Learn From The Master- Banking on 'variant perception'

By Larissa Fernand
Morningstar India
March 03,2016
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Michael Steinhardt is known for many things.

Being a very short tempered and intolerant man, he was a terror as a boss. (When a chastened employee humbly blurted out ‘All I want to do is kill myself’ after mismanaging some bonds, Steinhardt placidly asked him if he could watch.)

His estate houses one of the world’s largest private zoos.

He is one of Wall Street’s most successful money managers, one of its greatest traders and a key figure in the evolution of the hedge fund industry. When he was just 26, he formed his hedge fund along with Howard Berkowitz and Jerrold Fine, named Steinhardt, Fine, Berkowitz & Co. That was in 1967. By 1993 he was among the 400 richest people in the world.

One dollar invested with him in 1967, when he founded the firm, would have been worth $481 on the day he closed it (1995), versus $19 had it been invested in a Standard & Poor's index fund. He volunteered to liquidate his firm when he decided to walk away from high-profile money management. The reason being he was uncomfortable having the name continue without his direct control. (In 1979, Berkowitz and Fine left the partnership, which was then renamed as Steinhardt Partners.)

His investment philosophy can be summed up succinctly as ‘variant perception’. He develops perceptions (intellectually sound investment thesis) which are at variance with the general market view. In other words, a view that is at odds with the prevailing Wall Street view. He will play those variant perceptions until he feels they are no longer so.

In an interview, he pointed out that it is not simply about being a contrarian, which can be relatively easy. The trick is to be a contrarian and to be right in your judgement when the consensus is wrong. By his own admission, “it doesn’t happen much, but when it does, you make extraordinary amounts of money.”

He explains it in a bit more detail in another interview. “If you can have a conviction about something that is meaningfully off consensus, and that conviction turns out to be correct, you can say that just those facts alone should almost always result in profits.” He elucidates with an example: If your view is that the next year is going to have an inflation rate of 5% — and the world thinks it’s going to be 3% and you turn out to be right, you can almost invariably make money from that.

Or, if your view is that IBM is going to earn X (as opposed to Y, which is the Street consensus) and you turn out to be right, you can almost invariably make money from that.

Or, if you think the dollar is going to collapse next year because the U.S. economy is going to get weaker, and Japan for the first time is going to pick up, you can almost invariably make money from that.

It's quite evident that this strategy is not for the fainthearted and Steinhardt lived dangerously. He always believed that to make money you have to get in the way of danger.

Betting on falling prices held tremendous appeal for him. He confessed that he felt far more gratification from making money on the short side than long. He tended to short stocks that were favourites and backed by a great deal of institutional enthusiasm. If he shorted too early, he would usually start off with losses and if it went up a lot, he would still hold on to his position as long as his variant perception was intact.

But that did not mean he was adamant to the point of being foolish. He would hold on to his fundamental view while looking objectively at the short-term fervor in the market. If was going badly against him, he would trade around the position to lower the pressure. So even though he would be short in a particular situation, he might periodically be a buyer too.

In his book No Bull: My life in and out of markets, he states: Warren Buffett has said, “If you’re not willing to own a stock for 10 years, do not even think about owning it for 10 minutes.” The truth of the matter is I’ve never owned a stock for 10 years but have had the unique and profitable experience of owning some very good companies for 10 minutes.

As an investor, Steinhardt thought like a long-term trader, but used these insights to make short-term strategic trades. By doing the analytic work and making the sort of judgments that are long-term in nature, he would arrive at certain conclusions which he would then use for, both, longer-term judgments and trading. And of course, there is the element of timing. He explains that if one is focused on a company or an industry and there’s a sense that things are changing, if one can conclude quicker than the rest of the world what those changes are going to be – even though they are of a long-term nature, they often have a short-term impact..

He also believed that good trading is a balance between the conviction to follow your ideas and the flexibility to recognize when you have made a mistake. One must have a respect for the person on the other side of the trade by asking: Why does he want to sell? What does he know that I don’t?

Larry Connors of Trading Markets believed that Steinhardt’s edge is a combination of his intensity to get an edge with knowledge, combined with a mental intensity that few people could survive. Most individuals would self-destruct under such intense pressure. But for the few who can do this, the results are spectacular.

Charles Kirk, publisher of The Kirk Report, gleaned six rules of investing from a Steinhardt speech given over a decade ago. Here goes: •Make all your mistakes early in life.

The more tough lessons you learn early on, the fewer errors you make later. A common mistake of all young investors is to be too trusting with brokers, analysts, and newsletters who are trying to sell you bad stocks. •Make your living doing something you enjoy.

This way, you devote your full intensity to it which is required for success over the long-term.
•Be intellectually competitive.

This involves doing constant research on subjects that make you money. The trick in plowing through such data is to be able to sense a major change coming in a situation before anyone else.
•Make good decisions even with incomplete information.

In the real world, investors never have all the data or information they need before they put their money at risk. What matters is what you do with the information you have. Do your homework and focus on the facts that matter most in any investing situation.
•Trust your intuition.

Intuition is more than just a hunch. It resembles a hidden supercomputer in the mind that you’re not even aware is there. It can help you do the right thing at the right time if you give it a chance. In fact, over time your own trading experience will help develop your intuition so that major pitfalls can be avoided.
•Don’t make small investments.

You only have so much time and energy when you put your money in play. So, if you’re going to put money at risk, make sure the reward is high enough to justify it.

This article was also published in Morningstar on 03 March, 2016.