Billionaire Steve Cohen, hedge fund manager of SAC Capital Advisors, is a successful American business magnate and an investor known for short term trading in equities.
In his interview with author Jack Schwager in the Stock Market Wizards series, Cohen revealed his way of making trades via what he calls a ‘Catalyst’.
Schwager: When you put on a trade and it goes against you, how do you decide when you’re wrong?
Cohen: If I am in the trade because of a catalyst, the first thing I check is whether the catalyst still applies. For example, about a month ago, I expected that IBM would report disappointing earnings, and I went short ahead of the report. I was bearish because a lot of computer and software companies were missing their numbers [reporting lower-then-expected earnings] due to Y2K issues. Customers were delaying the installation of new systems because with the year 2000 just around the corner, they figured that they might as well stick with their existing systems.
I went short the stock at $169. The earnings came out and they were just phenomenal – a complete blowout! I got out sharply higher in after-the-close trading, buying back my position at $187. The trade just didn’t work. The next day the stock opened at $197. So thank God I covered that night in after-hours trading.
Schwager: Any trade stand out as being particularly emotional?
Cohen: I held a 23 percent position in a private company that was bought by XYZ. [Cohen asked me not to use the actual name because of his contacts with the company.] As a result, I ended up with a stock position in XYZ, which I held for four or five years in my personal account without the stock doing much of anything.
XYZ had a subsidiary, which had an Internet Web site for financial commentary. They decided to take this subsidiary public. XYZ stock started to run up in front of the scheduled offering, rallying to $13, which was higher than it had been at any time I held it. I got out, and was happy to do so.
The public offering, which was originally scheduled for December, was delayed and the stock drifted down. A few weeks later, they announced a new offering date in January, and the stock skyrocketed as part of the Internet mania. In two weeks, XYZ went up from $10 to over $30.
I couldn’t stand the idea that after holding the stock for all those years, I got out just before it exploded on the upside. But I was really pissed off because I knew the company. and there was no way the stock was remotely worth more than $30. The subsidiary was going public at $15. If it traded at $100, it would be worth only about $10 to the company. If it traded at $200, it would add only about $20 to the company’s value. The rest of the company was worth maybe $5. So you had a stock, which under the most optimistic circumstances was worth only $15 to $25, trading at over $30.
I started shorting the hell out of the stock. I ended up selling 900,000 shares of stock and a couple of thousand calls. My average sales price was around $35, and the stock went as high as $45. On Friday, the day of the offering, XYZ plummeted. On Friday afternoon I covered the stock at $22, $21, and $20. I bought back the calls, which I had sold at $10 to $15, for $1.
Schwager: This trade worked out phenomenally well. But when you go short, the risk is open-ended. Even here, you said your average price was around $35 and the stock did go as high as $45. What if it kept going higher? At what point would you throw in the towel? Or, if your assessment that the stock was tremendously overvalued remained unchanged, would you just hold it?
Cohen: A basic principle in going short is that there has to be a catalyst. Here, the catalyst was the offering. The offering was on Friday, and I started going short on Tuesday, so that I would be fully positioned by that time. If that offering took place, and the stock didn’t go down, then I probably would have covered. What had made me so angry was that I had sold out my original position.
The catalyst principle is akin to what famed investor Jim Rogers describe as Change. Although in Rogers’ view, he takes a longer term approach and he calls them either Positive Change or Negative Change.
When managing the Quantum Fund with George Soros in the 1970s, Rogers’ research told him that women began to turn away from overdone makeup or any form of makeup. He noticed a new social trend developing, and this would be negative change for any company still producing and marketing makeup products. Rogers discovered Avon Products, and decided that at over seventy times earnings, it was due for a fall. He shorted at $130, and held it through the entire period where the negative change still applied, covering it a year later under $25.
Both investors above operate with the Catalyst Principle, and if the catalyst for an investment decision is invalid, they would get out of the trade.