Steve Watson – Dialling for Dollars

Today’s post is a profile of Guru investor Steve Watson, who appears in Jack Schwager’s book Stock Market Wizards. His chapter is called Dialling for Dollars.

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This article is part of our ‘Guru’ series – investor profiles of those who have succeeded in the markets, with takeaways for the private investor in the UK.

You can find the rest of the series here.

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Steve Watson

Steve Watson appears in Jack Schwager’s book Stock Market Wizards. His chapter is called Dialling for Dollars. ((The reference is never explained, but this appears to be an American TV show from the 1950s and 60s ))

He’s another no publicity type – I couldn’t find a photo, or work out what he’s up to nowadays (the interview is from 2000).

Background

Steve Watson got interested in the stock market via an investment course at the University of Arkansas.

He did a project researching a local utility company to write a report on it. He thought it was a terrible company, but his local broker had lots of glossy research showing it was a buy.

Steve and his team re-wrote their report to match the broker research, and got torn apart by their professor. Steve was hooked.

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After college, he started out as a broker in Dallas, where he realised that it was a sales job, and he was terrible at sales. He was also a bad stock picker during this period (which included the 1987 market crash).

He quit to move to New York. He went to work for an insurance company, doing credit analysis. He enrolled at Fordham University for a semester, received good grades, and then transferred to business school at NYU.

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He graduated and started work at Bankers Trust in the small cap department. These were stocks he knew well, often working until 3 am researching these stocks on Bloomberg.

He liked his boss, but he left after three months, and Steve didn’t get along with his replacement, a momentum investor whose philosophy clashed with Steve’s value approach.

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Six months later he moved to Friess Associates, who ran the Brandywine Fund. The fund grew rapidly, and became too big for the small caps Steve loved.

After two years he left to start his own hedge fund with $20K of his own money, raising another $700K from small cap CFOs that he had given stock tips to.

He was given a small office and a Bloomberg terminal for free from someone who wanted to encourage him.

Track record

Steve runs two funds:

1. the microfund invests in companies with a < $350M market cap
2. the small cap fund invests in companies with a capitalization of $350M to $1.5 bn

After four and a half years of running his own funds, his worst drawdown was under 4 percent – equivalent to one month’s average return (after fees).

Trading Style

Steve buys cheap companies – PE of 8 to 12 – with a catalyst for change. This usually means turnarounds.

Catalysts could include:

• new management
• a big contract win
• improving margins
• a new product
• closing loss-making subsidiaries or plants

He holds more than a hundred positions and no holding is more than 3% (usually 1.5%) of the portfolio.

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Watson’s approach is heavily dependent on getting information from other people, a style that is a good match for his easygoing manner.

He finds out about turnarounds before everyone else by talking constantly to the companies. As well as CFOs, his funds speak to distributors, customers, and competitors.

Note that he doesn’t talk to CFOs whose stocks he is shorting, because they have talked him out of taking good short positions in the past.

Steve also looks for insider buying. He rarely uses charts because everyone uses them so there is no competitive edge.

He uses analyst’s earning estimates but not their research material, which is biased by their client relationships.

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He sells quickly, usually when a stock has doubled or tripled in price, and the PE is up to 20.

This means he misses out on big winners, but has more protection during market declines because he’s not in the very high PE stocks that get hit the hardest.

If a stock doesn’t move upwards soon after buying, the money will be rotated into the next good idea.

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Steve’s net long position is typically less than 50 percent of assets, sometimes as low as 20%.

At the time of the interview (March 2000 – the dot-com peak) Steve was 80% long and 40% short. He was very bearish, particularly about internet stocks.

When the fund was less than $1M, he took more risks – 70% to 80% net exposure, individual positions as high as 5% or 6%.

This produced triple-digit (> 100%) returns in the first year.

Peter Lynch

Peter Lynch (legendary manager of the Fidelity Magellan fund) is a big inspiration.

Steve has read One Up on Wall Street at least ten times. He asks in interviews whether prospective employees have read the book.

The big message of the book is that it is critical to do your own research rather than depending on Wall Street research.

Invest in what you know – the company you work for, companies in the same industry, or companies that make a product you can touch and feel.

And if you can’t summarize why you own a stock in four sentences, you probably shouldn’t own it.

Steve still believes you can get investing ideas from going to the mall (as Lynch recommended).

Shorts and risk control

For shorts, Steve looks for PEs of 30 to 40, and stocks with no earnings. One-product companies are a particular favourite.

The tough thing about shorting – apart from borrowed stock being called back as the price goes down – is timing.

A lot of overpriced stocks that just get more overpriced.

To cope, Steve spreads short positions across lots of stocks, and uses tighter risk control than on longs:

• a long position can fall 40%, but Steve will hold if he believes the fundamentals are sound ((I guess this answers the unasked question as to whether he believes in stop losses ))
• if a short rises 20% to 30%, he will cover the position

Often a terrible stock will quintuple on a combination of a company announcement and a short squeeze.

• Steve won’t allow a 1% short to become a 5% loss.
• He’s much more concerned about avoiding a large loss than missing a profit opportunity.

Quotes

You have to be willing to accept a certain level of risk, or else you will never pull the trigger.

My first and most important lesson about the stock market: Stick to your own beliefs.

Small caps have always been a love for me because I can’t get an edge on stocks like Microsoft or Intel. I can’t call up the CFOs.

Do the research and believe in your research. Don’t be swayed by other people’s opinions.

Invest without emotions. If you let emotions get involved, you will make bad decisions.

You can’t be afraid to take a loss. The people who are successful in this business are the people who are willing to lose money.

Advice for private investors

Steve recommends that PIs use the telephone like him.

I might not be able to call the CFO, but I could call other employees of the company, as well as consumers and distributors of their products.

He also recommends using the internet for information, as well as going to the mall to check out a company’s product.

Conclusions

This is a good interview with a successful investor who is clear about what he does, and how he does it.

There are a number of lessons for the private investor, though few will follow all of them:

1. you have an edge with small caps
2. talk to CFOs, distributors, customers and competitors
3. trust your own research and beliefs
4. invest in what you know
5. look for insider buying
6. invest without emotions
7. be prepared to take a loss
8. buy cheap (PE 8 to 12) and look for a catalyst for change
9. use shorts to cover half your long positions
10. for shorts, buy expensive (PE 30 to 40) stocks with only one product
11. hold 100+ positions, with nothing more than 3% of the portfolio
12. sell winning longs when the PE is up to 20 (usually a doubling or tripling)
13. sell losing longs when they are down more than 40%, or if the fundamentals change
14. sell shorts if they move 20% to 30% against you

Until next time.