Michael Lauer – Value over Fad – Investor Profile

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.

Michael Lauer

Michael Lauer was interviewed by Jack Schwager in May 1999 as part of the Stock Market Wizards book. His chapter is called “The Wisdom of Value, The Folly of Fad”.

He had been managing a fund for seven years at that point, with annual returns (net of fees) of 72%.

This would grow a £10K investment to £517K over the seven years, compared to £30K for an investment in the S&P 500 over the same period. The maximum drawdown was 8.7% and the fund – now worth $700M – never took more than 4 months to reach a new high.

Early career

His first degree was in International Relations (he also has an MBA in finance) and he initially worked for the US intelligence services.

A family friend recommended him to Oppenheimer where he worked as an equity analyst. He then did the same job for another three firms – specialising in tech stocks – before becoming a portfolio manager.

Lauer suffered large personal losses in the 1987 crash. He was in small caps, which dropped by around a third in one day. And he was leveraged.

He had a huge margin call to cover, and would have had to borrow money to cover it. He lost his whole years winnings (up 100% for the first nine months of 1987).

He no longer uses leverage.

Closet trackers

He believes that many big mutual funds – remember that this is back in 1999 – are simply closet trackers.

This is because fund managers are not evaluated on their absolute performance, but on their performance relative to an index.

• This is a bad idea since the goal of their investors is simply to make money.

Most managers overweight the largest stocks, which has led to a gap in the PE ratios of the top fifty S&P stocks versus the rest.

• 50 times earnings at the top against 20 times for the others.

So career risk is not aligned with investment risk, and investors who think they are in low-risk blue chips are taking on more risk than they understand.

Index funds

Although he approves of index-tracking as a strategy for the masses, he worries about the growth of index funds producing a self-fulfilling prophecy – as the tracker funds grow they must buy more of the same stocks.

• This pushes those stocks up in price and leads to out-performance from the tracker funds.
• Which sucks more money into them.

Lauer estimates that more than two-thirds of stocks are owned by index trackers or closet trackers.

• There is a danger of a crash if the closet trackers – around 25 fund management groups – start to unload their overweight positions.

At the time, Microsoft was the largest stock in the S&P 500, and Lauer thought that its price could crash by 80% to 90%.

• It was valued at 20 times revenues (note – not 20 times earnings) – more than the GDP of Canada –
• despite the risk of its operating systems being displaced or at least its margins being hit,
• and an anti-trust probe by the Justice department.

Trading style

All that is required for successful investing is the commonsense analysis of today’s facts and the courage to act on your convictions.

Lauer has a value focus and generally holds stocks where market cap is less than revenues.

Lauer believes in taking big positions in conviction stocks, he aims to hold a maximum of fifteen long positions, though rotation in and out of positions means that generally the top 15 stocks may represent as little as 75% of the portfolio.

• He thinks this is the only way to deliver outperformance.
• He also wants to make money in falling markets, which by definition requires decoupling from market indices.
• He believes that using fifteen stocks still retains 80% of the benefits of full diversification.

He disagrees with Warren Buffett:

This business is not about investing in great companies; it’s about profiting from inefficiently priced stocks.

Value screening

Lauer’s value screening process has six factors:

1. industry knowledge (and access to senior management)
2. market-adjusted (relative) decline of 50%
   • relative strength is a well-known outperformance factor, but buying after relative declines is less popular
3. strong balance sheet
   • debt has to be manageable relative to cash flow,
   • and book value close to market cap
4. either company share repurchases or insider buying
   • – these limit the downside
5. value – price to sales / cash flow / book value, but not necessarily price to earnings
   • price to intrinsic (private market) value is best, but subjective – what the company would be worth to an acquiring company in the same business
6. a potential catalyst for a price move upwards – restructuring, return to profitability etc.

Lauer’s typical target is to double his money in a stock within twelve months. He then starts to get out, even if he believes there may be another 20% to 30% in further upside.

He doesn’t use stops on the long positions because the screening process makes the downside risk manageable.

Shorts

Lauer also shorts stocks, but he looks for companies that are both over priced and with impending news (eg. sales figures) that could activate a decline.

• When earnings expectations are high, any disappointment can lead to a big drop.

Lauer tends to go short a week or two before the announcement. He then closes the position immediately after the announcement (and hopefully, the opening fall in the stock price).

He does use stops on short positions.

Other comments

• Lauer says that high daily trading ranges (he mentions 20% of price per day – this was 1999) indicate that the market doesn’t know how to price the stock and the price is being dominated by fund flows. These stocks are vulnerable to a change in sentiment.
• He was also sceptical about the continued success of internet stocks – the dot coms.

Court cases

This story doesn’t have a happy ending.

In 2003 Lauer was prosecuted by the SEC over claims that he lied to his investors about the nature of his business. He raised $1.1bn, but investors (including Britney Spears) lost $500M.

• The claim was that Lauer was running a scheme similar to Bernie Madoff, except that he was actually trading.
• It was alleged that Lauer bought large quantities of restricted stock in worthless shell companies, then bought a smaller amount of the same stock at higher prices in order to show big gains.

Lauer was found guilty and fined $44M. He appealed the decision for many years.

In 2008 the US Department of Justice indicted Lauer and four others – the controllers of the Lancer Group hedge funds – over the same artificial boosting of their funds’ values.

In 2011 Lauer was acquitted of the second charge.

It didn’t help Lauer’s case that he famously didn’t disclose his positions, citing:

1. the impact on relationships with corporate management (when shorting)
2. coat-tailing impacting the price as he scaled up a position
3. he didn’t want to waste time explaining every position to his investors

It’s hard to find out what Lauer is up to these days. I couldn’t even find a picture of him online.

Conclusions

Whether you want to follow rules given by a convicted fraudster – even one who protests his innocence – is up to you.

Personally, I find much of what he says compelling. ((This may be the confirmation bias kicking in ))

• Look for pricing mistakes, long and short
• Don’t use leverage
• Use stops where there is unmanageable risk (for him, on shorts only)

He also worries about closet trackers and impact of the growth of index trackers on the market. He was early on these, but these concerns are still present fifteen years later.

Finally, his value screening process is also worth considering:

1. understand the industry
2. a relative share price decline of 50%
3. strong balance sheet
   • debt has to be manageable relative to cash flow, and book value close to market cap
4. company share repurchases or insider buying
5. value – price to sales / cash flow / book value
6. a potential catalyst for a price move upwards – restructuring, return to profitability etc.

Until next time.