Every investment expert knows that you can’t achieve high returns, say an average of 40 or 50 percent per year, without taking on significant risk. Apparently, no one ever bothered to explain this basic concept to Alphonse Fletcher Jr. Otherwise he would have known better than to try to generate consistent high returns, with hardly any losing months, as he has done since placing his first trade thirteen years ago.
Fletcher began his financial career at Bear Stearns as a researcher and trader of the firm’s own funds. After two very successful years, he was lured away to a similar position at Kidder Peabody. * Although he loved working at Bear Stearns and was very reluctant to leave, Kidder’s job offer was just too lucrative to turn down. In addition to his salary, Kidder promised Fletcher a 20 to 25 percent bonus on his trading profits.
In his first year at Kidder, Fletcher made over $25 million for the firm. Instead of the $5-million-plus bonus he had anticipated, however, Kidder paid him $1.7 million, with a promise to make additional deferred payments over the next few years. When Fletcher protested that the company was reneging on its deal with him, he was told he shouldn’t complain because he was “one of the highest paid black males” in the country. One company officer is alleged to have commented that the bonus Kidder was obligated to pay Fletcher was “simply too much money to pay a young black man.” These quotes were taken from the court transcripts in the suit that Fletcher brought against his former employer with other specifics derived from published articles; Fletcher himself was very reluctant to discuss the details of the episode. Fletcher was ultimately awarded an additional $1.26 million by an arbitration panel. After leaving Kidder, Fletcher founded his own firm, Fletcher Asset Management.
I visited Fletcher on one of those brutally hot, humid New York City summer afternoons. I always prefer to walk in cities whenever possible as opposed to taking taxis or public transportation. But I was running a bit late for my scheduled interview with Fletcher, so I hopped a cab. The midtown traffic was horrendous. After going two short blocks in five minutes, about one-third of my normal walking pace, I handed the driver a $5 bill and jumped out, still a mile and a half from my destination.
By the time I arrived at Fletcher Asset Management, I must have looked as if I had walked through a shower. The offices are located in a 120-year-old limestone townhouse on the Upper East Side. I stepped through the large, heavy wooden door, moving from the heat and noise of the modern city into a cool, quiet, and elegant interior. The entranceway led to a large circular reception area with soaring ceilings and a hand-crafted spiral wooden staircase that rose to the offices on the four upper floors. The walls were painted in warm, rich complementary colors, which when combined with the lofty ceilings, wide ornamental moldings, and antique furniture created an atmosphere of a different time and place, far removed from New York City circa 1999. If I were filming a movie with a scene at an old-line Swiss investment firm catering to clients with tens or hundreds of millions of dollars, this would be the perfect set.
I was led into a library that served as a waiting room and was offered a large pitcher of ice water, which I rapidly gulped down as soon as the attendant left the room. After about ten minutes, I was escorted up the staircase to Fletcher’s office.
It is clear that Fletcher has deliberately created an environment that is in striking contrast to the typical modern Manhattan office. The result is very effective in creating a tranquil sanctuary from the frenzy of the city outside, with a sense of style that must send a subliminal message to investors: your money will be safe here.
Fletcher, however, doesn’t need impressive offices to attract investors. His performance results almost defy belief. That is not to say that he has the highest returns around—not by a long shot. However, those who look only at returns suffer from extreme naïveté. It is not return that matters, but rather return relative to risk. Here Fletcher shines. The Fletcher Fund, his flagship fund, founded in September 1995, has realized an average annual compounded return of 47 percent. Although this is quite impressive on its own, here is the kicker: He has achieved this return with only four losing months, the largest of these being a minuscule 1.5 percent decline.
Fletcher’s track record prior to launching his fund is, if anything, even more astounding. During the first four years of its existence, Fletcher’s firm, which was founded in 1991, primarily traded its own proprietary account. This account, which was traded at much higher leverage than his fund, garnered an incredible average annual compounded return of 380 percent during that period. (Although returns in these earlier years are not published or reported in any way because they represent a proprietary account, the figures have been audited.)
When I first saw Fletcher’s track record, I couldn’t conceive how he could achieve such a substantial return with virtually no risk. In our meeting, he explained exactly how he does it. Yes, in reading this chapter, you will find out as well. However, so as not to create false expectations, I will tell you at the outset that his methods are not duplicable by ordinary investors. Even so, why would he reveal what he does? The answer is explained in the interview.
When did you first develop an interest in the markets?
It probably started when I was in junior high school and my father and I worked on developing a computer program to pick winners at the dog racetrack. [He laughs robustly at the memory.]
Did you have any success trying to forecast dog races?
Oh yes. The computer would eliminate one set of races it couldn’t predict. In the remaining races, the program had an 80 percent accuracy rate in picking a dog that would place in the money [win, place, or show].
That’s pretty impressive. How much money did you make?
I learned an interesting lesson about odds: winning 80 percent of the time may not be enough if the odds are not right. I forget the exact number, but the track takes about 40 percent or more off the table.
Wow, that’s incredible—that even makes slot machines look good!
So even though we won 80 percent of the time, it still wasn’t enough to make any money.
What information were you using to predict the race outcome?
All the information that comes in the racing program—finish times for the dogs in different races, positions at different poles, weather conditions, etc.
How did you try to solve this problem? Did you use multiple regression?
Hey, remember I was only in junior high.
When did you actually get involved with stocks?
When I was in college, I had a summer job with Pfizer, and they had an employee program that allowed you to buy stock in the company for a 25 percent discount. That sounded like a great deal to me. Ironically, as we fast-forward to the present, both of these principles—the computerized analysis of odds and buying stock at a discount—are hallmarks of what we do today. Of course, I don’t mean this literally, since we don’t buy stocks at a discount, and we don’t make bets on who’s going to be the winner. Nevertheless, those concepts tie into our current strategies in a remarkable way.
Let’s go back to your origins. How did you actually get involved in trading the market?
I graduated Harvard with a math degree. At the time, everyone was going into M.B.A. programs or Wall Street.
As a math major at Harvard, I assume that you must have had phenomenal SAT scores.
Let’s just say that I did very well. The funny thing is that I didn’t take any of the SAT preparatory courses. I prefer to figure out things for myself rather than learn the tricks of the trade. I’m still like that today.
Sometimes I play word or math games for fun.
For example.
This is my latest thing. [He picks up an abacus. ] I have no interest in reading instructions on how to use it, but I am intrigued by the idea of trying to figure it out for myself. I want to work out what algorithm you would use to do addition, subtraction, multiplication, and division on this instrument.
Did you plan to go to Wall Street when you finished college?
No, actually I planned to go into the air force
Why the air force?
I had been in air force ROTC in college, and the idea of becoming a weapons officer and being responsible for all the new high-tech equipment appealed to me.
Did you join the air force?
No. In the late 1980s, there were significant cuts in the defense budget. In order to reduce the number of personnel, the air force encouraged us to go into the reserves. A good friend convinced me to look for a job on Wall Street. I was offered a position at Bear Stearns and fell in love with the place. They in turn virtually adopted me. I don’t know what the magic was, but Elliot Wolk, who was a member of the board of directors and the head of the options department, took a liking to me.
Were any of your courses at Harvard helpful in preparing you for the real world?
In my senior year, I took a graduate-level course in financial engineering. I did my project on the options market and found it fascinating. I tried to model what would happen if an option price was forced away from its theoretical value, say because someone placed a large buy or sell order that moved the market. My results convinced me that I had found a way to consistently capture profits in the options market. The idea that I could develop a model that would consistently make money in options, however, went against all the theory I had learned about the markets.
From that comment I take it that, at the time, you believed in the efficient market hypothesis, as it was taught at Harvard.
Yes indeed [he laughs loudly]. In many respects, I still believe it, but as you’ll see, there is an interesting other side.
You believe it—in what sense? After all, your own performance seems to belie the theory that markets are perfectly efficient.
If IBM is trading at $100 right now, it’s probably worth $100. I think it is very difficult to outsmart liquid markets.
You mean by using a methodology that depends on getting the future price direction right?
That’s correct.
So where doesn’t the efficient market hypothesis apply—say in your own case?
My analysis implied that it was possible to implement offsetting trades, in which the total position had little or no risk and still provided a profit opportunity. In the real world, such discrepancies might occasionally occur because a large buy or sell order might knock a specific option or security out of whack with the rest of the market. In a theoretical model, however, it should be impossible to show a consistent risk-free opportunity if the efficient market hypothesis is correct. As it turned out, my model was right. In fact, it was the basis for the very first trade I did for Bear Stearns, and it was very lucrative for them.
What was this virtually risk-free market opportunity that you say was consistently available?
The concept was based on the cost of financing. Sure IBM is worth whatever it’s trading at. However, let’s say that I can earn 7 percent on my money, and you can earn 9 percent on your money. Given the assumption of our having different rates of return on our money, I should be able to buy IBM and sell it to you at a future date for some agreed price, and we would both be better off. For example, I might buy IBM at $100 and agree to sell it to you for $108 one year from now. I would make more than my 7 percent assumed alternative rate of return, and you would lock in ownership of IBM at less than your assumed opportunity cost of 9 percent annualized. The transaction would be mutually beneficial.
Wouldn’t arbitrage drive that opportunity away?
Arbitrage will only eliminate opportunities where we both have the same costs of funds. If, however, your cost of funds is significantly higher or lower, then there will be an opportunity. In a more general sense, the markets might be priced very efficiently if everyone had the same costs of funds, received the same dividend, and had the same transaction costs. If, however, one set of investors is treated very differently, and persistently treated differently, then it should be possible to set up a transaction that offers a consistent profit opportunity.
Give me a specific example.
Instead of IBM, say we’re talking about an Italian computer company. Assume that because of tax withholding, U.S. investors receive only 70 cents on the dollar in dividends, whereas Italian investors receive the full dollar. If this is the case, a consistent arbitrage becomes available, wherein a U.S. investor could sell the stock to an Italian investor, establish a hedge, and after the dividend has been paid, buy it back at terms that would be beneficial to both parties.
It almost sounds as if you are performing a service. If I understand you correctly, you find buyers and sellers who have different costs or returns, due to a distortion, such as differences in tax treatment. You then devise a transaction based on this difference in which each party ends up better off, and you lock in a profit for performing the transaction.
Exactly. The key word you used was service. That’s one of the key reasons why the results we have delivered are so different from those of traditional investment managers, who buy and sell and then hope for the best.
How could you ever lose in that type of transaction?
Very easily. It is very important that there is a real economic trade in which the Italian investor actually buys the shares and is the holder of those shares at the time of the dividend payment. If that’s the case, then there are real transactions, with real exposure to economic gains and losses, and something can go wrong. For example, if there is an adverse price movement after the trade and before we can fully implement the hedge, then we could lose money.
The trading opportunity based on the option model you developed in college, however, was obviously different, since it only involved U.S. markets. What was the idea behind that strategy?
In my model, I was using two different interest rates. I found that assumption led to a consistent profit opportunity.
Why were you using two different interest rates?
I used the risk-free interest rate [T-bill rate] to generate theoretical option values, and I used a commercial interest rate to reflect the perspective of an option buyer who had a cost of borrowing funds that was greater than the risk-free rate. As a consequence of using two different rates, trading opportunities appeared.
What precisely was the anomaly you found?
The market was pricing options based on a theoretical model that assumed a risk-free rate. For most investors, however, the relevant interest rate was the cost of borrowing, which was higher. For example, the option-pricing model might assume a 7 percent interest rate while the investor might have an 8 percent cost of borrowing. This discrepancy implied a profit opportunity.
What was the trading strategy implied by this anomaly?
An option box spread.
[If you are one of the few readers who understands this, congratulations. If, however, you think an option box spread is a quilt design, a sexual position, or some other equally accurate conjecture, don’t worry about it. Any explanation I might attempt would only serve to confuse you further. Take my word for it. For the purpose of what follows, it is sufficient to know that an option box spread is a trade that involves the simultaneous implementation of four separate option positions.]
Given the substantial transaction costs (commissions plus bid/ask differentials), is this trade applicable in the real world?
You’re quite right. Normally, the interest rate differences are not sufficiently wide to offer any consistent opportunity once trading costs are taken into account. The key point, however, is that there are exceptions, and it is these exceptions that provide the profit opportunity. For example, a corporation that has a large capital loss would have to pay the full tax rate on interest income, but would not have any tax obligation if they earned the equivalent income in an option trade [because the capital gain on the option trade would be offset by their existing capital loss]. Assume their short-term interest rate is 8 percent and they can implement an option box spread at levels that imply the same 8 percent return. Although it is the same return, the corporation would be much better off because the return is a capital gain instead of interest income. To them, the return would look more like 11 percent.
Where do you get your income on the trade?
Initially, we made money either by implementing the transaction for the corporation and charging a commission, or by taking the other side of the trade. The difference in the tax treatment of different parties is what creates the profit opportunity. I would add that although the examples I have given you used illustrations in which the economic profits were enhanced by tax benefits, most of our trades are not tax-related.
What was your job at Bear Stearns?
I had no specific responsibilities; I was just told to figure out how to add value to the company. I started a couple of months before the 1987 stock crash. While all my friends are trading stocks and bonds, and the market is crashing and layoffs are going on, I’m sitting there without any specific responsibility and a mission to figure out how to make money in the Bear Stearns style.
And exactly what is that?
To commit very little capital, take on very little risk, and still make a significant return consistently. And if you can’t do that, they don’t want to put their money into the trade. They are a very smart firm.
Even though you were left to come up with your own ideas, you must have had an immediate superior.
Sure, Elliot Wolk.
Did you learn anything from him?
A great deal. One useful piece of advice he gave me, which summarized the philosophy of Bear Stearns was: Never make a bet you can’t afford to lose. My extreme aversion to risk traces back to Bear
Stearns. To this day, I am deeply appreciative of the opportunity they gave me and for what I learned at the firm.
Why did you leave Bear Stearns?
Kidder made me a great offer. It was really hard to leave. My initial intentions were to stay at Bear Stearns for my whole career.
Was this the proverbial deal you couldn’t refuse?
Yes.
Did Bear Stearns try to counteroffer?
I met with Ace Greenberg, Bear Stearns’s CEO at that time, over the course of two days, but his only real response was advice. He told me that the deal sounded too good to be true and that I should just continue to make my bet with Bear Stearns. It turns out that he was right. It’s a shame, because I was really excited about going to Kidder
Peabody. Not only did the firm have a great history, but the opportunities that existed with General Electric as the majority shareholder were truly remarkable. Unfortunately, some misunderstandings and miscommunication with management caused an uncomfortable situation. At that point, it was best for me to just leave.
I already know the situation you’re talking about. It was amply reported in the press. I prefer to get the story directly from you, however, as opposed to secondhand. I also know that the resulting legal suits were resolved, and therefore there is no legal restriction to your talking about the case.
The only restriction is that I really love not to dwell on it [he laughs]. I am glad it is all over. Kidder was great for me in many ways and bad for me in many ways. Essentially, they offered me a great deal to come over, and then the deal changed. Then they said a number of things that were very insensitive and impolite. So I left them and won the arbitration on the contract dispute. A suit on race discrimination ended up being unsuccessful—good riddance.
[Based on public documents, this suit was not lost on the merits of the discrimination case, but rather because the New York Court of Appeals ruled that the standard registration form signed by Fletcher as a condition of employment compelled arbitration. Although the court ruled against Fletcher’s petition because it felt such a decision was dictated by the letter of the law, the written opinion appeared to reflect a reluctant tone: “We stress that there is no disagreement among the members of this court about the general proposition that racial, gender, and all other forms of invidious discrimination are ugly realities that cannot be countenanced and that should be redressable through the widest possible range of remedies…”]
If you don’t mind my asking, other than this particular episode, have you encountered prejudice elsewhere in the industry?
I have definitely experienced some things, but it is usually more subtle. I really prefer not to dwell on it.
I’m just curious whether prejudice is still a factor.
Frankly, whenever there’s a difficult situation, race is always one of those easy cards to play. For example, if someone is envious. Usually, nothing is direct. Ultimately it’s a very subtle issue, and you never know for sure. Someone acts in a certain way, and you think it is one thing, but eventually you find out that it’s not. In the last eight years, I haven’t seen anything…actually, I guess I have seen a number of things that are somewhat direct [laughing]. My view is that as long as I do the best I can for the people who put their trust in me—my investors, my employees, and the companies I invest in—then everything else will take care of itself.
When I read about the whole episode, I thought it was pretty gutsy of you to bring a legal suit instead of taking a settlement. I assume that you just wanted to fight back.
I didn’t want to be adversarial, but they were sooo…. You got me talking about it; I didn’t want to talk about it. [He laughs long and hard.] Kidder was great, GE was great, and I really wanted to be there for a long time. If they had said to me, “We’re going to pay you half the amount we agreed to, and we’ll work out the remainder,” I probably could have lived with that. I wouldn’t have minded those issues if they were prepared to let me be part of the team and really participate and contribute going forward. But far worse than the compensation issue was the treatment—the attitude that I didn’t belong and some of the comments from senior management.
So it wasn’t just one person.
No, it wasn’t just one person.
But what’s odd is that you did so well for them.
Sometimes, I think that makes it worse.
But that’s what I don’t understand. They hired you. It’s not as if they suddenly discovered you are black. Oh well, I guess there is
no reason to expect prejudice to be logical. How did you go about starting your own firm when you left Kidder?
I went back to Ace Greenberg. Bear Stearns set me up with an office and gave me access to its very supportive clearance department, which provided financing and brokerage services for professional investors.
What did Bear Stearns get out of this deal?
I still had very friendly relationships with the people at Bear Stearns.
To some extent, they just wanted to help me out. But it was also beneficial to them because they gained a customer. Based on their previous experience with me, I’m sure they assumed that I would generate significant brokerage business for them.
After I left Ace’s office, I went downstairs to the computer store and bought myself a Macintosh, which I set up on my dining room table. I constructed the spreadsheets for a transaction opportunity I saw would be feasible over the next few days and then faxed the sheets to a Fortune 50 company for whom I had done similar deals that had worked out well. They liked the idea and gave me the go-ahead. The next day I opened the account at Bear Stearns and did the other necessary preparations for the trade. On the third day, I executed the transaction, and on the fourth day, I went to the bank to open an account for $100 so that I could receive the fee as a wire transfer. In effect, Fletcher Asset Management was funded for $100.
Could you elaborate on the strategies you’re using today.
A common theme in all our strategies involves finding someone who is either advantaged or disadvantaged and then capitalizing on their advantage or minimizing their disadvantage. Arbitrage opportunities are very difficult to find without that type of an angle.
We are still pretty active in the dividend capture strategy we talked about earlier. Our primary current activity, however, involves finding good companies with a promising future that need more capital, but can’t raise it by traditional means because of a transitory situation. Maybe it’s because their earnings were down in the previous quarter and everyone is saying hands-off, or maybe it’s because the whole sector is in trouble. For whatever reason, the company is temporarily disadvantaged. That is a great opportunity for us to step in. We like to approach a company like that and offer financial assistance for some concession.
For example, in a recent deal involving a European software company, we provided $75 million in exchange for company stock. However, instead of pricing the stock at the prevailing market price, which was then $9, the deal was that we could price the stock at a time of our choosing up to three years in the future, but with the purchase price capped at $16. If the price of the stock falls to $6, we will get $75 million worth of stock at $6 per share. If, however, the stock goes up to $20, we will get $75 million worth of stock at a price of $16 per share because that was the maximum we agreed to. In effect, if the stock goes down we’re well protected, but if the stock goes up a lot, we have tremendous opportunity.
Are you then totally eliminating the risk?
The risk is reduced by a very significant amount, but not totally. There is still risk if the company goes bankrupt. This risk, however, is small because we are only selecting companies we consider to be relatively sound. In fact, a senior officer of one of the companies we previously invested in is now part of our own staff and helps us evaluate the financial prospects of any new investments. With this expertise in-house, it would be rare for us to choose a company that went bankrupt.
The logic of the transaction is pretty clear to me. As long as the company doesn’t go bankrupt, if the stock goes down, stays about unchanged, or goes up moderately, you will at least break even, and if it goes up a lot, you can make a windfall gain. Although there is nothing wrong with that, doesn’t it imply that the vast majority of times these transactions will end up being a wash and that significant profits will occur only sporadically? Why wouldn’t you end up with an equity curve that is fairly flat most of the time, with only occasional upward spikes?
Two reasons. First, the money we invest in the company doesn’t just lie idle; it generates annual income—8.5 percent using the example we just discussed—until we price the stock. Second, since the maximum price we will have to pay for the stock is capped—$16 in our example—we can sell out-of-the-money calls against this position, thereby guaranteeing an additional minimum revenue.
[By selling options that give buyers the right to buy the stock at a specified price above the current price, Fletcher gives up part of his windfall profit in the event the stock price rises sharply. But, in exchange, he collects premiums (that is, the cost of the options) that augment his income on the deal regardless of what happens to the stock price.]
But are there always traded options in the companies you are financing through these stock purchase agreements?
Well, it’s not always possible to get a perfect hedge. But even when there are no options traded for the specific company, we can sometimes use private “over-the-counter” options. We can also use index options against a basket of companies in our transactions. The assumption is that if the stock index rises a lot, then the stocks of the companies we have invested in are likely to rise sharply as well. In fact, since we are buying stocks that have been under pressure and are more speculative in nature, if the market does well, these stocks may rise more than the average.
Taking into account the interest income and the option-selling income, it appears that you are virtually guaranteed to make at least a moderate profit on every transaction of this kind, and only lose in the disaster scenario.
Even in the disaster scenario, which again is unlikely because of the way we select our stocks, we can still sometimes protect ourselves by buying out-of-the-money puts, which at the strike prices implied by a bankruptcy are pretty cheap.
How long have you been employing this type of strategy?
For about seven years, and it has now grown to become our single most important market activity. The strategy actually evolved from the dividend capture strategy. [The strategy described previously in Fletcher’s example of U.S. investors holding shares in an Italian computer company.] One variation of the dividend capture strategy is dividend reinvestment, wherein companies allow shareholders to reinvest their dividends in the stock at a discounted price. We have been very active in buying shares from parties who did not want to be bothered with reinvestment. We would therefore be the recipient of $1 million of dividends and then elect to reinvest it, receiving $1.05 million of newly issued stock.
Why would a company give you more stock than the amount of the dividend?
Because the companies that provided this offer wanted to conserve their capital and were willing to grant shareholders a 5 percent discount as an incentive to reinvest their dividends in the stock.
Is it common for companies to offer this type of dividend reinvestment?
It is popular among companies with high dividends who don’t want to cut their dividends but need to preserve capital. For example, it was particularly prevalent among the banks in the early 1990s when they were trying to increase their equity.
Eventually, some companies started to offer shareholders the option to purchase additional discounted shares in an amount equivalent to the dividend reinvestment. Then some companies began waiving limits, allowing investors to buy virtually any amount of stock at a discounted price.
In the early 1990s, many banks were actively pursuing this type of program, and we participated heavily. That experience led us to going to a major U.S. electronics company in 1992 in what proved to be our first private equity funding deal. At the time, this company couldn’t raise capital through a stock offering because they’d had a bad quarter and the prevailing attitude was: “I don’t want to buy newly issued stock from that company.” That’s probably the best time to buy newly issued stock. When do you want to buy it—after they’ve reported record earnings [he laughs]? But that’s the way it works, and it was a perfect opportunity for us to step in and say here’s the check.
We told the company that we would buy $15 million worth of stock from them over a period of time. We stressed that we wanted it to be a very friendly and supportive deal. Therefore, instead of buying stock at a discount, we proposed being compensated by an option to buy more stock in the future. In this way, our incentives were perfectly aligned with the interests of management and shareholders. As we discussed earlier, in this type of arrangement, our most significant profit opportunity arises when the company does very well, although because of our hedge, we should be consistently profitable.
We had a wonderful relationship with this company. In fact, their former CFO ended up joining us. He’s the one at Fletcher Asset Management who explains who we are to the companies we approach and manages the negotiations and ensuing relationships.
There’s no better salesman than a satisfied customer. How did you sell a major corporation on your financing transaction, since you had never done anything like that before?
That’s a good question. When I first approached them, we were this tiny firm working out of rented space at Bear Stearns. Their initial reaction was: Who are you? Merrill Lynch couldn’t get us a secondary offering, Lazard is our adviser, and you are calling out of the blue to tell us that you can do the deal.”
I talked to a neighbor in my apartment building, Steve Rattner, who was a senior banker at Lazard. I told him that I was interested in doing a deal with a company that his firm was advising. I asked him to help me. He made a few phone calls, and the next thing I knew, I was on a flight to Chicago along with a banker from Lazard and our attorney to meet with the company. When the deal was all done, Steve said to me, “That was an extremely interesting transaction. Have you thought about taking on outside capital?”
Didn’t the idea of raising outside capital to fund your transactions occur to you before this deal?
Sure, the idea had come up a number of times before. However, every time we considered it, we asked ourselves why we should take money from investors, and give up the bulk of the profits, when we can borrow money to do the deal, and keep 100 percent of the profits?
Exactly, so why did you start a fund open to outside investors?
The big change was realizing that a friend like Steve could get us in the door where such a great transaction could happen. Wouldn’t it be nice to have other friends like that who had a vested interest in our success.
So the primary motivation wasn’t necessarily raising extra capital, but rather getting investors who would be allies.
Yes, that was the point Steve made that caught my attention. Raising capital, however, did provide some additional benefits over borrowing by allowing us to do many more transactions, thereby reducing our portfolio risk through greater diversification.
Using the U.S. electronics company as an example, I assume that if Steve had not been there, the deal would never have happened.
Exactly. We have some incredibly insightful people as investors whom I can call for advice.
It almost sounds as if you have selected your own investors.
Essentially, we have. We have turned away a number of investors, particularly in the U.S. fund.
If someone comes to you and wants to invest a couple of million dollars, you won’t automatically open the account?
Oh no, we have actually researched everyone who wanted to invest before they invested.
So you actually screen your investors.
Yes, investors are screened by either us or our marketing representatives.
And the reason?
If we were just looking to raise as much money as we could, sure, the more the merrier. At this point, we just want supportive investors. It is not worth the trouble having an investor who would be a distraction. Maybe in the future, with other pools of money, we may be less judgmental, but right now we want investors who will be friends and allies.
But, surely, not every investor is someone who will have useful contacts or be a source of advice.
If they are not, though, then they are usually either friends or family. For example, the head trader’s mother, who is a retired librarian, is one of our investors, as is my own mother, who is a retired school principal. In fact, eight of our mothers and mothers-in-law are investors in the fund. By the way, our mothers are the most demanding investors.
In what way?
They have no qualms about demanding an explanation for anything, from the reason for a slow start to the year to the reason for a particularly good month.
What prevents competitors from coming in and doing private equity funding deals similar to the ones you did with the U.S. electronics company and the European software company?
They come in all the time. In each of the strategies we have discussed, competition has increased and will continue to do so. That’s the nature of the market. Our advantage is that we were there first. What is unique about our firm is that we never imitate someone else’s strategy. Another advantage we enjoy is that we try to construct our deals so that they are fair to both the company and us. As a result of our approach, over time we have been able to evolve from doing deals with companies worth several hundred million dollars to companies whose market size is measured in billions.
Even though you have an advantage, with this one core strategy providing most of your profits, what happens if the field becomes sufficiently crowded to reduce the profit margins meaningfully?
Well, we are always working on developing new strategies. Our thinking is: Let the competition move in, we’ll be on to the next thing.
For example?
For example, right now we are deliberately using strategies that are uncorrelated with the stock market. There is tremendous demand, however, for an investment program correlated with the stock market that could consistently outperform the S&P 500. I would love to take on that challenge.
A lot of people have come up with the idea of S&P enhancement programs. Haven’t any of these enhanced S&P funds been successful?
Even the ones that have come close to doing it haven’t quite done it. These funds have attempted to beat the S&P 500 by 1 percent or a few percent, but they have not been consistent.
How do they try to do it?
At one extreme, PIMCO buys S&P futures for the stock exposure and tries to provide the additional 100 basis points return by managing a fixed income portfolio.
Sure, that would work if interest rates are stable or go down. But if interest rates rise, aren’t they taking the risk of a loss on their bond portfolio?
Yes, they definitely are. In effect, all they are really doing is taking the active manager risk in the fixed income market as opposed to the equity market.
What other approaches have people used to try to consistently outperform the S&P 500 benchmark?
Some people attempt to beat the S&P 500 by trying to pick the best stocks in each sector. They will balance their sector investments to match the S&P 500, but within each sector they will weight certain stocks more heavily than others. For example, they might weight their portfolio in favor of GM versus Ford, or vice versa, depending on their analysis.
Have you thought of a way of consistently beating the S&P 500?
Oh, sure.
Then why haven’t you started trading it as a model program?
We’ve been very busy. We will probably start it soon.
How did the idea of an S&P 500 enhancement program come to you?
I kept reading about the never-ending debate between those who felt active managers were better and those who felt you couldn’t beat the index, implying passive managers were better. I thought it would be really exciting to be able to consistently beat the index.
I understand how the idea for the product occurred to you, but what I am asking is how did you get the idea of how to do it?
I have to be tight-lipped here because we haven’t launched this program yet. I was able to talk about our other strategies because the competition has already figured out what we are doing and has begun to move in.
So you haven’t initiated this S&P 500 enhancement program yet, but once you do, the competition will know what you’re doing.
Then we can talk about it [he laughs].
The strategies you describe sound so well hedged and your risk numbers are so low that I’m curious if you ever had a trade that went really bad, and if so, what went wrong?
One of the companies we invested in declared bankruptcy. Our protective strategies worked well, but they can only work up to a limit.
What is the whole story?
Don’t make me relive it [he laughs]. This is our worst story by far.
The worst story is always more interesting than the best story.
Yes, I always focus on this episode whenever I talk to new investors. The company, which was a marketer of prepaid phone cards, needed financing. Although the deal was marginal, we decided to do it. Two weeks after the deal was completed, the company announced that all their financial statements were wrong and would be revised for the past two years. The stock dropped over 70 percent overnight. It happened so quickly that we didn’t have time to get our hedges fully in place. Although the company still had a viable business and assets, they declared bankruptcy to facilitate the sale of virtually all of their assets to another company.
How did you extricate yourself from this situation?
Fortunately, part of our deal was secured, placing us first in line in the bankruptcy proceedings. We have already recovered a large chunk of our capital and have a claim pending for more. If our due diligence is done correctly, then the companies we invest in should have significant liquidation value, which was the case here—the acquiring company wrote a check for more than $100 million. Of course, although the assets are there, we don’t know how much more money, if any, we will recover on our claim.
What did you learn from this whole experience?
The fact that the company negotiated aggressively for granting us less protection than is the case for our normal deals should have acted as a warning signal. The blindsiding that came from the financial restatement was really brutal, but I don’t know how that could have been avoided.
You’ve grown from a one-man shop to a thirty-plus-person firm. What have you learned about the process of hiring people since you started your company?
One of the best things I learned since starting a business was how to hire the right people. I used to hire anyone who insisted they were right for the job. If we had an open slot and someone said, “No problem, I could do that job,” I would hire that person because I knew that if I said that, I could do it. Through experience I learned that most people who try to aggressively talk their way into a position can’t do the job.
What have you changed in your hiring practices?
The people who have worked out best are the people that I had done business with successfully for years before I recruited them to join us. Literally, I went after them; they didn’t come after me. That’s been the big difference.
Fletcher’s initial success came from a brilliant insight: Even if the markets are efficient, if different investors are treated differently, it implies a profit opportunity. Every strategy he has employed, at its core, has been based on a discrepancy in the treatment of different parties. For example, the profit opportunities in his current primary strategy—private equity funding—are made possible by the fact that some companies have much greater difficulty attracting investment funds than other companies with equivalent long-term fundamentals. By identifying these temporarily out-of-favor companies, Fletcher can structure a financing deal that offers these firms funds at a lower cost than they can find elsewhere while at the same time providing him with a high-probability, low-risk profit opportunity.
The two other main themes to Fletcher’s trading success are innovation and risk control. Although the specifics of Fletcher’s approach are not directly applicable to ordinary investors, these two principles still represent worthy goals for all market participants.
Update on Alphonse “Buddy” Fletcher Jr.
During the bear market, Fletcher was successful in preserving capital, but not in maintaining his returns. Measured from the start of the bear market (April 2000) through September 2002, Fletcher’s original fund managed only a minuscule 2 percent cumulative return. Still, this performance compares very favorably with the equity markets, which saw contemporaneous cumulative declines of 45 percent in the S&P 500 and 75 percent in the Nasdaq.
Since the start of the bear market a little over two years ago, your flagship fund is up only a few percentage points. That’s a lot better than the indices, but before the advent of the bear market, was your goal to merely preserve capital during a protracted decline in equity prices, or did you expect to still make a double-digit return annually?
The insurance provided by our hedges allows us to successfully preserve capital. It does not, however, generate quality investment opportunities. Although we are seeing many more opportunities to invest directly in companies, interestingly, the number of acceptable opportunities has declined, leaving us with returns well below the historic average for our aggressive funds. Our more conservative income arbitrage fund, however, has continued to perform, with the annualized return averaging near 9 percent since the start of the bear market.
What have you learned during the past two-plus years of a bear market that you didn’t know or fully appreciate before?
It’s more a matter of reinforcement than learning. The market of the past two years has underlined the importance of our emphasis on liquidity and the virtue of patience. We can’t control when acceptable opportunities will appear, but we can certainly try to preserve our capital until those opportunities arrive.
An essential element of your core strategy is providing financing to companies. The accuracy of the company books is therefore very critical to your approach. In this light, have you been hurt by any instances of accounting deceptions that now seem to be coming to light in an almost routine fashion?
An essential element of our strategies is to invest directly in companies, and fortunately we have not been hurt by these current accounting incidents. Long before this current rash of scandals, we concluded that not every company’s financial statements are complete and accurate. This skeptical approach has helped us avoid some problems.