Buddy Fletcher – Win-Win Investing

Buddy Fletcher

This article is part of our 'Guru' series - profiles of successful traders, with takeaways for the UK private investor.
You can find the rest of the series here.

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Today’s post is a profile of Guru investor Buddy Fletcher, who appears in Jack Schwager’s book Stock Market Wizards. His chapter is called Win-Win Investing.

Buddy Fletcher

Buddy Fletcher

Alphonse “Buddy” Fletcher Jr. is a former hedge fund manager and founder of the Fletcher Foundation.

  • Fletcher first worked at Bear Stearns as a researcher and proprietary trader for two years, before moving to Kidder Peabody.

After a successful year at Kidder, they stiffed him on his bonus (giving him $1.7M instead of $7.5M – plus the promise of deferred payments later).

  • Fletcher sued and was awarded another $1.26M, but he lost a separate suit alleging racial discrimination1

He then started his own firm, Fletcher Asset Management, in 1991, with the support of Bear Stearns, and later Lazards.

  • The firm is based on the Upper East Side of New York.

Fletcher appears in Jack Schwager’s book Stock Market Wizards.

  • His chapter is called Win-Win Investing.

Performance

At the time of the interview, Fletcher had generated consistent high returns for thirteen years.

The Fletcher Fund, founded in September 1995, returned 47% pa compounded, with only four losing months.

  • The largest of these was a 1.5% fall.

In the first four years of his firm, Fletcher’s proprietary account (which used much more leverage) returned a compound 380% pa.

Fletcher’s fund is so popular that he turns investors away:

Investors are screened by either us or our marketing representatives. We just want supportive investors who will be friends and allies.

It is not worth the trouble having an investor who would be a distraction.

As the fund has grown, Fletcher says that he’s learned a lot about hiring people.

I used to hire anyone who said, “No problem, I could do that job,” because I knew that if I said that, I could do it. But most people who try to aggressively talk their way into a position can’t do the job.

The people who have worked out best are the people that I had done business with successfully for years before. I went after them, not the other way around.

Early days

Fletcher started out working with his father on a computer program to pick winners at the dog racetrack.

  • They used previous finish times for the dogs, positions at different poles, weather conditions etc to make predictions.

The program had an 80% record at picking dogs to finish in the top 3, but that wasn’t enough to beat the bookies’ odds.

  • Apparently in the US, the track takes 40% off the table.

Fletcher went to Harvard and got a maths degree.

  • His ambition at the time was to be a weapons officer in the Air Force.

In college he worked a summer job with Pfizer that allowed him to buy company stock at a 25% discount.

  • That was his first contact with stocks.
Options modelling

In his final year at college he took a course in financial engineering.

  • He modelled options pricing and became convinced that he had a way to consistently capture profits.
  • But Harvard taught the EMF, and his findings contradicted this.
See also:  Victor Sperandeo - Markets Grow Old Too

In some senses Fletcher still believes in the EMF.

If IBM is trading at $100 right now, it’s probably worth $100. I think it is very difficult to outsmart liquid markets.

When Fletcher graduated there were cuts to the defence budget and he could only join the reserves.

  • So he looked for a job on Wall Street, and ended up at Bear Stearns, where he implemented his options model just before the 1987 stock market crash.

This involved offsetting trades such that the overall position had little risk but still provided profit opportunities.

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The strategy was based on the cost of financing.

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.

Fletcher used option box spreads to exploit this.

  • These need four positions to be opened, with significant transaction costs.

Normally, the interest rate differences are not sufficiently wide to profit but there are exceptions. A corporation that has a large capital loss would pay the full tax rate on interest, but no tax on options gains.

Assume their short-term interest rate is 8% and they can implement a box spread that implies the same return. They will be much better off.

Bear Stearns

Fletcher’s boss at Bear Stearns was Elliot Wolk, from whom he learned the Bear Stearns philosophy:

Never make a bet you can’t afford to lose. My extreme aversion to risk traces back to Bear Stearns.2

When Fletcher got an “offer he couldn’t refuse” from Kidder, the Bear CEO Ace Greenberg said that “the deal sounded too good to be true”.

It turns out that he was right.

Arbitrage service

Fletcher explains more about his current approach:

Let’s say that I can earn 7% on my money, and you can earn 9% on yours. I should be able to buy IBM and sell it to you at a future date, and we would both be better off.

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% and you would pay less than your opportunity cost of 9%.

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The same reasoning applies more generally:

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.

But if one set of investors is treated differently, it should be possible to set up a transaction that offers a consistent profit opportunity.

Dividend capture

Fletcher offers an example of an Italian company, from which US investors would only receive 70% of the dividend because of withholding tax.

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.

So in effect, Fletcher is providing a service, rather than trading.

  • He usually places the trades and charges a commission.
  • Sometimes he takes the other side of the trades.

Of course, the trades can still lose money, if there is an adverse price movement before a hedge is fully implemented.

See also:  Mark Cook - Harvesting Profits
Dividend reinvestment

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.

This is popular among companies with high dividends who don’t want to cut their dividends but need to preserve capital. We buy shares from parties who don’t want to be bothered.

Capital raising

Our primary current activity 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, or because the whole sector is in trouble.

In a recent deal for a European software company, we provided $75M in exchange for $75M of company stock at the prevailing market price any time in the next three years, with a cap of $16 against the current $9.

If the stock goes down we’re well protected, but if the stock goes up a lot, we have tremendous opportunity. There’s also 8% pa interest until we swap the loan for stock. And we can sell out-of-the-money calls above our guaranteed $16 stock position.

There is still some risk if the company goes bankrupt, but we can protect ourselves by buying out-of-the-money puts, which at the strike prices implied by bankruptcy are pretty cheap.

It’s not always possible to get a perfect hedge. We sometimes use private “over-the-counter” options, or index options.

Future plans

Right now we are deliberately using strategies that are uncorrelated with the stock market. There is tremendous demand for an investment program that could consistently outperform the S&P 500.

P1MCO buys S&P futures for the stock exposure and tries to provide an additional 11% by managing a fixed income portfolio. That works work if interest rates are stable or go down, but if interest rates rise, they take a loss on their bonds.

All they are really doing is taking the active manager risk in the fixed income market as opposed to the equity market.

Fletcher wouldn’t provide more detail on his own idea, since it hadn’t been implemented yet and he didn’t want the competition to know about it.

Conclusions

This has been a fascinating interview with a very smart guy who was pretty open about his techniques for success.

  • And these techniques are high-profit and low risk.

Unfortunately, they can’t be put into practice by a private investor.

As Schwager points out, 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.

But he also innovates constantly and applies a high level of risk control.

  • Which is about all that we can take away from today, as fun as it’s been.

Until next time.

  1. He was reluctant to talk about this in Schwager’s interview []
  2. They must have changed in between the time Fletcher was there and when I came across them in 2008 – I was working at JP Morgan when we took them over during the financial crisis []

Mike Rawson

Mike is the owner of 7 Circles, and a private investor living in London. He has been managing his own money for 35 years, with some success.

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2 Responses

  1. Avatar weenie says:

    Interesting stuff. I never knew there was such at thing as ‘financial engineering’!

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Buddy Fletcher – Win-Win Investing

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