Vernon – Buying the Glitch

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.

Today’s post is a profile of Guru investor Vernon, who appears in Guy Thomas’s book Free Capital. His chapter is called Buying The Glitch.

Vernon – buying the glitch

Vernon is one of the anonymous investors in Guy Thomas’ book Free Capital.

Vernon describes himself as a “contrarian and misanthrope”.

• He buys what he calls “good” companies that have recently released bad news.

My ideal company is one which has stumbled, probably more than once, so that the City is thoroughly fed up with it.

I try to catch that company when nobody wants it, while it is still working through its problems.

He nicked the name of his approach (and the title of his chapter in Guy’s book) from eternal optimist Ken Fisher (( He would be, he manages equity funds using other peoples’ money )) – they call it “buying the glitch”.

Guy sees this approach as a welcome contrast to the way that “inexperienced investors are often suckers for a good story”.

• I’m no fan of blue-sky, jam-tomorrow firms myself, but Vernon’s approach sets alarms bells ringing for me.

Alternate names for this investing style include “catching a falling knife” and “bottom-fishing”.

• As we saw last year, companies that issue bad news (specifically, profit warnings) don’t usually recover quickly.

Early career

As a youth, Vernon wrote computer games for the Sinclair ZX80. (( I did the same for the later Spectrum, though Vernon is younger than me, so he must have been precocious )).

• He got a maths degree from a redbrick uni, then a PhD in computer science.

Following in his father’s footsteps, he began an academic career as a research assistant, before starting to worry about money. He became a systems analyst at a management consulting firm.

• He progressed, but became disillusioned by the constant upselling. (( Exactly the same happened to me ))

Legacy

Then in the early 1990s, Vernon’s uncle – an unsuccessful investor – died and left him some money. Vernon became a “not very successful” investor himself.

• He focused on software stocks, but found his computing background a hindrance.

My intellectual world was deterministic ­ in computing consequences always follow with absolute certainty from premises. The computing paradigm of certainty in a closed system was not helpful when thinking about investing.

Tech boom

In late 1998, Verson became a freelance computer contractor (( I’d done the same a few years earlier )) working on the Y2K bug. This gave him more time to follow his investments, and with good timing, the dot com boom was beginning.

I realised about 1998 that if I could harness that power and avoid big mistakes or bad luck, I would probably become wealthy. Specifically, if I could compound my money at 30% per annum, £1 spent foolishly now would cost me £200 in 20 years’ time.

That’s quite the target Vernon set himself there.

But because of the boom, by March 2000 Vernon was up 1400%.

• Some of his larger holdings were taken over in mergers near the peak.
• Because he was unfamiliar with the acquirers, he sold the resulting shares.

It was my ignorance that saved me.

He then – again with great timing – got into shorting the NASDAQ which meant that by late 2002 he was still up 1000% and sitting on more than £1M. (( I sold pretty quickly in 2000, but I didn’t end up anywhere near 1000% up ))

After Y2K proved to be a damp squib, the contracting market suffered. (( My own daily rate peaked in 1998, though I continued to work off and on for another 13 years )) Vernon took a few more jobs but gave up in 2003 at the age of 38.

• After making his money through the tech boom, Veron switched tack and became a full time investor specialising in “buying the glitch”.

Glitches

As discussed above, the most common type of glitch is the profit warning.

• This can lead to “kitchen-sinking”, where management exacerbate the market reaction by getting rid of all possible bad news in one go.

Another kind of glitch is the index demotion.

• Once the sell-off from the index-tracking funds has taken place, there could be a buying opportunity.

Of course, the company has been demoted because it’s market cap hasn’t kept up with the index.

• So it has had problems, and perhaps they are not all in the past.

A third variety is the unfair sector read-across, usually from another company’s profit warning.

• Guy quotes an example that Vernon was able to profit from, when Lloyd’s insurers were mistakenly assumed to have exposure to losses arising from 9/11.
• The split capital trust crisis of the early 2000s is another example.

A fourth glitch is the failure of a bid, which creates a situation similar to a short squeeze, where lots of people are left holding positions they no longer want.

All of these situations feel risky to me.

• They all feel like doubling down on losses, rather than cutting them.

But Guy makes it clear that Vernon doesn’t buy immediately after the bad news.

• He might wait weeks or even months.

And of course, Vernon doesn’t hold the shares before the bad news is announced.

Screening

As well as company announcements, Vernon looks for new four-week and 52-week share price lows.

• He then reviews these shares individually to see if any are fast growing companies which have recently hit a glitch.

He still focuses on tech, but has added oils, minerals and emerging market property to his portfolio.

• Focusing on a limited number of sectors leads to “economies of scale in knowledge”.

At the same time, looking at too few sectors means that you “risk getting stuck at local optima” (at the top of the nearest mountain, rather than the highest).

Supporting factors

As well as potential over-reaction to a glitch, Vernon looks for:

1. cheap accounting metrics
2. forthcoming legislative changes
3. recent directorial purchases
4. excessive director remuneration
5. CEO’s track record
6. credible negative comments on a bulletin board (eg. from a disgruntled employee)

Selling

Vernon sells stocks “when they become popular”.

• Selling is more difficult than buying, and Vernon thinks about it in terms of switching to alternative (and more attractive) investment.

He has some rules of thumb:

1. “when it doubles, always sell some”
2. “when it’s tipped, sell some”

Leverage

Vernon uses spread-betting mostly for hedging via shorting the FTSE-100 for up to 25% of his exposure.

• He thinks that short-term leveraged products suit trend-followers more than contrarians (because out-of-favour shares can take a long time to recover).

IPOs

Vernon sees IPOs as the opposite of glitches, and doesn’t buy them.

You have a small army of people promoting the story, and sweeping bad news under the carpet. That is not the time to be buying.

Psychology

Vernon thinks that the best skill is to be lucky, but he means this in the sense of the quote from Louis Pasteur:

In the fields of observation, chance favours the prepared mind.

Technical knowledge can help, but plenty of technical people are unsuccessful investors. Broad knowledge-gathering and being emotionally able to change your mind are more important.

He thinks that investing is not technically difficult, but it does require some mental habits which are unusual:

You need to keep several competing ideas or insights in your mind in parallel, accepting uncertainty for long periods, and choosing between them at the last possible moment.

Vernon calls this operating with “multiple mental models”.

He also thinks that investors should:

Search for the truth, rather than [try to] support prior affiliations.

I take this to be the behavioural investing advice that you need to look for evidence that disproves your thesis rather than supports it.

One difference between investing and most other fields is that the question “whose side are you on?” is meaningless:

Investment is not a team sport.

Contrarians will never be popular:

This concept of being happy alone is so culturally alien that English seems to have no positive words for it ­ only negative words like lonely, solitary, or isolated.

Negative and positive scoring

Vernon distinguishes betweem activities with `positive scoring’ (gaining points) activities with ‘negative scoring’ (avoiding faults).

Most things (sports, sales, leadership) have positive scoring.

• `Having a go’ and risk-taking are often rewarded and the downside of making errors is low.

Things like driving a car or flying a plane, or anaesthesiology are negatively scored.

• The best people make the fewest mistakes.

The ease of online dealing makes many people act as if investing was positively scored, but the arithmetic of compounding dictates that it is really negatively scored. Success in investing consists mainly of avoiding big mistakes.

Vernon likes to study other people’s mistakes.

Investment books and articles have a bias towards success stories. I find it useful to read about disasters.

Time management

Time is a limited resource with strongly diminishing returns. The first hour you spend researching a company is much more important than the tenth hour.

Some private investors are management groupies ­ they spend too much time on their favourite companies, posting on bulletin boards and going to AGMs and all the rest of it.

They are squandering time which would be better spent looking for new ideas.

Vernon quotes the behavioural research which suggests that decisions are best made with no more than five to seven points of information.

Conclusions

I was initially skeptical about Vernon’s approach, but grew more positive as the interview progressed.

Don’t get me wrong, I don’t think that being a contrarian is for everyone, and I think that I would find it too stressful.

• Vernon and I have a lot in common in career terms, but less in terms of personality.

But for a contrarian, Vernon has a pretty thoughtful and systematic style.

It should be no surprise that someone with the mental strength to be a contrarian should have thought so seriously about his decision making, but I was impressed.

Until next time.