Accepting Responsibility for Losses
One of the turning points in Weinstein’s trading career followed a large soy bean trade loss. After emotionally and financially recovering from the loss, Weinstein realized that his trading results were dictated by his actions, not any form of market luck.

“I don’t believe anyone ever gets wiped out in the market because of bad luck; there is always some other reason for it. Either you were off when you did the trade, or you didn’t have the experience. There is always a mistake involved.”

Waiting for Ideal Trade Conditions
Weinstein’s strategy centers around low risk short term trades. He waits for what he perceives as a “can’t lose” situation to enter the trade.

To control risk, Weinstein trades frequently, selling positions quickly to lock in many small short term profits. Weinstein also pays attention to his gut feeling. If a trade does not feel right he will exit a position.

News
The star trader echoes the belief of other top traders profiled in Market Wizards about using the reaction of the markets to news as a broad indicator.

“A market that is fundamentally and technically poised to move higher is not going to reverse direction because of a news item - even a dramatic one.”

Weinstein’s 7 Trading Rules
1. Work hard and know the important details about the security you are trading.

2. Most successful traders are humble and realize that no one is really above the markets.

3. Understand your personal limits. Knowing your psychological or trading weaknesses, and trading to minimize the impact of these weakness is key to being a winning trader.

4. Have a contrarian mindset, and be wiling to trade against the herd.

5. Be patient and wait for ideal conditions to align before trading. Understanding when to be out of the markets is also very important.

6. Your trading strategy should be flexible and dynamic to change as markets change. Everyday successful traders fight not to become a dinosaur in the ever changing markets. A dynamic strategy that can shift as old inefficiencies evaporate and new inefficiencies appear is very important to trading success.

7. Once a trade is profitable, do not become complacent. Many traders lower there attention to detail once profits are made, but this can be sell destructive.

Final Advise
Weinstein’s final advise is to learn how to lose and quickly cut losses. This advise is also stressed by countless traders in Market Wizards.

Special Note: In the Market Wizards chapter, Weinstein stated that he had no losing weeks that he could remember since 1980 to the date the Market Wizards interview occurred. For full disclosure, many are skeptical that this is possible. The author of Market Wizards, Jack Schwager, talked with a trusted close mutual friend of Weinstein and Schwager, who somewhat verified Weinstein’s performance claims. However, they would release no official performance records.

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• General Overview of Investment Banks

Bankers advise clients that need capital or are planning a strategic action, such as a merger or acquisition. Bankers also help execute these strategic actions. Normally, the investment banking division is divided between industry, product, and capital markets groups.

Industry Group
As the name implies, industry groups are divided by sectors. Examples of traditional industry groups are financials, industrials, and energy. Bankers in a specific industry group have specialized knowledge and expertise for the sector.

They try to win business from clients in their specific industry that are seeking to raise capital or execute a strategic action. Bankers in industry groups are exposed to multiple products such as mergers and acquisitions  (M&A).

Product Group
Working in partnership with the industry groups, product groups primarily help execute transactions. Normally, M&A is the largest product group. The M&A group, for example, may provide valuation and deal structure services. The other product groups include leveraged finance and restructuring.

Capital Markets Group
Bankers in the capital markets group assist clients in raising capital. The capital markets group is traditionally divided by financial instruments. Capital markets groups include equities, high yield, fixed income, and structured finance.

Bankers in the capital markets groups also frequently work with members of the industry and product groups. For example, bankers in the mergers and acquisitions product group may help structure and execute an acquisition, and the capital markets group would assist the client in raising capital for the acquisition.

While most large bulge bracket investment banks are structured as outlined above, not all investment banks are the structured this way. The interactions between groups frequently differs between investment banks.

Also, smaller boutique investment banks frequently specialize in one area of investment banking. For example, a boutique healthcare investment bank would only provide investment banking services to clients in the healthcare industry, and thus not need multiple industry groups.

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Primary Functions
Investment banks primarily have two functions. The first function is to raise and invest capital. The second is to advise clients on strategic actions, such as mergers and acquisitions. Investment banks primarily serve as intermediaries between companies that need capital and companies wanting to investment capital.

In addition, investment banks have been increasingly employing their own balance sheets to generate profits without directly serving clients through groups such as proprietary trading and internal alternative investment funds.

Typical Investment Bank Divisions
There are multiple division within most large bulge bracket investment banks. These divisions include investment banking, sales and trading, private wealth management, equity research, and more. Thus many investment banks provide more services than simply investment banking.

The investment banking division is generally divided into two groups, corporate finance and capital markets. The corporate finance group primarily attempts to win business from clients and execute strategic transactions. The capital markets group assists clients in raising money, generally through debt or equity markets. Capital markets groups are generally divided by the capital product, such as high yield debt.

Different Investment Bank Structures
The structure outlined above is typical of the large bulge bracket investment banks. Smaller middle market or boutique banks may lack part of this traditional structure, instead specializing in a specific area or a different target client.

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Stock Selection Process
1. Ryan only buys stocks within a few percent of their base to control downside risk.

2. Another early step Ryan initially takes is to \examine charts and identify stocks of interest from a technical analysis perspective.

3. After narrowing his universe of stocks, Ryan employs an earnings per share screen. Ryan compares the previous five year earnings growth record and the last two quarters earnings relative to the previous year’s earnings.

This comparison allows Ryan to evaluate the earnings growth trend. For example, if the previous two quarters of earnings growth were lower than the five year average, that would signal a warning about future stock performance.

The strong relative earnings growth that Ryan seeks is not always discounted into stock prices. For example, if the general market is weak, an individual stock with strong earnings growth may be held down in price. When the general market conditions improve, these stocks that have been held down but have strong earnings fundamentals generally outperform.

4. A degree of institutional ownership is also an important factor in Ryan’s stock selection process. He seeks stocks with 1-20% institutional ownership. Like William O’Neil, Ryan wants a small degree of institutional ownership, so that once Ryan buys the stock and it eventually becomes more attractive to the general market, the demand caused by further institutional buying will increase the stock price.

5. Ryan also selects stocks that have a growth catalyst, such as a innovative new product or service. Having a growth catalyst reduces the risk of investing in a value trap.

6. Volume is also an important part of Ryan’s screening process. For example, if a stock moves to a new high on low volume, that is a negative signal. This volume indicator is used by many of the star traders in Market Wizards.

Also, if volume remains very high for an extended period, that may indicate a top caused by increased selling. “You want an increase in volume when a stock breaks out, but you want a decrease as the stock consolidates.” Increased volume combined with no further price decreases may signal support from buyers, and thus a bottom.

7. Even with this rigoruous stock selection process, Ryan still states that only about 50% of his stocks are winners. The key to his profitability is risk control. He sells individual stocks if the stocks fall more than 7%.

8. Ryan generally advises to buy growth stocks without the premium valuation.“The most profitable trades are when you find a stock with a strong trend that is trading at a P/E ratio in line with the broad market ratio.”

9. Every time Ryan buys a stock he lists the reasons for his purchase.

Listing the buy rationale is an important step that provides guidance for when to sell the stock. If the reasons for the initial purchase are not present after buying and holding the stock for a certain time period, that may indicate a wise time to sell. Also, listing purchase reasons provides a way to learn from mistakes, by comparing results to the initial rationale.

“The single most important advice I can give anybody is to learn from your mistakes. That is the only way to become a successful trader.”

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O’Neil does not simply buy low priced stocks with low traditional valuation measures, such as a low P/E ratio. He cautions against investing in value traps, stocks that have attractive valuations but flat line in price. Instead, O’Neil employs a growth focused quantitative and qualitative strategy. He uses the acronym CANSLIM to describe this investing strategy.

C
C stands for current earnings per share. O’Neil’s back tested research indicated that the best stocks normally have large earnings increases in the current quarter before the stock price increases. Thus, this type of current quarter earnings increase is a leading indicator. Rising earnings drive fundamental growth.

A
The A stands for annual earnings per share. Again, O’Neil’s back tested research demonstrated that top performing growth stocks had a prior 5 year compound annual growth rate (CAGR) of 25%. Because of this correlation between strong earnings and stock performance, O’Neil seeks stocks that have consistent strong year over year earnings growth.

N
A new innovative catalyst is another key factor that O’Neil seeks in potential investments. Identifying a growth catalyst for a specific company, such as a new product or service, is important. Selecting stocks with potential catalyst reduces the risk of buying a value trap.

S
S stands for supply and demand. If a stock has limited shares outstanding, more buying will help drive up the stock price. I think this also links to investing in smaller cap stocks with less shares outstanding. Institutional buying in some of these small cap stocks that are not traditionally followed by the large institutional players can dramatically move stock prices.

L
The L symbolizes leader over laggard. O’Neil favors investing in stocks that have strong price performance relative to peers during the previous 12 months.

I
The I stands for institutional sponsorship. Institutional stock investments can be somewhat volatile, or less stable than long-term investors. O’Neil does not invest in stocks that have very high institutional ownership. Instead, he favors purchasing stocks with lower levels of institutional ownership. By buying before institutions potentially do, investors’ can capitalize on stock price increases from this large buying.

M
M stands for market direction.  Macro market moves generally dictate the price movement of individual stocks. Buying stocks after a major market downturn is a bad idea according to O’Neil.

O’Neil also shares some general macro strategies in Market Wizards. If stocks that have been leading a specific sector or market begin to break downward, that is an indicator of a weak market. Also, if the Fed raises rates 2-3 times, that is normally a bearish indicator. Last, high volatility indicates directional strength. For example, if a stock breaks to new highs on high volume that is a bullish indicator. If the stock breaks to new highs on low volume, that is a bearish indicator, as there is less demand to support future price increases.

Risk Control
O’Neil incorporates strong risk control into his investment strategy. Unlike Larry Hite, however, O’Neil runs a concentrated portfolio believing that “diversification is a hedge for ignorance.”  To control risk, O’Neil uses a strict stop loss policy and sells stocks if the price falls more than 7%.

*Image courtesy of thestreet.com

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Contrarian Perception
The star investor first discuses his theory of variant perception that is rooted in contrarian ideas. Steinhardt attempts to develop perceptions different than the consensus market view. He then trades on these variant perceptions until the general market perception aligns with Steinhardt’s opinion.

A tobacco trade provides a great example of the application of the concept of variant perception. Steinhardt shorted a specific tobacco ahead of a pending litigation decision. At the time, tobacco companies rarely lost these cases. Therefore, Steinhardt believed the general market perception would also expect the tobacco company to win the case. Because a victory was discounted into the stock price, if the tobacco company did not lose, Steinhardt expected the stock price to barely increase. The limited price appreciation potential if pending litigation was won caused Steinhardt to short the tobacco company. This was a low risk trade with high upside if the company lost the case, and low downside if the tobacco company won the case. Trading these favorable odds is a strategy echoed by many star traders including Larry Hite.

Top characteristics of successful contrarian investors are also highlighted by Steinhardt. “In order to win as a contrarian, you need the right timing and you have to put on a position in the appropriate size. If you do it too small, it’s not meaningful, if you do it too big you get wiped out if your timing is slightly off. The process requires courage, commitment, and an understanding of your own psychology.” Thus, successful contrarian investing is also dependent on excellent trade execution and commitment.

The Opposite Side of the Trade
Steinhardt stresses the importance of understanding why someone took the opposite side of your trade. For every buyer there is a seller who is making the opposite decision. “The major advice I would give to anybody is to recognize that this is a very competitive business, and that when you decide to buy or sell a stock, you are competing with people who have devoted a good portion of their lives to the same endeavor. In many instances, these professionals are on the opposite side of your trades, and on balance, they are going to beat you.”

I also think this quote about the competitiveness of investing emphasizes my views about small cap investing. For small investors buying individual stocks, I believe it is generally more wise to purchase smaller capitalization stocks that are covered by less professionals. Competing in a small pond is easier than fighting in an ocean full of sharks.

The Importance of Dynamic and Adaptable Investing Strategies
Steinhardt also emphasizes the need for flexible investment strategies. Successful investors normally do not exploit one market inefficiency for the long term. Overtime, a persistent inefficiency will attract more traders who subsequently eliminate the inefficiency. ”As soon a formula is right for any length of time, its own success carries the weight of its inevitable failure.”One of Steinhardt’s keys to success was employing a dynamic investing and trading strategy that capitalized on changing market conditions.

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Theoretical Basis
Comparable company analysis is rooted in the idea that companies with similar characteristics should have similar valuation multiples. Typically, a group of comparable companies includes companies from the same industry as the company being valued and companies with similar fundamental characteristics.

Multiples Valuation
After identifying the list of comparable companies, the comparable valuation multiples are applied to the company being valued to establish a relative valuation. Common valuation multiples include price to earnings, price to book, and enterprise value to EBITDA ratios. For example, the mean or media price to earnings ratio of the comparable companies would be multiplied by the earnings of the company being valued to establish a relative valuation. By valuing the company using many multiples, a relative value range is established.

Benefits
A key benefit of comparable companies analysis is that the methodology is based on the current market stock price. The current stock price is generally viewed as one of the best valuation metrics because markets are considered somewhat efficient. Also, because comparable company analysis is based on stock prices, the technique is especially useful for valuing potential IPOs.

Drawbacks
Finding true comparable companies that closely resemble the company being valued can be difficult. In addition, comparable multiples based on small companies that are less liquid in public markets provide less reliable valuation metrics. Another drawback is that comparable company analysis only values a minority, non-controlling interest in a company, which is less useful for acquisition valuations.

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Basic Shares Outstanding
Basic shares outstanding are the total shares that a company issued and are outstanding. This number is directly reported on the financial statements. Not all shares that are issued are still outstanding. For example, treasury stock reduces the number of shares outstanding. Treasury stock are shares repurchased by the company in the secondary market.

Fully Diluted Shares Outstanding
Fully diluted shares outstanding are the company’s outstanding shares, adjusted for potentially dilutive securities and stock options. Convertible debt is an example of a dilutive security. If the convertible debt is converted to equity shares that increases the total number of shares outstanding.

Calculating Fully Diluted Shares Outstanding
Fully diluted shares outstanding are calculated using the treasury stock method and or the if-converted method. The treasury stock method accounts for the share impact of options, and the if-converted method accounts for the share impact of convertible debt and or preferred stock.

Treasury Stock Method
The treasury stock method includes the impact of stock options by calculating the additional shares created when the options are exercised. Only in the money options are included because out of the money options are anti-dilutive as the options would never logically be exercised. This method also assumes that proceeds from the sale of stock when options are exercised are used to repurchase shares at the current price. This partially offsets options’ dilutive effect.

Fully diluted shares are then calculated by adding the additional shares to the basic shares. Additional shares are calculated by determining how many new shares could be purchased from the profits of exercising in the money options. The calculation is current stock price minus strike price divided by stock price all multiplied by the number of options.

A company’s most recent 10k contains information about all of the current options outstanding. Normally there are multiple options with different strike prices that need to be calculated.

If-Converted Method
The if-converted method is used to calculated the share impact of convertible securities by determining how many new shares would be issued if an in the money convertible is exercised. The end calculation in this process is to multiply the number of securities being exercised by the conversion ratio to determining the new shares.

Also, convertible debt that is converted eliminates interest expense. The after tax interest savings from the conversion is therefore added to earnings per share when calculating the diluted earnings per share.

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Work Ethic
In any profession, a strong work ethic is important for success. Work ethic is especially important in trading, an extremely competitive career. Schwartz always tries to be better prepared than his competition. His preparation involves long hours and attention to detail, and this work ethic is crucial to his outstanding trading results.

Accepting and Recognizing Wrong Decisions
Removing ego from his trading psychology, is another important factor for Schwartz’s trading success. When Schwartz was a losing trader early in his career he struggled to admit when he was wrong. He corrected this detrimental psychology to become a winning trader. A component of being a winning trader is accepting that you cannot always be correct. Sometimes the market acts in improbable ways that one trader cannot fight against. Winning traders are able to recognize when they are wrong and cut losses. “One of the most suicidal thing you can do is to keep adding to a losing position.”

Coping With Large Losses
Even the best traders have to face large losses at times. Schwartz trades around large losses by reducing the size of his trades until he regains confidence. “After a devastating loss, I always play very small and try to get black ink, black ink. It’s not how much money I make, but just getting my rhythm and confidence back.”

Risk Control
Schwartz, similar to many traders including Larry Hite, employs strong risk control to be a winning trader. By limiting downside risk and preserving capital during down markets, Schwartz is able to position his portfolio to take advantage of early bull markets.

Macro Market News
Similar to many of the traders profiled in Market Wizards, Schwartz monitors how markets or stocks react to news to gain a better macro view of the market. When the market drops after good news, that indicates market weakness. Conversely, a market rally on bad news signals strength.

Schwartz’s 6 Top trading Rules
1. He compares moving averages of a security to the price of the security. “I try not to go against the moving averages, it’s self destructive.”

2. Schwartz also looks for specific types of market divergences such as a stock not declining when the general market has been falling. This divergence example would be a bullish indicator for the individual stock.

3. Similar to after a large loss, Schwartz reduces the size of his positions after a large gain. He has a personal track record of making over confident trades after a winning streak, so reducing his positon size increaes profit.

4. He does not generally attempt to pick the bottom of falling stocks. Schwartz believes this is very difficult and needs strong justification to buy a stock that is near all time lows.

5. Always have a set downside limit that outlines how much you are wiling to lose before entering the trade. This risk control measure is outlined by many other star traders.

6. “Work, work, work.” By learning from your mistakes and researching new methods traders improve over time and become more profitable.

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The previous weeks economic data was mixed and the S&P 500 ended the week about even. On a positive note, industrial production increased 0.2%, beating the 0.0% expectation. Industrial production decreases during normal recessions, so a continued positive industrial production number suggests some economic strength. However, this industrial strength may be driven by the relative weakness of the US dollar, which attracts exports. The slightly better than expected trade balance number demonstrates the growing economic role of exports. Recently the US dollar has been strengthening, which could counteract this industrial trend.

However, CPI increased 0.8%, greater than the 0.4% market expectation. I think growing inflation continues to be an economic question mark. Recent drops in values of commodities combined with a rising US dollar have placed downward pressure on inflation, but significant inflation still has a negative impact and handcuffs the Fed.

Next Weeks Economic Data (August 19 - August 21)

The housing starts and building permits numbers will provided insight into the strength of the weak housing sector. If these indicators are in line or above expectations, the data may support the idea that the falling housing market is beginning to stabilize.

Another important economic indicator is PPI, a measure of inflation. In addition to the CPI, the PPI will provide important data about the impact of changing commodity prices and a slowing economy on inflation.

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