m selling even though the thesis is intact, only because of portfolio sizing.

Now sometimes you might say, “Well, I’m just going to a neutral on the stock, so I’ll sell it and leave the money on the sidelines for now.”

First of all, I don’t get along real well with analysts that are “Neutral” on stocks.  What are you, Switzerland? This isn’t politics at a tea party.  Do some work and get an opinion.  When people on Wall Street tell me they are “neutral” that is code word for either “I haven’t done the work” or “I have no courage.”  (I was going to say I have no b---s, actually.)

So if I’m long ACME and I’m getting a bit skittish, then I think to myself BEFORE I EVEN SELL IT, should I do the 180 Rule here?  If I answer to myself (I talk to myself a lot, at least in my mind) “No, I wouldn’t short ACME,” then I won’t even sell it.

See the power of this rule?  It not only helps you make money on shorts, but it helps you clarify your sell decisions in the first place.  I strongly believe THE BIG MISTAKE is selling winners too early.  For every time I have round tripped a stock, I can name times when I rode a stock to 2, 3, even 5 times gains.  Find good stocks, buy them and hold on to them, says Warren Buffett and he’s doing pretty well for himself besides eating at that awful steak house in Omaha.

THE BIG MISTAKE of selling winners too early can be mitigated by following the 180 rule.  If I told you that you HAD TO short every stock that you decided you wanted to sell, I guarantee you that you’d hold on to a lot more winners.

The Game is a perpetual mindf—k full of mental mazes and torrents of emotions.  Even if you use the 180 Rule, you will find ways to convince yourself that you are really selling a stock for some reason, when the truth is you are selling because the stock is down a lot that day.  It’s a tough game.  It’s OK to just say “this ACME is too hard.  I know I’m right but it’s too volatile for me and I can’t handle fighting the crowd on this one.”  In fact, after making a ton of money on Pandora (P) in 2013, I said this very thing and sold it.  I followed the 180 Rule- I DID NOT short it because my thesis had not changed.  I just did not have the constitution to fight everyone that said Pandora was expensive and how everyone else was going to beat them.  The stock went up 35% in the first 2 weeks of 2014 after I sold it.  I was right, but I don’t feel that bad, because I sold it because I was a coward. But at least I admitted to myself that I was a coward, so there’s that.

(By the way, the 180 Rule also works the other way around- if you are short a stock and cover, you should consider going long.  My best examples of this are NFLX and GME, both of which I was short in 2012 and was long all of 2013.)

If you found this helpful at all, or if you think its complete bulls—t, hit me up on Twitter.  I would love to hear your comments.  I am @dasan.

Tuesday, December 10, 2013

Twelve Style Tips for Gentlemen

Twelve Style Tips for Gentlemen

  1. No khaki pants.  Especially with cuffs on the bottom.  In fact, no pants at all with cuffs on the bottom.  Only wear Dockers khakis if you want to ensure your bloodline dies with your present generation or if you are going for the lumpy dad effect.  Add a blackberry holster to make the look complete in that case.  For the rest of us, no khakis!
  2. No polo shirts.  No mortal man looks good in a polo shirt, even if he is on the back of a lumbering horse with a mallet in his hand.  The only time I’ve ever seen a polo shirt look good on a man was the last time Tiger Woods wore his red polo shirt on the final holes of the Masters when he won by 14 strokes.  I think that was back in 1997.
  3. No baseball caps.  Unless you are Russell Simmons- then you can get away with it. Or if you are Derek Jeter on the field at Yankee Stadium. Otherwise you look like a “bro.”  Speaking of “bros”…
  4. No oversized sports team jerseys.  Unless you are on the ice pounding someone against the boards, no hockey jerseys. A gentleman does not dress like this.  Unless you have one of those plastic hats that holds two beers with tubes to your mouth and you are tailgating in the parking lot of taxpayer-funded pro football stadium, just don’t do it.
  5. No cheap watches.  This includes sporty marathon or G-shock watches.  No plastic watch should be on your wrist, unless you are screaming around on a fixie in a crit in Red Hook.  If you are running the Iron Man in Kona, you can wear an Iron Man plastic watch and look good. If you are showing up to a place of employment or are out for dinner, wear a real watch.  If you can’t afford one, save your pennies until you can afford one.  No watch is better than a crappy watch.
  6. Details matter.  Wear decent socks with no holes in them.  They don’t have to be black.  Wear a decent belt. Add a pocket square instead of a tie.  Don’t try too hard with folding the pocket square- just fold it in quarters and have a little sprezzatura.
  7. Get a suit that fits.  In fact, make sure all of your clothing fits.  I’ll take a $300 suit that fits well over a $3000 suit that bunches around the ankles and looks like it’s your dad’s suit.  Most men wear suit jackets that are too big.  Unless you’re an NBA player, get a suit that fits.
  8. Wear decent underwear. Women know how important this is.  Why don’t we men?  Even if no one but you notices, you will feel better and walk the city streets with some pep in your step knowing that you aren’t wearing some worn-out tighty whiteys. Sorry, Fruit of the Loom is not a cool brand. I’m partial to 2Xist but it may just be a phase I’m going through.
  9. Shine and take care of your shoes.  Shoes are tires on a racecar.  Get your shoes re-heeled.  Shine them weekly.  Successful people notice a man with poorly maintained shoes.  It implies lack of attention to detail and it ruins your whole look.
  10. Plain t-shirts only.  I have violated this one with a vintage black Rush concert T-shirt or two, but that’s just nostalgia.  No “I’m with stupid” t-shirts or stupid slogans.  A plain black, grey or blue t-shirt looks classic.  Dress like a man.
  11. Upgrade your wardrobe constantly.  Better, not more. Even men’s clothing styles do change over time.  Dispense with the misguided man rule that says you must wear an item of clothing until it is threadbare.  When you buy a new shirt, get rid of the oldest one in your closet. It’s also a great idea to buy a new shirt when going out with someone you’d like to impress.  The shirt will never look better than the first time it’s worn. It’s OK, really, you don’t have to still wear that 3” wide tie that you wore to prom.
  12. Get a decent haircut.  Shave the hair off your neck between trips to the barber.  Nothing ruins a great haircut like hair growing down your neck like a neanderthal.

Tuesday, November 26, 2013

IDEA VELOCITY. What I learned from SAC.

SAC, the infamous hedge fund led by mercurial, secretive, super art collector Stevie Cohen is legendary. They have recently been accused of insider trading and it sure looks like they are guilty.  But there are a lot of very smart people that worked there that had nothing to do with this scandal. PMs and analysts in Hedgistan dream of toiling there and making obscene riches.  As an unabashed trading addict and player of The Game, I was like a moth to the flame.  I had to check this place out.  I did.  Although by dumb luck and a well-calibrated BS detector, I was able to avoid joining them, I did meet with them over a dozen times.  I learned some principles that have changed my way of trading forever.  For the good.  Out of a spirit of equanimity and gratitude, I will share them with you.


1. RULE ONE: IDEA VELOCITY.  This is so important and it will seem so obvious after I tell you that you will wonder why no one talks about it.  Let’s do some math.  Let’s say you’re a long-short PM and you typically have 15 longs and 8 shorts at any given time.  Call it 25 positions.  If your average holding period is 6 months because your portfolio turns over twice a year, which is fairly typical for an actively managed stock fund, that means you need 50 positions per year.  That is one high conviction idea per week!  That doesn’t sound like all that much, but tell me, do you really have a discipline in place to come up with at least one, highly researched, well-thought out, high conviction idea per week?  I’m not talking about being pitched a quick stock pick by the sell-side either.  .  In tech, things change fast, and sitting on winners that have stalled out too long is a mistake.  It’s also called complacency.  The only way to know these numbers, such as your average holding period, number of positions, is to analyze your trading records ruthlessly and honestly. This is the concept of IDEA VELOCITY.

2. POSITION SIZING.  When you find an idea, a high conviction stock idea, how do you build your position?  Do you scale in?  Do you buy half and another half later after you see how the stock trades?  This is what most investors do.  TOTALLY WRONG.  That’s right.  If you have a high conviction, well-researched idea, what is the point in putting on only a half position?  If your original position drops by 15%, what do you do, buy more?  Does that make any sense?  Or if it goes up after you buy it, yes, it makes sense to buy more, but didn’t you just lose the gains you would have had if you had the cojones to buy the whole position at once?  Furthermore, what are you doing putting on a “half position” if you don’t have the conviction to put on a full position.  So when you put on a position, do it all, at once, one day.  POSITION SIZING- the key to good performance.

3. CASH IN THE PORTFOLIO.  How much cash should you carry in your portfolio?  Most PMs will play around with the amount of cash in their fund.  Some even brag about how their performance for is all of the S&P upside while being only 65% invested, because they are holding 35% in cash.  What kind of stupid logic is this? If I’m paying you 2 and 20 to invest my money, then invest it all!  This is the key concept- INVEST IT ALL!  If you are so good that you can get all of the S&P returns with 35% cash, then just give me the cash back so I don’t have to pay 2% on the cash.  Let me make my own asset allocation decisions. So an equity long-short fund should be 100% long and some portion short.  In SAC case, they would prefer PMs be no more than 15% net long, so that meant they would be 100% long and 85% short for example.  I’m not advocating that.  But I’m saying equity funds should not carry more than a minimal amount of cash.  If you don’t have ideas for the money you’re managing, you need to re-read rule number one, IDEA VELOCITY.

4. SHORTING INDICES.  Many fund managers think they are great stock pickers.  Actually, we all do, by definition, because we are charging people for our great skills- otherwise they could cheaply invest in an unmanaged index.  But these same managers decide they will pick the longs in the fund and then use an ETF to short against the longs, as a “hedge.”  WTF kind of backward thinking is this?  So you can pick what stocks will go up, and not the stocks that can go down?  Does this make any sense?  Then the clever among this group will argue with you that because the market goes up over time, it’s important to spend time on longs and “hedges always lose money.”  NONSENSE.  Even in a bull market there are stocks that are going down. (Do you need examples?  IBM, “Big Blue,” the bluest of the blue chip techs,  is down 8.5% as I write this, versus the NASDAQ up 33% for the year.) I’ll tell you what- if you want to play with indices, and you tell me the market goes up most of the time, I will suggest that you LONG the index and spend all your time finding individual name shorts instead.  Did your brain just blow a fuse?  Let me suggest the best approach and that is pick longs and shorts and never short an index.  If you don’t have enough shorts, because “Shorting is hard” and all that, then go re-read RULE NUMBER ONE.

5. COLD STREAKS.  SAC is ruthless, because they employ a lot of leverage.  When one of their PM has a big drawdown, they tell them to slow down.  This is the one case in which a PM will carry more cash.  Or quite simply get some of their assets pulled from them.  So let’s say you’re cold, your strategy and discipline is not currently working, and you need to cut back your positions.  What do you do?  TRADE SMALLER.  So that means keep making new trades.  Don’t freeze up.  Did Jordan quit shooting when he got cold?  So if you are going to cut your portfolio in half, say, to quell the bleeding, how do you do it?  Most people will say, “well, I’ll cut my lowest conviction positions and keep the ones I really like.”  Wait a minute- more stupid logic.  What business do you have holding ANY low conviction positions?  The right answer is you cut your entire portfolio in half, equally, across the board.  If you have low conviction positions, you haven’t been following RULE ONE- IDEA VELOCITY.  

So perhaps it’s obvious to you now how important the idea of IDEA VELOCITY is to a trader/investor.  It’s the underpinning of everything in The Game.  You have to work VERY HARD to come up with high conviction ideas every single week.  The hours you have to put into this Game and the mental horsepower and the emotional toll are all much, much greater than most people realize.  You can see why some of them wanted to cheat, to cut corners.  This is a tough game.  You know what?  SAC didn’t need to cheat.  If they all would have stuck with these principles, they would be thriving today.  You can adopt these principles into your trading regimen and improve your performance.

Monday, March 25, 2013


UPDATED RULES OF “THE GAME”

1. Time horizon is one year, not one day
2. Sangfroid wins.  Equanimity is more important than anything else
3. Make your own decisions; listen to yourself
4. When you sell a long, consider a 180 and shorting it (and vice versa)
5. Don’t buy a stock right ahead of an earnings call
6. Your performance is better when you don’t listen to underperformers.
7. Listen to analysts only for potential stock ideas- and do my own work
8. Don’t agree and don’t argue (when you differ in opinion)
9. Be humbly confident when things go your way.  Say “I got lucky this time”
10. Ego has no place here.  Trade to make money, forget pride.
11. Act without full information, while doing efficient work
12. It’s OK to make mistakes.
13. Correct mistakes early- sell on missed earnings/changed thesis, and buy back something you’ve sold if things change.
14. Learn every day- build a new sheet - read filings- listen to calls
15. Don’t worry too much about what the crowd thinks
16. Don’t waste too much time on big Macro
17. “Sometimes you have to let the other guy make some money too”
18. Worrying is not doing
19. Don’t be a second-guesser or let them hover around you
20.  Sometimes you have to suffer first before you win.
21.  Just because the majority agrees on something doesn’t mean they’re right.
22.  Focus on The Game