Chapter 2 Follow the Money

Whale watching—that is, following well-known investors—is a favorite pastime on Wall Street. The media love reporting on the latest purchase or sale by Warren Buffett or Carl Icahn or Steve Cohen. There are expensive newsletters and data services dedicated to this sport, and no doubt some people have earned back their subscription fees by mimicking the moves of “legendary” investors. But I contend that blindly following anyone into a single trade is a fool’s errand and there are many reasons to support this conclusion. For one thing, no investor, no matter how legendary, has a perfect record, and you just might find yourself following a legend right over a cliff. It is also the case that legendary investors may have very different investment objectives from yours. For example, what if the legendary investor is looking long term—happy and able to be in a position for decades, as Buffett is,¹ while you are seeking short-term profits? Buffett can wait out a losing position or absorb it as need be, but you, on the other hand, likely do not have the same resources. These can be hard lessons. At least, I found them to be so.

My Wall Street career began on the equity trading desk at Oppenheimer & Co. in what could now be defined as the dark ages of technology. E-mail was more of a novelty than a default communication mode; the Internet was still a twinkle in Al Gore’s eye (wink, wink), and High Frequency Trading (HFT) was defined as calling the floor broker and yelling at him in a shrill voice. As the newbie, my job was to hit the lights—trading desk parlance for answering the phone. (With hundreds of incoming calls and a large number of traders, there are no ringing phones on a trading desk.) Boredom quickly set in, so I surveyed the cavernous room and determined that my future was in research sales, communicating investment ideas to experienced hedge fund and mutual fund managers. Telling a story, relating an investment case, and debating a much more seasoned investor than myself about the merits of a particular stock was a challenge that I enjoyed; it was far more interesting to me than shopping buy and sell orders on a laundry list of stocks.

So one day, as I sat on the trading desk answering incoming client calls and passing them on to the traders—I hadn’t picked up any accounts yet, and since Oppenheimer was a commission shop, it was unlikely anyone would willingly pass any on to me—I decided that having mastered sales trading, I would now try my hand at research sales. I picked up my meager belongings, a pen, a pad, and a book of stock symbols, and moved a few rows back into an open seat on the research sales desk. My boss was a player coach, covering accounts while managing the department, and he was too busy to notice that the most junior person in the room had relocated. A number of days went by before I informed him of my career decision, which was much more important to me than to him. Nonetheless, he would ultimately evolve into one of my favorite colleagues of all time.

It took another few weeks for me to receive my first accounts. This occurred when the saleswoman behind me resigned, complaining that she couldn’t “make any money at this place with these accounts,” and literally handed me her black loose-leaf binder containing a list of investment managers, banks, and insurance companies she had been assigned to cover. The first thing I noticed was how obediently each page stayed captive to the three metal rings affixed to the binding, not one sheet torn away from its anchor. It didn’t take long for me to free them from their bondage. After all, they are supposed to be loose; it’s not a tight-leaf binder. On every page was a typed-out contact list for each account the now departed salesperson had covered. No fancy customer relationship management system or electronic database; hell, we didn’t even have desktop PCs, only a shared Quotron, the now-ancient system for quoting stock prices that at the time was the standard for market data. I marched into my boss’s office, held the binder in front of me, and asked to begin my sales career. “Sure,” came the response after a moment’s deliberation as a smile formed on his face. “Not what I had in mind for you, but have at it.” The something else he had in mind was allowing me to be consumed by boredom while the traders lodged bets on how many times my head would hit the desk as I nodded off while working my way through one dry research report after another. No thanks.

So off I went, energized, calling my new accounts, introducing myself, and finding out as much as possible about every client’s particular investment style. It was easy to get through to my new clients; most were small players on Wall Street who didn’t get called all that much. At the time, Oppenheimer—OPCO, as it was known—was a small firm compared to Goldman Sachs, Merrill Lynch, and Morgan Stanley, the behemoths then and now, but it did have an excellent research product and a strong core group of analysts. And precisely because this was during the relative dark ages of technology, e-mail and voicemail had not yet became barriers to forming solid relationships and engaging in productive dialogue. In fact, the biggest barrier I faced to becoming a master of the universe was the population of my universe—widow and orphan custodians who did not trade much and rarely ventured away from such blue-chip companies as Coca-Cola and Procter & Gamble. The other barrier was that few had ever done business with Oppenheimer. But I was perhaps too ignorant to be deterred, so I soldiered on, synthesizing and sometimes taking the other side of my analysts’ recommendations extolling the virtues of certain companies I deemed to be solid investments.

I began to get traction and turned out to be pretty damn good at stock picking; I was on my way to becoming a top salesperson. In short order, I was given more accounts, accounts that had potential to increase their level of business but were nascent at the time. Unlike the bulk of my account package, composed of clients who were primarily concerned with not making a mistake, these new accounts were more focused on generating returns; they were willing to look at companies that weren’t completely correlated to the market indices. They listened to my recommendations, “calls” in the vernacular, but waited weeks, sometimes months, to go along, often keeping track of what I had suggested. Once I earned their trust, I did very well. Oppenheimer’s profile was also helpful since the firm followed a large number of companies that were not mainstream thus allowing me to further differentiate myself from salespeople at other firms. Perhaps most helpful of all, it was a bull market. Anyway, I was making money for all my accounts. Well, almost all of them. And herein is the story.

Let’s call the account DG Partners. I got along great with them except for one thing: We just never seemed to click at what mattered most—making money. I would recommend a number of stocks for them to buy or short, but DG had an incredible knack for picking the one idea that didn’t work out. It started with the first share they bought as it instantaneously went against them, and kept going lower from there. If I suggested a buy idea, the stock would undoubtedly collapse like a balsam step stool under an NFL lineman; a call to short a stock could lead to it hitting the new high list. At one point during our tortured relationship, I suggested that they could make a fortune by going in the opposite direction of my call. After all, consistency is one of the most valuable qualities that a stock-picker can possess, so it shouldn’t matter if you’re always wrong or always right as long as there is no pretense about the direction. Admittedly, I am embellishing the facts because DG never hung around long enough to lose much, not to mention let an idea play out. They moved in and out of the market very quickly, scalping nickels and dimes while passing up dollars. But the point is that they had an uncanny ability to ignore all my winners, opting instead for the dogs. We liked one another so we continually talked it out, trying to find out why we didn’t click.

“We’re not asking for all the time, we’re just asking for one time,” was the not unreasonable reply.

“It’s just as much your fault as mine. My other accounts don’t seem to have the same issue.”

“That’s not the case. I’m making the same call to them as I am to you, but there are two major differences. First, the other trading accounts fire a shotgun at my ideas whereas you guys use a rifle, trying to pick the one idea that will work, that seems the most attractive. I’m just not that good—no one is, at least not within the short time frame that you’re going to be holding the stock. Most of the other accounts give the idea some time to work out.

“I appreciate your confidence in me,” I added, clearly tongue in cheek, “but timing of the buy and sell is going to have to be your responsibility since I’ll never be as quick as you guys. I’ll stick to fundamentals.”

No one, not Warren Buffett, not anyone, is so good that they have anywhere near a perfect track record picking stocks. I remember Steve Cohen, one of my ex-bosses and the founder of perhaps the industry’s top-performing hedge fund, SAC Capital, saying that the best traders win only 50 to 55 percent of the time. That is the issue right there. Piggybacking on the purchases and/or stock sales of professional investors is an inherently risky strategy, regardless of how successful those individuals have been. The reason is simple: If the best of the best are only right slightly more than half the time, then the average professional is correct in his or her stock selection less than that. But let’s be more generous than Steve Cohen by assuming that the hit rate of the best pros is 65 percent. That means that if you pick up the Wall Street Journal and read that a very accomplished investor purchased shares in XYZ Company and you decide to follow that investor’s lead, you have a better-than-even chance of succeeding. Compared to other endeavors, that isn’t terrible. The best hitters in professional baseball sport a batting average close to .300 or 30 percent; the best shooters in the NBA have a field goal average of just over 50 percent; and superstar NFL quarterbacks complete less than 60 percent of their passes, on average. So on this scale professional investors are the true superstars. And while most would tell you they hate to lose any money at all, the truth is they get pretty giddy when their batting average approaches the aforementioned levels. But one investment does not make a profitable portfolio; portfolio construction is so much more critical.

Say that you are willing to accept the odds of following a professional into an investment. So you once again pick up the Wall Street Journal and read that some well-known investor who manages billions of dollars—and is worth a billion as well—just filed a Schedule 13D² (beneficial ownership report) on a particular company. You immediately log onto your laptop, do a cursory amount of research, and buy a few thousand shares online. “Good enough for Mr. Billionaire, good enough for me.” Besides, at two to one, the odds are in your favor.

Or say you are scrolling through your news alerts and you discover that David Einhorn, a noted hedge fund manager with a very good track record who made a killing shorting Lehman into the abyss, has just purchased a stake in General Motors (GM). You are also aware that GM is going to release its third-quarter earnings report in a couple of days. Based upon the timing of Einhorn’s share purchase, his record for outperformance and reputation for in-depth analysis, you assume that he has a very good feel for the quarter. You decide to follow his lead, buy shares in GM, and look forward to booking a nice gain after the quarterly report. Easy pickings.

The first rule in the investment business is that if it seems too easy, it likely is. And assuming that blindly following large, smart buyers into a stock or other investment will prove to be a winning investment strategy falls into the trouble zone. In fact, you may wind up like my old account, DG Partners, unlucky and on the wrong side of every trade for some of the same reasons. Before buying the equity of a company, a professional considers many factors, including the total number of positions in the portfolio, weighting of each position, risk profile of each position, and the holding period—that is, how long it will take for the investment case of each position to play out. However, none of these factors are decipherable from the Schedule 13D, news stories, or services that capture activity by noteworthy investors or insiders.

Insider Buying: To Follow or Not to Follow

For purposes of this sidebar, let’s define insider as senior management of a company or a member of the Board of Directors; in other words, someone who is in a position to either influence a company’s direction or has significant insight into the execution of the corporate strategy. These individuals are subject to various filing* requirements when they either buy or sell shares, regardless of the size of the transaction, unlike non-insiders who must file when their ownership is equal to or greater than 5 percent of the shares outstanding. As a result of these stringent filing requirements, there are numerous services, offered for free and by subscription, that track this activity. The subscription services, in particular, offer support for the theory that there is a high correlation between insider activity and the direction of the stock price.

As with most theories on investment strategy, this one should not be taken at face value. For example, senior managers of public companies are receiving a greater portion of their compensation in stock and options, tying them more closely to the financial performance of the company and the share price. Because of this there is significantly more selling activity as those shares vest* and these insiders seek to diversify their net worth away from the company that also employs them, a prudent strategy. Additionally, Chief Executive Officers are well aware of the reliance some investors place upon insider activity and try to use it to influence the stock price. When I was at Lehman Brothers, Dick Fuld, the CEO, frowned upon his senior management team selling shares because he believed that it would send the wrong message to the market. As a result, very few officers sold any stock. This is likely a directive they deeply regretted following since Lehman would ultimately file for bankruptcy and wipe out its shareholders. Other CEOs will make a token purchase of shares, relative to their net worth, hoping that their purchase makes its way into the news and will then be noticed by potential investors who will follow into the stock. When I review a Form 4 (changes of beneficial ownership of securities) filing by a member of the Board of Directors, a CEO, Chief Financial Officer, or someone of similar seniority, I always look at how many shares are purchased or sold relative to their entire holdings and overall compensation. If a very well compensated executive purchases $100,000.00 worth of stock, I basically ignore it as an indicator. Sure, it’s nice to see, but hardly a major vote of confidence.

The sale of stock by insiders should not be taken at face value either; I attempt to determine the underlying rationale for any sale before acting upon the information. Since the Internal Revenue Service does not impute ownership of any shares until they are vested, this is when a tax liability arises. Many officers, regardless of wealth, will sell enough shares to cover their taxes. This is a legitimate reason, in my view, as is a sale for the purpose of diversification. Again, everything is dependent upon the totality of the circumstances: years of service, total ownership, compensation, even net worth if discernible.

Perhaps one of the most critical factors in determining the directional value of insider activity is the stock price. If the shares are trading at an all-time low and the executives are selling instead of buying, then I become very concerned. In fact, I may use this as one of the indicators to short the stock.

What it comes down to is this: Company insiders are prohibited from acting on material non-public information. In other words, they cannot either buy or sell shares in their company based upon information that could influence the direction of the stock price before that information is disseminated to the public. Simply put, this would be a violation of insider trading rules. However, transactions by insiders can be an indication of sentiment—how these key employees feel about the business prospects of the company where they work.

Insider activity should have the same value in your investment decisions as whale watching. Use the information as one data point in the research process, placing the appropriate weight on this input as the circumstances dictate.

*The Securities and Exchange Commission offers the following about Form 4: “The information will be used for the primary purpose of disclosing the transactions and holdings of directors, officers, and beneficial owners of registered companies. Information disclosed will be a matter of public record and available for inspection by members of the public.”

*Typically, ownership of the shares or options awarded to an employee phase in over a period of time, usually years. This is the vesting schedule. Employees do not own the shares or options until they vest, and would generally have to be employed by the company on the date they vest to claim ownership.

Of course, the counterargument is that following in the footsteps of a talented investor, particularly when the investor evidences the conviction required to purchase more than 5 percent of a company, can’t be a bad thing. There are a few issues with this logic, the first of which is that what may seem like a large position to the average person may in fact be an insignificant holding. For example, the mutual funds run by Fidelity Management are so large that they often have to take filing positions in order for the stock to potentially have an impact on the overall portfolio, the point being that fund managers do different things for different reasons. Without delving deeper than the headline, David Einhorn’s rationale for owning GM shares could range from hedging a short position in Ford to wanting to own a proxy for consumer spending, both of which would be very unlikely if you understood his discipline. (This is an extremely important point worth repeating—headlines and insider buying databases do not provide qualitative data.) And of course, the other factors in portfolio construction, as noted above, are also at play. Or Einhorn could just have made a bad stock decision; that happens too. Finally, timing is to be considered. Einhorn is a value player, and value players are notoriously early to a situation, often averaging down their cost and sometimes facing years before their thesis plays out.

So how did this real-life example turn out? Not so well initially but the stock has begun to act much better as of this writing. In a quarterly letter written to the investors in his hedge fund, Greenlight Capital, Einhorn discussed his investment in GM. The document found its way to the Internet on November 7, 2011, the same day it was received by investors.

GM is the largest auto manufacturer in the United States. After the business failed under its legacy high-cost structure during the recession, the U.S. government bailed out the company and took over most of the ownership. Last November, GM completed an IPO of about 30 percent of its stock at $33 per share. The government continues to own about one-third of the company. After the IPO, the shares initially advanced to almost $40 before retreating. When the shares broke the IPO price, we determined that the shares were attractive, but only purchased a small position, believing that there might be a better opportunity later when the government exited the rest of its stock. Instead, during a weak third quarter where the market punished all cyclical stocks, the shares fell well below the price where we planned to add to our position. We decided that the shares were cheap enough that we were more than fully compensated for the possible overhang of the government’s stake, and we established a position at an average price of $25.78 per share.
GM is being priced by the market as a cyclical company trading at less than 6x this year’s earnings. While some may see it as normal to value cyclicals at low multiples of peak earnings, we believe that 2011 is not a peak and, in fact, is below mid-cycle. Prior to the crisis, U.S. auto sales ran between 15 and 19 million units for many years. While sales have bounced from the recession low to about 13 million units, GM is poised to grow earnings from both a return to mid-cycle volumes, which we estimate to be 15 million units, and from a coming major refresh of its North American product portfolio. The market appears focused on GM’s “legacy liabilities.” However, the new GM does not have pension and healthcare liabilities that are likely to over-run the company. Instead, GM sits with $33 billion of gross cash, which represents nearly its entire current market capitalization. We see potential for GM to begin to return capital to shareholders over the next year. While we are cognizant of the various investment risks that include near-term global economic weakness and the government ownership overhang, we think these concerns are more than priced in at current levels and see significant upside even if the U.S. experiences a very slow “new normal” type of economic recovery. The shares ended the quarter at $20.18 each.

Einhorn noted that the average cost of his GM shares was $25.78 and that the stock ended the quarter at $20.18—a 20 percent loss to his fund. However, the price did recover to $24.01 on the day the news media reported on the contents of the letter, slightly outperforming the market. Fast-forward two days to Thursday, November 9, 2011, when GM issued its much anticipated earnings report. The company disappointed investors, traders, and Einhorn followers, and the shares traded down more than 8 percent, resulting in a decline of over $2.5 billion in market capitalization. The stock price, again as of this writing, has since recovered to $25.20. I guarantee that Einhorn wasn’t sitting in his office cursing his bad luck but, instead, maintained a stoic commitment to his successful strategy of being a long-term investor. However, I would doubt that the casual investor who followed Greenlight into the stock was as unshaken in their commitment.

What happened? Wasn’t Einhorn supremely confident in the outlook for GM as evidenced by his highlighting it in his quarterly letter? Wasn’t it a great opportunity for investors to step in and buy the stock at a discount to what a very successful hedge fund manager paid? Yes and yes, but here’s the rub: Einhorn takes a very long-term view on stocks, and while he does not want to see any period of underperformance, he is patient; he knows that there will be peaks and valleys along the way as his investment case plays out, so it is too early to make any determination on the ultimate impact GM will have on the performance of his fund. I regard David Einhorn as a brilliant investor, and there is nothing written here that could not also be said about so many other great investors. The overriding issue is that no one has a perfect track record even though his investment in GM may not be one that ultimately resides in the loss column.

Now, in full disclosure, I would be more supportive of someone following Einhorn into GM³ given that he disclosed his rationale than I would be if that person were just reacting to a headline reporting his fund’s ownership in the stock. But I would caution about looking for a quick trade since, as he also noted, his holding period is years, not days, weeks, or months.

Here is another point to consider. The letter mentioned that Greenlight Capital had exited a number of positions in the quarter, all profitable, one flat. What if those stocks had precipitously declined after their exit, and what if one of them happened to be a stock that you had purchased upon hearing that Einhorn was involved? Since none were filing positions, there would not be any way to act in a timely manner relative to Einhorn’s decision. As easy as it may be to follow someone into a stock, it can be more difficult to follow him out.

Sometimes it is challenging not to get caught up in the hype surrounding a celebrity investor. Research In Motion Limited (NASDAQ: RIMM), the manufacturer of the Blackberry smartphone, has lost significant market share to Google’s Android operating system and the iPhone, resulting in a decline of near 80 percent in its share price in 2011 alone. Despite deteriorating fundamentals, the company continues to be an intriguing investment to some people, no doubt because of familiarity with the product. However, these attempts at catching a falling knife have all ended in losses from the peak price of $70.54 a share in February to the bottom set in December 2011 of $16.00.⁴ Taking the market by surprise in November, one of the legendary hedge fund managers mentioned in The Billion Dollar Mistake was found to have purchased shares in the company when he released the holdings of his portfolio. This caused a 10 percent spike in the share price as soon as the news hit the tape. I was on television on CNBC that day, and I cautioned that the position size was small relative to the overall size of the portfolio, and that if this investor, whom I knew very well, really had confidence in the stock’s potential, he would have owned at least five times the amount that was reported, but that did not seem to matter to those snapping up shares. That evening, I sent an e-mail asking my friend why he had bought Research In Motion, and he responded that it was an extremely small position, so insignificant, in fact, that it was put on by his analyst and, while he did have a conversation with one of the co-chief executive officers at Research In Motion, the recommendation by the analyst did not have to go through the thorough investment policy process required of more meaningful investments. Basically, it was an odd lot, a vote of confidence for someone who worked at his firm. He also mentioned that in his 40 years in the business, no other position had elicited so much attention. This is not to say that this particular manager ever goes into a stock with the expectation of losing money—he guards his capital more zealously than anyone I know—but the approximately $25 million position was well within his risk appetite for speculative bets. The point of this is that while the position was basically insignificant to the professional investor, it likely was significant to those who followed his purchase. They should have followed his rationale and process instead but, and here’s the rub, they had no way of knowing what he was thinking. However, if they had performed just a little more due diligence they could have done the math⁵ and perhaps saved themselves some aggravation and money, at least in the short term. Postscript: After trading up on the news of the hedge fund’s involvement, the stock price hit a new low as the company once again disappointed investors with more bad news, although the story is far from over.

There is an old Chinese proverb that goes something like this: Give a man a fish and you feed him for a day. Teach a man to fish and you feed him for a lifetime.

And that is the point of The Big Win. This book profiles legendary investors, all of whom are extremely successful, spectacularly wealthy, and very disciplined in how they look at and react to opportunities. Each chapter concludes with an example of a very profitable investment—in the cases of Jim Chanos and Jim Rogers, investment theses that are still playing out as I write. You can go along with them if you like; there is more than enough information on these pages to get you started. The true value of these case studies, however, is in understanding each investor’s methods, not standing in awe of their results. Mimicking an investment decision of a smart investor will undoubtedly yield results but not always what was envisioned, despite the odds favoring a positive outcome. The DG syndrome is always lurking in the background.

But understand how a legendary investor thinks, the tenets upon which his or her investment style is based—what the investor looks for in commodities, stocks or bonds or real estate—and you can develop your own profitable strategy that can be applied to all types of investments. Importantly, understand the risk profile of these investors—when they admit to themselves they are wrong, or how they protect their downside when entering into an investment; preservation of capital is by far the most critical factor in any investment strategy. Possessing this knowledge is so much more valuable than whale watching and then blindly following the legendary investor into a trade.

Each big win in this book offers a lesson that can be an effective tool for taking greater advantage of the information on what successful investors are buying and selling; the big wins illustrate a tried-and-true process for independently assessing opportunity.

Understand the process, the means to the end. That is what is important, and that is how you can build a repeatable process to generate a positive return over the long term.

1. Most hedge fund and mutual fund managers have holding periods that fall far short of Warren Buffett’s.

2. A Schedule 13D must be filed with the Securities and Exchange Commission within 10 days of a person or group acquiring 5 percent or more of a company’s shares with the possible intention of influencing the company. There are other Form 13 filings: 13F is a quarterly report that discloses the stocks held by an institutional investment manager; 13G is a shorter form than the 13D and is used by passive investors. Given issues with liquidity—getting in and out of a sizeable position—and the cost of filing, very few institutional investors will buy enough shares for a “trade” that will require a Section 13 filing.

3. As of this writing, the author has a position in GM shares. Einhorn’s analysis made sense and led me to perform my own analysis which included a constructive view on the US economy, a necessity in my view for owning a cyclical company. Consistent with all discussions on stocks in this book, this is not a recommendation to purchase GM shares.

4. As of this writing the stock has rebounded to $17.31, due in part to an upward move in the broader market and continued rumors that the company will be acquired. Owning a stock solely because it is a rumored acquisition target rarely yields positive results.

5. Do the math: A quick search on the Internet would have revealed that the total value of the portfolio referenced in the news reports was about $5 billion, meaning that the fund’s position in Research In Motion was approximately one-half of 1 percent of all assets. The same filing that revealed the RIMM position also showed significantly larger portfolio positions, some exceeding 4 percent, indicating RIMM was a lower confidence holding.