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Tom Klagus – Change of Plans

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This article is part of our ‘Guru’ series – profiles of successful traders with information for UK private investors.

You can find the rest of the series here.


Today’s post is a profile of Investor Guru Tom Klagus, featured in Jack Schwager’s book, Hedge Fund Market Wizards. His section is titled Change of Plans.

Tom Klaugus

Thomas Klaugus graduated in chemical engineering, got an MBA and worked his way up the corporate ladder for 15 years.

But he was interested in the stock market from childhood (his father bought stocks) and over the years invested two-thirds of his income.

When he was making more in stocks than as a chemical executive, he quit and became a portfolio manager.

Klaugus appears in Jack Schwager’s book, Hedge Fund Market Wizards.

  • His section is titled Change of Plans.

Productivity

The Klaugus Public Account (a $5 billion Greenwich Means hedge fund) has returned 17% per year over 19 years.

  • His private account returned 33% per annum for the seven years before that.

He has five down years out of 26, with two of them losing just 3%.

  • The worst were 1991 (down 12%), 2008 (down 25%) and 2011 (down 9%).

Klaugus is contrarian, meaning it often lags the market when things are going well, but makes up for it in downturns.

  • It usually has a good year after a bad one (like the 56% gain in 2009).

He suffered a small loss in 1999 (when the S&P 500 was up 21%), but then made a lot of money during the bear market from 2000 to 2002.

  • But of course it went down with everyone else in 2008.
Early years

My father was a product of the depression and he was scared to death of being poor again. Somehow he conveyed that insecurity to me. From a very young age, I knew I wanted to be financially independent.

When I was a freshman in college, I made a 30-year financial plan that outlined how I could save and invest my money. By saving two-thirds of my income and earning 10 percent a year on my investments, I could be a millionaire by age 53.

Closing

Shorts are actually easier to find than long ones. It’s easier to spot a broken company than a good one. Bad management is easier to identify than good.

I have people telling me all the time that I should short stocks after they break. All I can tell you is that if you didn’t short a stock when it was at 80, it is psychologically very difficult to sell it when it was at 50.

In 1986, I became concerned that the market was overpriced. I knew I didn’t have the discipline to stay out of the market, and I felt the stock was too expensive, so I started shorting.

In the summer of 1987, I lost so much money that I had to call my mother to get a loan to cover the margin. There was no way my father would lend me money.

How the market collapsed [in October 1987], I thought I could start going long to reduce my net short position. Most of the stocks I was missing were low quality, so instead of covering my shorts, I started buying stocks I really liked.

I always tried to be long and short on things that I really believed in long term.

1987 was the first year I made more money from the market than from my job. Every year after that I made more money from the market than from my job.

Switching careers

If you had asked me a year before I left Rohm & Haas if I would ever leave, I would have told you that I was there all the time. My desire was to be CEO of Rohm & Haas.

My net worth reached $1.6 million. I figured 3 percent of $1.6 million was $48,000; I could live for it. Suddenly, the economic necessity to continue working disappeared.

Realizing that I had the financial freedom to sustain a business turned me upside down. I spent a year in a terrible mess.

I started a hedge fund in 1990 with $3 million; some of it was mine and the rest from friends and family. I had to manage the portfolio myself away from home. I had very low self-esteem. I missed my friends.

For the first six months, I climbed, but then I started paying back. I think I was still in a bit of a state when I began to seriously question my decision to manage the fund.

The responsibility for owning other people’s money really rested on me. If you have a 10-year horizon, you can make good decisions and make a lot of money. But if you only have a three-month horizon, anything is possible.

I closed myself off [the fund] at the end of the first year.

Klaugus planned to return to the chemical firm, but they offered him a job in Asia.

I went out to put a for sale sign in front of my house and I just couldn’t do it. I was giving up on my dream.

He fell into depression and was treated by a psychiatrist. Eighteen months later, he started a second hedge fund.

Trading style

I’m a mean-reverting thinker. We use standard deviation bands to define extreme readings. Your maximum long position will be on the bottom bar and your maximum short position will be on the top bar.

It sounds like Bollinger Bands, but these are short-term indicators. According to Schwager:

Klaugus derives the best-fit regression line for the log of prices using all data up to 1932 and then calculates a 95% confidence interval—two equidistant lines parallel to the best-fit line that cover 95% of all months.

Klaugus uses the S&P 500, Nasdaq and Russell 2000 indexes to derive a composite signal.

Back to Klaugus:

On the bottom lane we would be 130% long and 20% short. At the midpoint we would be 100% long and 50% short.

We are 50% net long, not neutral due to long-term secular growth in stock prices. On the top band we will have 90% short and 20% long, or 70% pure short.

But obviously there are times when you can stay out of groups for a long time. This is where we will lose money.

After determining the portfolio’s net exposure, we perform a similar analysis by sector, trying to identify sectors that are cheap and sectors that are expensive.

The relative estimates are a guide only. Brazil may seem expensive, but the fundamentals are very good, so I don’t want to be short.

The next part is to figure out why the sector or stock is expensive or cheap, and are we seeing something that will change that? It is where we spend 90 percent of our time.

I look for anomalies. I’m looking for quarterly earnings that are up more than 50% or down more than 30%.

I have what I call the Evel Knievel screen. These are companies that are trying to jump the Grand Canyon and probably won’t make it. There are only two conditions for the screen.

First, the company trades at more than five times book value. Second, the company loses money. My job is to figure out which stocks aren’t going to cross the Grand Canyon and then go short those stocks.

Risk control

For many people, controlling risk means having a plan for what they will do if something goes wrong. I try not to get into this situation in the first place.

Threat to survival is a drop of more than 7% in a month and it is not known why. Ninety percent of our monthly returns are between +7% and -7%. If I can’t figure out what’s wrong, I have to lower the exposure.

Risk factor number one for me[{” attribute=””>leverage. Our net exposure is usually less than that of a typical mutual fund.

Outcomes

Just because you made money doesn’t mean you were right, and just because you lost money doesn’t mean you were wrong. It is all a matter of probabilities.

A big mistake investors make is that they judge whether a decision was right based solely on the outcome. There is a lot of randomness in the outcome. The same set of conditions can lead to different outcomes.

Whether a trading decision was right or wrong is not a matter of whether you won or lost, but rather whether you would make the same decision all over again if faced with the same facts.

Stock picking

The general principle is that we look for future revenue generation that can be reasonably anticipated but that is not reflected by the current market price. This idea is probably the single most important concept in our stock selection process.

The source of the improvement can be new production, new technology, or an expected increase in asset values.

Claugus says that if a revenue source is more than a year away, the market will often fail to attach any value to it.

He also touched on stock behaviour during crashes and recoveries:

When the market sells off really hard, it is usually a matter of liquidity. There’s no place to hide; people sell everything because they have to, not because they want to.

The reverse rarely happens on the upside. People don’t run out and buy everything. There are always some stocks that are going down.

Macro

We track a number of basic indicators to get a feel for the real economy: rail traffic, truck traffic, load factors on airlines, RevPAR [revenue per available room] for hotels, construction and housing construction.

But if you look at budget and trade deficits and government spending, the situation got out of control. We clearly need to rein in government spending, and if that happens, it’s likely to slow down the economy.

The Western world has a huge debt problem and is managing it very badly.

Conclusions

Klaugus is another guru I hadn’t heard of before his interview which I really enjoyed.

Schwager says the main lesson here is:

Vary the exposure as needed.

That sounds good to me, and Klagus has been pretty open about how he rates overall exposure.

Another key point is not to judge decisions by their results.

  • You can be right for the wrong reasons and be unlucky even if you did everything right.
  • You have to stick to your system.

I also liked the look of Klaugus’ standard Even Knievel screen and might try to create something similar in the future.

Until next time.

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