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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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We also disagreed in our approaches to working with institutional investorsExamples of The Vital Few versus The Trivial Many IN 1988, I WAS WORKING AS DIRECTOR OF RESEARCH FOR INVEST/NET Corporation, a South Florida company that held the SEC contract to process insider filings. One of my responsibilities was to write a weekly newsletter to institutional clients advising them of any interesting insider buying. By this time, I was thoroughly indoctrinated into Paretos 80:20 Rule and totally engrossed in analyzing insider behavior. I had also trained myself to view the media as a contrary indicator. In the spring of 1988, I recommended Columbia Pictures (KPE) to our clients because the insider filings revealed that Dan Lufkin, founder of Donaldson, Lufkin and Jenrette, and Charlie Allen, co-founder of Los Angeles investment company Allen and Company, were buying large blocks of the stock at $7. Lufkin was on the board of Columbia Pictures, and Allen was on the board of Sony Corporation. I thought these insiders were well schooled in the ways of Wall Streets response to news, and there was a possibility that good news was coming. When I read in Barrons magazine that Goldman Sachs was recommending KPE as a short sale to its hedge funds, I became even more interested. Goldman believed the company had no decent films on the horizon, a bad balance sheet, and an incompetent creative director, but I begged to differ since Lufkin was on Columbias board, and it was quite possible that the research from Goldman was flawed. A few weeks after my recommendation, Columbias stock rose to the $9 area as rumors circulated that it was a takeover candidate. At the same time, I observed that analysts on popular investment television programs were adamant that there was no deal in the futureDan Dorfman being the most strident. This famous (and infamous) market commentator, with his trademark squeaky voice, was the highest paid financial journalist in the world as well as one of the most influential. At his zenith, his remarks carried such influence that the Chicago Board Options Exchange instituted a rule just because of him, which they called the Dorfman Rule. His opinions carried so much weight that the Exchange actually would temporarily halt trading options of stocks he mentioned in his broadcasts. Dorfman often broke news in his columns, including some of the largest mergers and contested takeovers at that time. His negative comments brought the stock back to $7. I recall watching the show as he pointed his finger at the television camera and almost hyperventilated, I can tell you with great certainty that there is no deal in the making for Columbia Pictures. A few weeks later, I saw insider filings that both Lufkin and Allen had bought more stock into the price dip. Dorfman had incited The Trivial Many to sell, while The Vital Few (including some of my followers) continued to buy. I reiterated my recommendation to my institutional clients. Ten months later, Sony made a cash buyout offer for $27.50 per share. Allen and Company handled the negotiations, making millions in investment banking fees, while Charlie Allen and Dan Lufkin loaded millions of dollars in trading profits into their personal accounts. In the late 1980s, the SEC prosecuted Ivan Boesky and Michael Milken for insider trading violations, and Boesky was the first stock trader to pay a fine of $100 million. Both went to jail. Milkens $600 million penalty left him with only about a billion dollars, while Boesky completed his truncated jail term in 1990 with $100 million left in cash. It seems to me the prosecution of Boesky and Milken is another example of the futility of insider trading rules. The SEC catches only the big fish, the tip of the iceberg, while every day violations occur that the government has neither the manpower nor the will to prosecute. It was that way in 1988, and I believe it will always be that way. I left Invest/Net after Thomson Financial Services had bought them in 1994. Thomson seemed more interested in marketing than in pure research. We also disagreed in our approaches to working with institutional investors. My approach was simply to provide the best insider research available and constantly work to improve my product. I completely believed in the proverb If you build a better mousetrap, the world will beat a path to your door. After leaving Invest/Net, my wife Maria I started our own consulting firm with only two accounts, each managing between $150-$200 million dollars. At the beginning of 2002, eight years later, Muzea Insider Consulting Services consisted of 7 employees advising 60 money management firms in the U.S. and Europe, totaling approximately $1 trillion dollars under management. This was accomplished without having a full sales force, vindicating my better mousetrap theory. I was especially pleased when we signed on a very successful hedge fund, the Quantum Fund, run by George Soros and Stanley Druckenmiller. Institutional Investor magazine hailed Soros as the worlds greatest money manager. In 1992, Soros and Druckenmiller risked $10 billion that the British pound would fall. Their instincts were right and the Quantum Funds profit was almost $2 billion. This earned them international notoriety and guru status among traders. I had developed a niche business that would fall within the realm of nontraditional Wall Street research, which is typically obscure. The people who operate this type of business usually work out of a small office and are often quite independent. They are free from the pressure that traditional Wall Street research analysts get from their investment banking departments. It is difficult to be objective when you know your firm will lose millions of dollars of underwriting fees if you publish a negative research report. Nontraditional research firms face none of this pressure. I observed how difficult it was for many professionals to stay disciplined when I worked in the investment business in New York and Boston. Rumors circulated daily and opinions flew readily from all sources. When new clients ask me, Why do you live in Reno, Nevada? I tell them about the fantastic quality of life here and add, Besides, I like operating in relative obscurity in a small mining town in the West. Demise of Enron Corporation, and others too numerous to mention, was the tip of the iceberg for the first decade of the twenty-first century. Enron reminds me of a company in the early 1970s called Equity Funding, a popular institutional stock whose Chief Executive Officer was promoting the growth of the company at analyst meetings and conference calls. He was selling heavily at the same time he was promoting the stock. As a stockbroker with E.F. Hutton, I had alerted my retail clients telling them to avoid the stock. The company was indeed growing as fast as the CEO told analysts, except they were using fictitious names of new customers. When the whistle blew, the stock was halted from trading at $35 and never reopened. After that, I always figured I would never find a business fraud comparable to Equity Funding. That was, of course, until Enron. In just 15 years, Enron grew from nothing to Americas seventh largest company, employing 21,000 people in more than 40 countries. The firms success, however, turned out to be nothing more than an elaborate fraud. Enron lied about profits and was accused of a range of shady dealings, including concealing debts so they did not show up in the companys financial statements. What astonished me was the zeal the investment community had for this company. Enron fooled many smart people, but in the end, these executives were no different from some insiders. They are in the category of those who do not back up their words with deeds. When Enron stock was trading in the mid-80s, I issued a sell signal to my institutional clients and repeated that sell signal again and again over the next 14 months while insiders continued to sell their stock at lower prices, a surefire sign of major problems. The company went into bankruptcy, and many employees and small investors were hurt. Meanwhile, the media pumped up the Enron story, forcing the SEC to promise insider trading reforms again. This time some changes were made, most notably the requirement that insiders report their trades within two business days, when in the past they had 30 to 45 days to report. Nothing much has changed though. Every day there are small violations that the SEC ignores; the next nationwide scandal is probably in the making right now, just waiting for the whistle to blow. In my opinion, insiders will always take advantage of what they know (greed is a powerful emotion). In spite of all the regulations, their risk of being apprehended is small, even though there are billions of dollars at stake. One of the more interesting regulations adopted in 2000 was Regulation Full Disclosure (Reg FD). This rule eliminated the practice of selective disclosure. Reg FD requires that when a public company chooses to release any information, it must be done in such a way that the general public has access to it at the same time as institutional investors and analysts. If information is released to specific parties, the company must disseminate that information widely within 24 hours. Regulation FD underscores the need for companies to be extremely careful in the way they communicate to the investment community any material information that has been nonpublic. Among the measures that many companies take to exercise care are: (1) limiting in writing the group of persons authorized to speak for the company, (2) making conference calls with analysts readily accessible by the public, (3) preceding the calls with clear announcements of how the calls can be accessed, and (4) encouraging analysts to ask all of their questions during the conference calls, thereby minimizing follow-up calls seeking private advice. I love Regulation FD! I have always had a disdain for traditional Wall Street research and consider most security analysts simply reporters. Reg FD has dealt the streets good old boy network (a select group of analysts and their followers who received advance material information) a death blow. If you need proof that Reg FD is working, all you have to do is observe how consistently wrong the majority of research analysts are with their quarterly earnings projections. Those few analysts who actually kick tires and spend a lot of time researching companies and analyzing company prospects are finally getting the recognition they deserve. For those of us who spend our days analyzing insider trading, Reg FD is a bonanza. Our institutional clients use a variety of techniques in picking stocks, and our evaluation of insider trading in stocks on their watch lists has always been important to them. Now, because of lessened reliance on traditional Wall Street research, they are relying even more heavily on our insider research. Individual investors have gained as well with Regulation FD. In a way, it forces the average investor to do what he or she should have been doing all alongdeveloping their own style of investing and avoiding reliance on others, especially research analysts. If you are going to be a consistent winner in the stock market, you have to do it yourself. The main reason I wrote this book was to help individual investors become self-sufficient when it comes to investing. By keeping a close eye on the insider trading of stocks you own or are considering, you can often act before the company announces important news that will affect trading in their stocks. Much of the time, insider trading analysis will reveal no clues. In those cases, you are on your own. Our back testing has taught us that when insiders are neutral in a stock, the chances of good news and subsequent market performance is a 50/50 proposition. However, when insider trading supports your own analysis, the chances of success are greatly enhanced. |
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