Imagine two swimmers a mile apart on a river who decide to have a race, each swimming to the other’s starting point. There is a strong current. The swimmer heading downstream wins. Is she the better swimmer? Obviously this is a nonsensical question. An Olympic swimmer could lose to a novice if the current is strong enough.
Now consider two money managers: one only buys stocks and is up an average of 25 percent per year for the period while the other only sells stocks and is up 10 percent per year during the same period. Which manager is the better trader? Again, this is a nonsensical question. The answer depends on the direction and strength of the market’s current—its trend. If the stock market rose by an average of 30 percent per year during the corresponding period, the manager with the 25 percent return would have underperformed a dart-throwing strategy, whereas the other manager would have achieved a double-digit return in an extraordinarily hostile environment.
During 1994–99 Dana Galante registered an average annual compounded return of 15 percent. This may not sound impressive until one considers that Galante is a pure short seller. In reverse of the typical manager, Galante will profit when the stocks in her portfolio go down and lose when they go up. Galante achieved her 15 percent return during a period when the representative stock index (the Nasdaq, which accounts for about 80 percent of her trades) rose by an imposing annual average of 32 percent. To put Galante’s performance in perspective, her achievement is comparable to a mutual fund manager averaging a 15 percent annual return during a period when the stock market declines by an average of 32 percent annually. In both cases, overcoming such a powerful opposite trend in the universe of stocks traded requires exceptional stock selection skills.
Okay, so earning even a 15 percent return by shorting stocks in a strongly advancing market is an admirable feat, but what’s the point? Even if the stock market gains witnessed in the 1990s were unprecedented, the stock market has still been in a long-term upward trend since its inception. Why fight a trend measured in decades, if not centuries? The point is that a short-selling approach is normally not intended as a stand-alone investment; rather, it is intended to be combined with long investments (to which it is inversely correlated) to yield a total portfolio with a better return/risk performance. Most, if not all, of Galante’s investors use her fund to balance their long stock investments. Apparently, enough investors have recognized the value of Galante’s relative performance so that her fund, Miramar Asset Management, is closed to new investment.
Most people don’t realize that a short-selling strategy that earns more than borrowing costs can be combined with a passive investment, such as an index fund or long index futures, to create a net investment that has both a higher return than the index and much lower risk. This is true even if the returns of the short-selling strategy are much lower than the returns of the index alone. For example, an investor who balanced a Nasdaq index–based investment with an equal commitment in Galante’s fund (borrowing the extra money required for the dual investment) would have both beaten the index return (after deducting borrowing costs) and cut risk dramatically. Looking at one measure of risk, the two worst drawdowns of this combined portfolio during 1994–99 would have been 10 percent and 5 percent, versus 20 percent and 13 percent for the index.
Galante began her financial career working in the back office of an institutional money management firm. She was eventually promoted to a trading (order entry) position. Surprisingly, Galante landed her first job as a fund manager without any prior experience in stock selection. Fortunately, Galante proved more skilled in picking stocks than in picking bosses. Prior to founding her own firm in 1997, Galante’s fourteen-year career was marked by a number of unsavory employers.
Galante likes trading the markets and enjoys the challenge of trying to profit by going the opposite of the financial community, which is long the stocks that she shorts. But the markets are an avocation, not an all-consuming passion. Her daily departure from the office is mental as well as physical, marking a shift in her focus from the markets to her family. She leaves work each day in time to pick up her kids up at school, a routine made possible by her western time zone locale, and she deliberately avoids doing any research or trading at home.
The interview was conducted in a conference room with a lofty, panoramic view of the San Francisco skyline. It was a clear day, and the Transamerica building, Telegraph Hill, San Francisco Bay, and Alcatraz stretched out in front of us in one straight visual line. The incredible view prompted me to describe some of the palatial homes that had served as the settings for interviews in my previous two Market Wizard books. Galante joked that we should have done the interview at her home. “Then,” she said, “you could have described the view of the jungle gym in my backyard.”
Note: For reasons that will be apparent, pseudonyms have been used for all individuals and companies mentioned in this interview.
When did you first become aware of the stock market?
My father was a market maker in the over-the-counter market. When I was in high school, I worked with him on the trading desk during summer vacations and school breaks.
What did you do for him?
In those days, although we had terminals, we didn’t have computers. Everything was done by hand. I posted his trades while he was trading.
Did you find yourself trying to anticipate market direction?
I don’t really remember, but I was never really obsessed with the market, like a lot of the people that you have written about. I like the market, and I think it’s exciting and challenging, but I don’t go home and think about it.
What was your first job out of college?
I worked for Kingston Capital, a large institutional money management firm. I started out doing back office and administrative work. Eventually, I was promoted to the role of trader, and I did all the trading for the office, which managed one billion dollars.
By trader, I assume you mean being responsible for order entry as opposed to having any decision-making responsibility?
That’s right, I just put in the orders.
What was the next step in your career progression?
In 1985, Kingston was taken over in a merger. The acquiring firm changed everyone’s job description. They told me I couldn’t do the trading anymore because it all had to be done out of New York. They wanted me to move into an administrative role, which would have been a step back for me.
Henry Skiff, the former manager of the Kingston branch office, went through an analogous experience. He was shifted to a structured job that he couldn’t stand. He and another employee left Kingston after the merger to form their own institutional money management firm. Henry offered me a job as a trader and researcher. Although Henry was a difficult person to work for, I liked the other person, and I didn’t want to go back to an administrative position.
I left with Henry and helped him start the office for his new firm. I did research and trading for him for two years. Although it was a good experience, I realized my future was limited, since Henry was not willing to give up much control over the portfolio. Around the time I decided that I had to leave, my husband got a good job offer in another city, and we decided to move. I found a job at Atacama Investment, which at the time was an institutional money management firm. I started out as a portfolio manager, comanaging their small cap fund [a fund that invests in companies with small capitalization], which had a couple of billion dollars in assets.
Had you had any experience before?
Not picking stocks.
Then how did you get a job as a portfolio manager?
I originally started out interviewing for a trading job. But the woman who had been managing the portfolio, Jane, was on maternity leave. She only had about six months’ experience herself, and they needed someone to fill the slot. Mark Hannigan, who ran Atacama, believed that anyone could do that job. He called us “monkeys.” He would tell us, “I could get any monkey to sit in that chair and do what you do.” He also used to tell me that I think too much, which really annoyed me.
Mark’s philosophy was that if a stock’s price was going up on the chart, earnings were growing by 25 percent or more, and if a brokerage house was recommending it, you would buy it. There was minimal fundamental analysis and no consideration of the quality of earnings or management. This is the origin of why I ended up trading on the short side of the market.
Did being a woman help you get the job because you were replacing another woman?
No, I probably got the job because they could pay me a lot less.
How little did they pay you?
My starting salary was twenty-five thousand dollars a year.
What happened to Jane?
After two months, she returned from maternity leave, and we worked together. She was a perennial bull. Everything was great. She was always ready to buy any stock. I was the only one who ever thought we should wait a minute before buying a stock or suggested getting out of a stock we owned before it blew up.
Were you and Jane working as coequals, or was she your boss because she was there before?
We were comanagers. I actually had more experience than she did, but she joined the company six months earlier. We worked as a team. Either one of us could put a stock in the portfolio.
Was it a problem having to comanage money with another person?
Not really, since neither one of us had much experience. I would pick a stock and say, “Look at this,” and Jane would say, “Yeah, that looks good; let’s buy 100,000.” The real problem was the trading desk. Once we gave them a buy order, we had no control over the position. The trade could be filled several points higher, or days later, and there was nothing we could do about it.
Do you mean that literally? How could there be such a long delay in a trade being filled?
Because the trader for the company was front-running orders [placing orders in his own account in front of much larger client or firm orders to personally profit from the market impact of the larger order he was about the place]. If a stock we wanted to buy traded 100,000 shares that day and we didn’t get one share, he would say, “Sorry, but I tried.” Since I was a trader, I knew enough to check time-and-sales [an electronic log of all trades and the exact time they were executed]. If you questioned him, however, he would just rip you in front of everybody. (We all worked in one large room.)
Rip you in what way?
He would scream at me, “You don’t know anything about fucking trading. Just go back and sit at your desk.”
Did you realize he was crooked back then, or did you just find out later?
He was the highest-paid person there. He was probably making several hundred thousand dollars a year. But he lived well beyond even his salary. He had a huge house, and he was always taking limousines everywhere. Everyone suspected that something was going on. It turns out that there was; it all came out years later when the SEC investigated and barred him from the industry.
It’s rather ironic that as a trader who was merely responsible for entering orders, he was making ten times what you were making as the portfolio manager. I assume this is fairly unusual.
Yes, it is. Normally, the traders always make much less.
When did you get your first inclination to start shorting stocks?
I sat close to Jim Levitt, who ran Atacama’s hedge fund. I was very interested in what he was doing because of his success in running the fund.
Was Jim a mentor for you on the short side?
Yes he was, because he had a knack for seeing reality through the Wall Street hype. I jokingly blame him for my decision to go on the short side of the business. When things are going badly, I’ll call him up and tell him it’s all his fault.
What appealed to you about the short side vis-à-vis the long side?
I felt the short side was more of a challenge. You really had to know what you were doing. Here I was, just a peon going up against all these analysts who were recommending the stock and all the managers who were buying it. When I was right, it was a great feeling. I felt as if I had really earned the money, instead of just blindly buying a stock because it was going up. It was a bit like being a detective and discovering something no one else had found out.
When did you start shorting stocks?
In 1990 after Jim Levitt left Atacama to form his own fund because he was frustrated by the firm’s restrictions in running a hedge fund.
What restrictions?
The environment wasn’t very conducive to running a hedge fund. One of the rules was that you couldn’t short any stock that the company owned. Since the firm held at least a thousand different stocks at any time, the universe of potential shorts was drastically limited. They also had a very negative attitude toward the idea of shorting any stocks.
When Jim Levitt quit, I was on vacation in Lake Tahoe. Mark called me and told me that I would be taking over the hedge fund because Jim had left the firm. Mark’s philosophy was that anyone could short stocks. He ran computer screens ranking stocks based on relative strength [price change in the stock relative to the broad market index] and earnings growth. He would then buy the stocks at the top of the list and sell the stocks at the bottom of the list. The problem was that by the time stocks were at the bottom of his list, they were usually strong value candidates. Essentially you ended up long growth stocks and short value stocks—that approach doesn’t work too often. But he had never been a hedge fund manager, and he thought that was the way you do it.
Did you use his methodology?
No, I really didn’t.
How were you picking your shorts then?
I looked for companies that I anticipated would have decreases in earnings, instead of shorting stocks that had already witnessed decreases in earnings.
How did you anticipate when a company was going to have decreased earnings?
A lot of it was top down. For example, the year I took over the hedge fund, oil prices had skyrocketed because of the Gulf War. It was a simple call to anticipate that the economy and cyclical stocks would weaken.
Why did you leave Atacama?
In 1993 Atacama transformed their business from an institutional money management firm to a mutual fund company. Also, both my husband and I wanted to move back to San Francisco. I spoke to a number of hedge funds in the area, but none of them were interested in giving up control of part of their portfolio to me, and I didn’t want to go back to working as just an analyst after having been a portfolio manager.
With some reluctance, I had dinner with Henry Skiff. It was the first time I had seen him in five years. He said all the right things. He assured me that he had changed, and he agreed with everything I said. He had formed a small partnership with about one million dollars. He told me I could grow it into a hedge fund, run it any way I wanted, and get a percent of the fees.
What, exactly, was it about Henry that you didn’t like when you had worked with him five years earlier?
I didn’t have a whole lot of respect for him as a portfolio manager. I’ll tell you one story that is a perfect example. During the time I worked for him, junk bonds had become very popular. Henry had a friend at a brokerage firm who offered to give him a large account if he could manage a junk bond portfolio. We had no clue. Henry gave us all a book about junk bonds and told us to read it over the weekend. The following Monday we began trading junk bonds; Henry was the manager, and I was the trader. The book had said that the default rate was 1 percent, which turned out to be completely bogus. The whole thing ended up blowing up and going away. Also, although I didn’t find out about it until years later, Henry had embellished his academic credentials in the firm’s marketing documents, falsely claiming undergraduate and Ph.D. degrees from prestigious universities.
Anyway, Henry convinced me that rejoining him was a great opportunity. He offered to give me a large raise over what I had been making. He even offered to pay for my move. I figured the job would give me a way to move back to San Francisco and that if it didn’t work out I could always find another job. Henry had a great marketing guy, and we grew the fund to $90 million. But Henry hadn’t changed; he second-guessed everything I did.
Henry would see a stock go up five dollars and get all excited and say, “Hey Dana, why don’t you buy XYZ.” He wouldn’t even have any idea what the company did. I would buy the stock because he wanted me to. The next day the order would be on the trade blotter, and he would ask me, “Hey, Dana, what is this XYZ stock?” That was another experience that turned me off to the long side of stocks.
There was tremendous turnover at the firm because Henry treated his staff so poorly. We had a meeting every morning where the managers talked about the stocks in their portfolio. Henry would just rip the managers apart. One of his employees, a man in his fifties, committed suicide. Henry would tear the confidence out of people, and this poor guy just didn’t have it in him to take it. I had worked with him for a while, and he was a broken man. I can’t say he killed himself because of the job, but I wouldn’t be surprised if it was a factor.
Was Henry critical with you as well?
He was constantly second-guessing me and arguing with me every time I put on a trade he didn’t agree with.
Then how much independence did you have?
I had independence as long as I was doing well, but every time the market rallied, he wanted me to cover all my shorts. We fought a lot because I didn’t give in. One thing I did is that if Henry insisted I buy a stock, I would buy it, but then immediately short another stock against it. That way I would negate any effect he was trying to have on the portfolio. I did well, but after two years, I couldn’t take it anymore and quit.
Did you start your own firm after you left Henry the second time?
No. After I quit, I was hired by Peter Boyd, who had a hedge fund that had reached $200 million at its peak. He told me that he’d heard a lot of good things about me and was going to give me a portion of his fund to manage. He said that I could run it any way I wanted. I told him that I thought I could add the most value by trading strictly on the short side because that was something he didn’t do. He started me out with $10 million and gave me complete discretion. It was great for me because it was like having my own business without any of the administrative headaches.
Everything was fine for the first two years, but in the third year, the fund started to experience very large redemptions because of poor performance. Boyd had to take the money from me because his own portfolio wasn’t very liquid. He had lost the money by buying huge OEX put positions, which expired worthless only days later. [He bought options that would make large profits if the market went down sharply but would expire as worthless otherwise.]
It almost sounds as if he was gambling with the portfolio.
It sure appeared to be gambling. Looking back, it seemed that he tried to hide these losses by marking up the prices on privately held stock in his portfolio. He had complete discretion on pricing these positions.
How was he able to value these positions wherever he wanted to?
Because they were privately held companies; there was no publicly traded stock.
Is it legal to price privately held stocks with such broad discretion?
Yes. In respect to private companies, the general partner is given that discretion in the hedge fund disclosure document. The auditors also bought off on these numbers every year. He would tell them what he thought these companies were worth and why, and they would accept his valuations. They were these twenty-two-year-old auditors just out of college, and he was the hedge fund manager making $20 million a year; they weren’t about to question him.
Another hedge fund manager I interviewed who also does a lot of short selling said that the value of audits on a scale of 0 to 100 was zero. Do you agree?
Yes.
Even if it’s a leading accounting firm?
Oh yeah.
How could hedge fund investors be aware whether a manager was mispricing stocks in the portfolio?
The quarterly performance statements are required to show what percent of the portfolio consists of privately held deals. His performance was so good for so long that people didn’t question it.
What percent of his portfolio consisted of private deals?
In the beginning it was about 10 percent, but as he lost more and more money, the portion of the portfolio in privately held companies continued to grow. By the end, privately held stocks accounted for a major portion of the portfolio, and he was largely left with a bunch of nearly worthless paper.
It sounds as if he was gambling in the options market and hiding his losses by marking up his private deals. Wouldn’t the truth come out when investors redeemed their money and received back much less than the reported net asset value?
Although I’m not sure, I believe the first investors to redeem received the full amount, but as more investors redeemed their funds, the true magnitude of the losses became apparent.
Did you know what he was doing at the time?
I knew about the option losses, but no one knew about the private deals. They were off the balance sheet.
It sounds as if you worked with quite a host of characters. You didn’t do too well picking your bosses.
Yes, I know. You think that wouldn’t be a good sign, but…
How did you start your own firm?
I had one account that I had met through Peter. He hired me to run a short-only portfolio. That was the account I took with me to get started.
What year was this?
1997.
Your track record shows your performance back to 1994.
To generate the early years of my track record, I extracted the short trades for the period until I started trading the short-only portfolio.
Do you use charts at all?
I use them for market timing. I think that is one of the things that has saved me over the years. If, for example, the stock I am short collapses to support, I will probably get out.
How do you to define support?
Price areas that have witnessed a lot of buying in the past—points at which prices consolidated before moving higher. Some dedicated shorts will still hold on to their positions, but I will usually cover. I’ll figure the market has already gone down 50 percent. Maybe it will go down another 10 or 20 percent, but that is not my game. I look for stocks that are high relative to their value.
That is an example of how you use charts for profit taking. Do you also use charts to limit losses?
When a chart breaks out to a new high, unless I have some really compelling information, I just get out of the way.
How long a period do you look back to determine new highs? If a stock makes a one-year high but is still below its two-year high, do you get out?
No, I am only concerned about stocks making new all-time highs.
Have you always avoided being short a stock that made new highs, or have you been caught sometimes?
No, I have been caught sometimes.
Can you give me an example.
One stock I was short this year, Sanchez Computer Associates, went from $32 to $80 in one day.
In one day?
It’s a company that makes back-office and transaction processing software for banks. Most of their clients are in underdeveloped countries and don’t have their own systems. The business was slowing down, and the Street cut its annual earnings estimate from 75 cents a share to 50 cents. The stock was still trading at $25 at the time, and as a short, that news sounded great to me. I thought the stock would go a lot lower. Shortly afterward, the company announced that they would start an on-line banking software service. This was at a time when the on-line banking stocks were going ballistic.
What was the previous high in the stock?
It was in the low thirties. The stock just blew way past it.
Were you still bearish the stock when it went to 80?
Yeah, nothing had changed.
How do you handle that type of situation from a money management standpoint?
I had never been in that type of situation before—not even remotely. Our portfolio is relatively diversified. The most I had ever lost on a single stock in one day was one-half of one percent. That day, I lost 4 percent on the stock.
What portion of your portfolio was the stock?
Before it went up, about 2.5 percent. That is a fairly large position for me, but I had a lot of conviction on the trade.
Did you try to cover part of your position on the day the stock skyrocketed?
The stock was up almost $10 right from the opening. I started scrambling around, trying to figure out what was going on. Then it was up $20. Then $30. I tried to cover some of my shorts, but I only wound up getting filled on about one thousand shares out of a total of forty thousand that I held.
At the end of the day, you were still short thirty-nine thousand out of forty thousand shares, the stock had already exploded from 30 to 80, and you were still bearish on the fundamentals. What do you do in that type of situation? Do you decide to just hold the position because the price is so overdone, or do you cover strictly because of money management reasons?
This was a unique situation. I never had a stock move against me like that. I’ve also never been short an Internet stock. Initially, being the realist that I am, I just tried to get the facts. I checked out all the companies that did Internet banking to see what kind of software they used, and Sanchez’s name was never mentioned.
The next day the stock dropped $15. I thought the stock would go up again, because typically these types of situations last more than one day. I covered enough of my position to bring it down to 2.5 percent of my portfolio. Because of the price rise, it had gone up to 7 percent of my portfolio, and I can’t allow that. Then the stock went down some more. By the time it went back down to 50, I had reduced my short position to five thousand shares.
What was your emotional response to this entire experience?
I was almost in shock because I felt a complete lack of control. I had never experienced anything like it before. Most people are afraid to go short because they think the risk is unlimited. That never bothered me. I consider myself pretty disciplined. I always thought that I had a good handle on the risk and that I could get out of any short before it caused too much damage, which up to that point I had. But here, the stock nearly tripled in one day, and I didn’t know what to do. I was numb.
I was struck by a horrifying thought: Could the same thing happen to any of the other stocks in my portfolio? I began worrying about which of my shorts would be the next company to announce an online Web page. I started combing my portfolio, looking for any stock that might become the next Sanchez.
What eventually happened to the stock?
It went back up again. But when Sanchez started to look like it was ready to roll over, I rebuilt my short position. Ironically, when it subsequently broke, I made more money on my new short position than I had lost being short when the stock exploded several months earlier.
How large is your organization?
There are just two of us. Zack works with me and is an integral part of Miramar. There is a lot of money out there, and interested investors call me almost every day. I tell them that I am closed to new investment.
Is that because your methodology can’t accommodate any more money?
I don’t want to grow. I don’t want to manage people; I want to manage the portfolio.
Could you grow your size by just taking larger positions instead of expanding the number of shorts?
I have only run shorts in a bull market. It’s a constant battle. I have to find the best way to fight the battle with the lowest amount of risk. I need to know that I can cover my short positions if I have to. The larger my short position, the more difficult that would be. I’ve seen what happens to people who grow too fast, and I have taken the opposite extreme. I want to be comfortable doing what I do. I don’t want to be scouring for new shorts because I am managing more money. I have my family, and when I go home, I don’t think about work. I don’t read Barron’s over the weekend.
I suppose to some extent your attitude reflects a difference between male and female perspectives. Maybe, as a generalization, men want to become empire builders, whereas women don’t.
That’s probably it.
How do you select the stocks you short?
I look for growth companies that are overvalued—stocks with high P/E [price/earnings] ratios—but that by itself is not enough. There also has to be a catalyst.
Give me an example of a catalyst.
An expectation that the company is going to experience a deterioration in earnings.
How do you anticipate a deterioration in earnings?
One thing I look for is companies with slowing revenue growth who have kept their earnings looking good by cutting expenses. Usually, it’s only a matter of time before their earnings growth slows as well. Another thing I look for is a company that is doing great but has a competitor creeping up that no one is paying attention to. The key is anticipating what is going to affect future earnings relative to market expectations.
In essence, you look for a high P/E stock that has a catalyst that will make the stock go down.
Right, but there is another key condition: I won’t short a stock that is moving straight up. The stock has to show signs of weakening or at least stalling.
Can you give me an example of a typical short?
Network Associates has been a stock that I have been short on and off for the past two years. The company was masking higher operating expenses by taking huge research and development charges related to acquisition each quarter. They were taking other expenses as one-time charges as well. The SEC eventually made them change their accounting procedures to take these expenses over time as opposed to one-time charges. After the SEC stepped in, the chairman came out and said something like, “It’s just an accounting issue. We don’t pay much attention to accounting.” He also made statements berating the shorts, saying they would get buried.
When a company blames the price decline in its stock on short sellers, it’s a red flag. A company’s best revenge against short sellers is simply reporting good numbers. Decent companies won’t spend time focusing on short sellers. “Our stock was down because of short selling.” Give me a break. We represent maybe one billion dollars versus nine trillion on the long side.
What was Network Associates’ product or service?
Their primary product was an antivirus software, a low-margin item whose price had been coming down over time. They also bought out a number of companies that were making similar products, usually paying a large premium. The companies they were buying were stocks that I was short. I was upset because once they bought out these companies, I couldn’t be short them anymore. At one point, they were virtually giving away their antivirus product. All you had to do was look at the Comp USA ads. After adjusting for all the rebates, they were selling their software for only about five dollars. That told you that their product wasn’t moving.
If they were so desperate in their pricing, didn’t their sales show a sharp drop-off?
No, because they were stuffing the channels.
What does that mean?
They were shipping all their inventory to distributors, even though the demand wasn’t there.
Why would a company do that if they know the product is just going to get shipped back?
To make the revenues look better. Once they shipped the product, they can book it as sales.
But they can’t keep that up forever.
They did it anyway. But it did come back to haunt them; eventually, the stock collapsed.
You mentioned that it’s a red flag when a company blames shorts for the decline in its stock. What are some other red flags?
A company that goes from its traditional business to whatever is hot at the time. For example, during the gambling stock craze, there were companies that went from having pizza restaurants to riverboat gambling. Right now, the same thing is going on with the Internet. One company we shorted recently went from selling flat panel displays to offering an Internet fax service, trashing their whole business plan in the process.
Other red flags?
Lots of management changes, particularly a high turnover in the
firm’s chief financial officer. Also, a change in auditors, can be a major red flag.
Can you give me an example?
One of my shorts was Pegasystems, which was a software company that caught my attention because of high receivables [large outstanding billings for goods and services]. The company was licensing its software for a monthly fee, typically in five-year contracts, and recognizing the entire discounted value of the contract immediately.
Is this a valid accounting procedure?
It was certainly contrary to the industry practice. Apparently, the original accountants didn’t go along with the figures, because the company fired them and hired a new accounting firm. They said they were making the change because their previous accounting firm didn’t understand the business and wasn’t aggressive enough. But the incredible thing is that people ignored that red flag.
You mean the stock still went up even after they fired their auditors?
Yes.
When did you get short?
After they fired their auditors.
Any other examples of questionable accounting?
I’ve had a few shorts that turned into frauds. One example was a company that ran a vocational school that purportedly taught people computer skills. They were getting funding from the government, but they were providing very poor quality education. I became aware of this stock as well because of high receivables.
What are receivables for a training company?
Tuition fees. The students weren’t paying the tuition they owed. That’s what first drew my attention to the stock. Then I learned the company was being investigated by the Department of Education in response to student complaints that they were using old software and that the instructors were inept. I shorted the stock in the forties, and got out near 10. The stock eventually went down to 1.
It sounds as if high receivables is a major indicator for you.
Yes, it’s one of the screens we look at.
What are some of the other screens?
We also screen for revenue deceleration, earnings deceleration, high P/Es, high inventories, and some technical indicators, such as stocks breaking below their fifty-day moving average.
Do you screen for these factors individually, or do you screen for multiple characteristics?
Usually multiple characteristics, but you can’t screen for all these factors at one time, or else you won’t get any stock that fits all the search requirements.
Although you have done fine as a 100 percent short seller, have you had any second thoughts about your choice since we have been in such a relentless bull market?
No, I find short selling more rewarding because of the challenge. You make a lot of money in this business, and I think you need to work for what you get. To just sit there and buy Internet stocks every day doesn’t seem right. I can’t relate to it. In fact, I wonder how I will do if we ever do get into a bear market because I am so used to a bull market, watching people ignore bad news and taking advantage of that.
But I would imagine that in a bear market, your job would be much easier.
In August 1998 when the market went down fast and hard, I was more stressed out than I am normally.
But you did very well during that period.
I did great, but I thought it was too easy. I wasn’t fighting a battle. I felt as though I didn’t have to work. Any stock I went short would go down. It was a weird feeling. That’s what people do all the time on the long side; they just buy stocks, and they tend to go up.
And you didn’t like that?
No, it was very uncomfortable. Maybe I am a little sick; I don’t know what’s wrong with me.
When a market suddenly breaks a lot, as it did then, do you reduce your short exposure?
I did in that instance because it happened so quickly. I made 30 percent in one month. That has never happened to me before. I covered about 40 percent of the portfolio.
What kind of risk control strategies do you use?
If I lose 20 percent on a single stock, I will cover one-third of my position. I limit the allocation to any single stock to a maximum of about 3 percent of the portfolio. If a stock increases to a larger percentage of the portfolio because of a price rise, I will tend to reduce the position. I also control risk through diversification: There are typically fifty to sixty names in the portfolio spread across different industry sectors.
Do you know other short sellers?
Yes. With the exception of a couple of short sellers that have become my friends, most short sellers tend to be very pessimistic on the world and life. They tend to be very negative people.
But you’re not?
I don’t think I am. I think I am just a realist. One thing that differentiates me from other short sellers is my experience on the long side.
Why is that important?
Because it’s all about why people buy and sell. My experience in working with momentum-type managers gives me a sense of their thought processes, which helps me know when to get out of the way and when to press my bets. I have some friends who are short sellers that have never worked on the long side. They would call me up and ask, “Dana, why are they buying this stock? It has negative cash flow, high receivables, etcetera.” They look at the raw numbers, and they are realists. They don’t understand that a lot of people just buy the stock because it’s going up or because the chart looks good. We’ve gone to the stratosphere now. Most of the people I know who were short sellers have been blown away. They don’t even ask me those questions anymore.
What advice could you give to the ordinary investor who trades only on the long side?
A good company could be a bad stock and vice versa. For example, Disney is a good company—or at least my kids love it. But during the past few years we were able to make money on the short side because the company had become very overpriced on overly optimistic expectations that its business would grow robustly forever.
Although Galante is a 100 percent short seller, her ideas are still relevant to the long-only investor. Galante’s methodology can be very useful as a guideline for which stocks to avoid or liquidate. The combination of factors Galante cites include:
All three of these conditions must be met. Investors might consider periodically reviewing their portfolios and replacing any stocks that meet all three of the above conditions with other stocks. By doing so, investors could reduce the risk in their portfolios.
In addition, Galante cites a number of red flags that attract her attention to stocks as potential short candidates. By implication, any of these conditions would be a good reason for investors who own the stock to seriously consider liquidating their position. These red flags include:
Update on Dana Galante
After a career spent fighting a long-term uptrend, Galante in recent years finally found herself trading in the market direction. Therefore, it should come as no surprise that Galante has done quite well during the bear market. During the 2½-year period since the first month of the bear market (April 2000), Galante’s fund was up an imposing 89 percent (119 percent before fees).
This is a rather unusual experience for you: shorting stocks in a bear market. After all the years of trading against the broad market trend, what does it feel like trading with the trend in your direction?
The first year of the decline [2000], it felt pretty good because there were so many overvalued shorting opportunities. The second and third years of the decline, however, were just as difficult as the upmarket years because of the sporadic, sharp bear market rallies. Also, the lower valuations, especially now, make it difficult to find shorting opportunities.
How do you compare the differences and similarities in being a short seller in a bear market versus a bull market?
Previously, there was a lot more downside in stocks. Now, many stocks are getting to real value levels. As a result, our exposure levels are much lower now than they were during the bull market. In 1999–2000 we were 100 percent invested. This year [2002], our highest exposure was 70 percent, and right now we are only 20 percent invested.
Are you concerned about having so much more company on the short side, particularly from other hedge funds (not just short funds)?
In the twenty years I have been trading the markets, there has always been some new angle that affects what I do. I try to look at how I can capitalize on a new situation rather than worrying about how it may hurt me. In the case of new participants on the short side, I actually think it creates more opportunities because you get these short-term run-ups in certain stocks triggered by short-covering from people who don’t know what they are doing. There are a lot of former long-only managers who have decided to become hedge fund managers by also trading the short side, despite their lack of experience.
Do you see short sellers being made scapegoats for the market decline? What is your opinion about such criticism?
The people who are saying that should be happy there are short sellers out there because they are the ones who are buying. Short sellers are the ones who have the reason to buy and the power to buy, and the rallies we have seen in this bear market have been driven by short-covering. The only time in my life I felt bad about short selling was after September 11; I would have felt guilty shorting then, so we didn’t do much of anything at the time.
Identifying companies that employ overly aggressive accounting is an important element in your approach. Has the recent spate of highly publicized accounting scandals meaningfully changed the situation?
In the past, as long as a company reported good earnings, even if it was just beating the street estimate by a penny, no one looked at how they got that number. The market frequently all but ignored the red flags we look for such as negative cash flow, excess receivables, excess inventories, and aggressive revenue recognition. The good thing for us is that now if people see these factors in a company, it’s an issue.
What other changes do you anticipate as a result of the market’s much closer scrutiny of accounting issues?
One issue I expect will garner increasing attention is the still widespread use of pro forma accounting instead of GAAP accounting.
Please define pro forma accounting.
Pro forma accounting is an artificial creation of the late 1990s, which takes out all sorts of charges that the company claims are non-operating charges, when in reality they often are. There are some companies that even take out costs that occur every quarter, which is the very essence of an operating charge. The SEC requires GAAP reporting, and that is the number a company lists in its annual report; but a company can report any number it wants to the street. The biggest culprit is First Call because they accept pro forma earnings as the company’s earning estimate, so that’s what the street looks at. Some brokerage companies—Merrill Lynch was the first—are now reporting earnings both ways. For a lot of companies, there are huge deviations between the GAAP and pro forma numbers. Even for the S&P 500 index as a whole, pro forma earnings are about 20 to 30 percent higher than GAAP earnings—the difference is that large! One of the things we are doing to identify possible shorts is to look for companies that have a large gap between pro forma earnings and GAAP earnings.
Are frauds likely to become less prevalent because of all the publicity and legislative actions (both enacted and pending)?
Greed is something that never goes away. Maybe the types of frauds we’ve seen will change, but there will always be some new scheme to take advantage of investors.