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John Del Vecchio: Pain Spotting

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johndelvecchio

John Del Vecchio

A bear to the bone, John Del Vecchio looks for companies hiding dirty, disgusting messes-and then cleans up.

Late in the fall of 2006, John Del Vecchio, an analyst with Dallas-based David W. Tice & ­Associates, managers of the Prudent Bear Fund, was about to get on a conference call when it hit him: He had written his last research paper.

I should be trading, Del Vecchio thought as the voices, challenging his research on a stock, came out of the squawk box. “I knew my research was dead-on,” he recalls. “I just had this moment of ­clarity. I was tired of arguing my points. I realized I should be trading these names myself.”

Del Vecchio’s ideas made money. He began to paper-trade them using strict money-management rules while he contemplated finding a trading opportunity in which he could have discretionary control over his ideas, and his income.

In June 2007, he departed from Tice’s firm to join Ranger Capital Group, a Dallas-based company that runs a hedge fund called Ranger Alter­native Management. Ranger manages more than $1.3 billion; Del Vecchio oversees the fund’s short-only portfolio, taking on as many as 30 positions at a time. While he wouldn’t break out how his portfolio has done or how large it is, he appears to have done his part to help Ranger Alternative to a 24 percent return this year through August.

Del Vecchio, 32, now puts his convictions into action, not white papers. He walks into his eleventh-floor office in downtown Dallas every day looking for someone to bet against. A traditional short seller, he abides by a simple theory: If there’s robust demand for a company’s products, management has no reason to engage in accounting gimmicks that mask operational deterioration. “I can see where the companies are utilizing some aggressive accounting or understating inventory. If they’re a one-product company, they’re going to have risk if the bottom falls out of their market,” he says. “But since we’re all looking at the same numbers, it’s going to come down to putting on the trade and having the conviction. Not that everyone is a crook, but we all know that executives try to support their stock as long as they can.”

Del Vecchio, who focuses on small- and mid-cap names, generally looks for evidence of low earnings quality and aggressive accounting. With that, though, he is acutely aware that small- and mid-cap names can get terribly thin if they go against you. He doesn’t sleep with one foot on the floor, because he uses stops to protect his capital; he also avoids shorts that draw crowds.

In one such trade last fall, he went short IMS Health Inc., a provider of market intelligence to the pharmaceutical and health-care industries, because his fundamental criteria were met. He sold it short when it was trading in the low 30s. Then the news hit the tape: “Days sales outstanding” (DSO) had jumped five days in June, and deferred revenue fell $6.5 million. DSO jumped 10 days in September.

Del Vecchio’s decision to short was based on his understanding that an increase in DSO is indicative of extended payment terms. That trend would accelerate into autumn. Also, the deferment put pressure on IMS’s ability to meet future targets as well. Look out below! In the end, Del Vecchio covered, for a 25 percent gain.

Short selling, clearly, is only for traders with steely constitutions. Those who know Del Vecchio aren’t surprised he has the requisite makeup.

“His greatest strength is understanding why a particular name or company makes for a timely investment,” says Craig Sheets, a principal/analyst with Wilmington, Delaware–based Assay Research. “He’s seemingly able to differentiate noise from real issues when names go against him — another trait of successful investment managers.” One of Del Vecchio’s favorite noises while attending Bryant College in Smithfield, Rhode Island, was the sound of horse hooves thundering down the stretch at nearby Lincoln Park. The Syracuse, New York, native always made time for between-class trips to the track, two miles from campus, and unlike a lot of young kids, he didn’t let the gambling bug drag him down — he maintained a 4.0 GPA and won more on wagers than he lost. More importantly, he became fascinated with odds and the wisdom of crowds. He graduated in 1998 with a degree in finance, and by 25 had earned his CFA.

Parimutuel wagering interested him because he believes that people systematically under- and overestimate the odds of something happening — in this case, a horse winning a race. “This led to my interest in stocks, since the market is bigger, but the concept is the same — with better odds,” he says.

His interest in shorting stocks began in 2000, when he was working for an Internet company (which he chooses not to name) that had solid backing and a good brand. However, a look at his employer’s revenue model and financials, along with the knowledge of how the VCs wanted to burn through company cash, indicated to him that disaster loomed for the entire dot-com sector. His instincts proved spot-on.

“Most CFAs are too literal and not dynamic enough, but John has a grasp of the intangibles,” says John Sidawi, vice president and senior trader at Federated Investment Management in Pittsburgh, and a longtime colleague. “We all share the same information content; John has the ability to translate it into performance.”

In 2001, Del Vecchio landed a job at Rockville, Maryland–based CFRA, Inc., working as one of a team of forensic accountants. The group had an enviable track record of uncovering lousy stocks that then plummeted. “At CFRA I took away two key concepts,” he says. “First, every company is guilty until proven innocent. In other words, let the numbers and the nuance of the SEC filings, not management, tell you if business is good or not. Second, the higher up on the income statement a concern is, the more critical it is.” Del Vecchio went to work for David Tice in late 2002, honing his skills alongside one of the most famous bears alive. “I realized during my stint there that if I stick to accounting issues, I can find shorts that work even in a bull market,” he says. “Where I lost, almost all of the time, is when I strayed from this and wrote research on fundamental issues such as the health of the advertising market or iPods.”

At Ranger, a firm with broad infrastructure and support, Del Vecchio now has another opportunity to put his theories about aggressive accounting and risk management to the test. One short over the past year and a half that he liked — but which failed to pan out — was Stanley Inc. “When it reported improved backlog, I exited the position as the concerns regarding unbilled A/R abated,” he explains. “We got out at a small loss rather than trying to hold and hope things went our way.” “There are always timing mistakes,” he adds. “My biggest mistakes happen when I fail to recognize that the issues I’ve identified as being problems are no longer relevant. To be a winner as a short, you have to be a great loser.”

This article originally appeared in the October, 2008 edition of Trader Monthly.

John Del Vecchio wrote a guest spot on Marc Faber on MartinKronicle.

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Bill Dunn: Unbreakable

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Adherence to his system enabled commodities veteran Bill Dunn to stage a monster comeback.

If you’re a trend follower, and you trade commodities, the past few years have been fun. But for Bill Dunn, a futures trader since the days of Richard Nixon’s price controls, the recent commodities explosion has been anything but a joyride.

While most trend following CTAs took elephantine profits in recent years, DUNN Capital Management, which runs $360 million, lagged sorely behind. In 2003, 2004, and 2005, Dunn’s World Monetary & Agriculture program lost 13.4%, 16.7%, and 16.4%, respectively. Worse yet for Dunn, who was always in the market (never in cash), was his firm’s “0 and 25” fee structure. His trading revenue for those three years, in other words, was non-existent. (Note to hedge fund managers: Dunn’s internally managed confidence strategy has survived unscathed.)

Some traders would have closed up shop or perhaps faked their own death. But Dunn didn’t flinch. Despite three consecutive double-digit down years, he stuck to his reversal-based trend-following system — which, in the pursuit of lasting market moves, often sends him from net long to net short in one fell swoop, and vice-versa. His average return since 1974 is around 15%.

Dunn’s steadfastness led to a reversal of fortune. In 2006, he notched an up year. It was nothing spectacular — 3.1% — but he had stopped the bleeding. Then, in 2007, he produced a return of 7.6%. But true vindication has come this year: Dunn, making all the right moves as commodity prices have surged, has pounded out a 37.4% return through the end of June.

His year-to-date performance ranks his Stuart, Florida-based operation fifth among CTAs with more than $50 million, according to Institutional Advisory Services Group. By following his original system, just as he has been doing for the last 34 years, Dunn proved unflappable in the face of turmoil.

“The best I can do each day is follow my rules,” he says. “So if it didn’t work out today, big deal. There was no guarantee that it would work anyway. We never override the system.”

Not one discretionary trade since 1974? (Well, there was one during Y2K.) That’s practically unheard of. Is Dunn never gripped by a desire to take a flyer once in a while?

“No,” he insists. “What’s the point? Why do people think they are smarter than the market long term? What gives them that confidence? I guess people feel dumb if they can’t predict what the market is going to do in the short-term. They’re too proud to admit they don’t know what to do when they’re wrong. They don’t have the capacity to understand the digits that are scrolling by on the bottom of the television. I don’t. It’s too much noise. That’s why we rely on our system.”

Dunn’s approach to the markets has always relied on logic, order, and numbers, leaving bravado and emotion for the suckers. Born in Alton, Illinois, he was an undergrad University of Kansas (where he studied engineering physics) and obtained his PhD in theoretical physics from Northwestern in 1966. He taught physics at the University of California and Pomona College and then did top-secret operations research and the Department of Defense. “I found the work entirely tedious,” he recalls.

In 1970, he discovered something much more intellectually stimulating: the US stock market. But there were simply too many individual stocks to follow with any meaningful focus. He had one other problem: highly intelligent and dead set on making sense of the market, he couldn’t find a broker or money manager who impress them enough to enlist. “I had no confidence in any of them,” he says.

He read a newsletter — he can’t remember it’s name — about making money and commodities, which gave him an interest in technical analysis. He set out to develop his own system that would apply to all commodities. “There were only two dozen futures traders doing that back then,” he says. “I could keep track of the prices in my head, for heavens sake. And guess what? It worked.”

Today Dunn’s model tracks and trades more than 50 commodity and financial futures contracts. He has programmed his system to be statistically robust; his signal generator is constructed with only two parameters, which he refuses to reveal. He will, at times, adjust positions as volatility changes. For example, once a target risk profile is set, the system might buy 400 gold contracts when he puts a position on, then trim it by 10 or 20 contracts as volatility increases to better control the overall risk to the portfolio. He employs a macro overlay that mimics a value at risk (VaR) at the portfolio level. At that point, “we try to stay that course.”

Over the years Dunn has tweaked the model, but for the most part he has stuck to the game plan. He has a material amount of his own net worth committed to his system, and has never felt the need to sweet-talk clients, even during the dark days of 2003 to 2005. “We interview them as much as they seek information about us,” he says. “There’s no ambiguity — we tell clients that they have to be with us for the long haul, or we do not want their money.”

As a result, Dunn’s clients are loyal. Few bail out. “They leave because they want to buy a ranch in Colorado,” he says. “Or they die.”

“No one talks more straightforwardly than Bill Dunn,” says Ted Kingsbery, a principal at Dallas-based CTA Liberty Funds Group, who has known Dunn since 1981. “He’s an impressive guy. You know he believes in his system — he lives it.” Dunn, Kingsbery says, issues his statements on the first of the month (“the fastest I’ve ever seen”) and the figures, no matter how ugly, will be honest.”

As far as Dunn is concerned, his system doesn’t fail; it performs within its intended expectations — that is, Dunn knew, based on historical guidelines, that’s such an extended downturn was possible. But he doesn’t sweat the short-term; he doesn’t pour over tea leaves or act on cheap sentiment. So while the rest of us follow Obama/McCain and hurricane season, Dunn will merely be following his system. Just as he always has.

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Tech Two?

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TraderDaily.com

Tech Two?

Nearly a decade after the turn-of-the-­millennium technology-stock meltdown, that familiar exuberance is in the air.

by Mike Martin








THEN
NOW
10 Vital Plays
CMGI, ICGE, VERT, AKAM, BCOM, LU, JDSU, QCOM, SEBL, WCOM AAPL, RIMM, BIDU, GOOG, VMW, GRMN, FSLR, GME, GS, ICE
Swollen Stock
QCOM $650 GOOG $680
Plaything Perils
eToys crashes like Santa on a balsa sleigh, filing for bank­ruptcy after Street analysts reveal dismal 2000 holiday-season orders Mattel shares sink nearly 25 percent after authorities reveal children are likely ­better off eating paint chips for breakfast than ­playing with Chinese-made gewgaws
Seer Status
Oracle (of Redwood City) at $50; Oracle (of Omaha) at $50,000 Oracle (of Redwood City) at $20; Oracle (of Omaha) at $140,000
Marvelous Gadgets of Wonder
iPod birthed; Steve Jobs’s vision of putting “1,000 songs in your pocket” blows minds Even your granny’s toaster oven holds 20,000 songs, plays DVDs and uploads to YouTube videos of her swearing after burning dinner
Nightmare Scenarios
Purported Y2K debacle far less perilous than anyone envisioned All-too-real CDO debacle far more perilous than anyone envisioned
Online brokerages
E-Trade advertises it has clients “with money coming out the wazoo” E-Trade shareholders, whatever their stake in the brokerage, get spanked on the wazoo thanks to a series of ill-advised loans
Boorish Loudmouths
Broadcast.com’s Mark Cuban ­elegantly pirouettes around the market ­collapse by selling to Yahoo for stock; swiftly eliminates downside risk via elaborate hedge Cuban clumsily (and sleevelessly) mambos with Kym Johnson on Dan­cing With the Stars; swiftly elimi­nated from competition
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Financial Markets in India: A Snapshot

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—This article originally appeared in the Aug/Sep 2006 edition of The Reporter, newsletter of the Managed Funds Association.

When I was in India in July 2005, the Sensex had just crossed 7,000 and a local brokerage firm was handing out celebratory chocolates – “Sensex 7000” read the high-relief exclamation. In May, 2006, the index crossed 12,600 and now stands at 10,300. Local investors feel like Derek Jeter does in the playoffs: that monthly returns of 5-10% are their birthright.

There does seem to be a “country myopia” running rampant through India. To be fair, investors in the U.S. lived with the same mania in the late 90s through early 2000. Indian investors cannot export investment funds to other asset classes, so all they know is India. This perspective affects transaction in extra-India investments including foreign exchange. There is a maximum that one can invest outside the country and that is $25,000 per year, per person. At an exchange rate of INR 45 = $U.S. 1, that amounts to Rs 11,25,000 (how they write 1,125,000) or as they say, “11 lacs.” From that perspective, one might conclude that Indians are not a great target market for investments made outside their country, unless they have money outside of India already – and that is not readily available information.

Despite the massive run-up in the market, most investors feel that scrips (what Indians call stocks) will continue to burgeon as will their account balances. The power of the emerging middle class shows no sign of slowing either. Investors can tell you their exact holdings and the prices that they own them and why they bought them. I speak with corporate treasurers and institutional investors. On a few occasions I have asked them “when do you know when to sell?” They either say “Never, because growth will never slow” or “I don’t know, maybe after it doubles.”

At this moment I recall my old professor, the economist Jagdish Bhagwati, telling the story of when his wife Padma Desai, a brilliant economist in her own right, was being interviewed during Naturalization: “Ms. Desai, can you tell us the significance of July 1776?” the interviewer asked. She said, “That’s so easy, it is when Adam Smith wrote Wealth of Nations!” “Uh, we were thinking more along the lines of the signing of the Declaration of Independence?” “Oh, yes of course. How could I have missed that one?”

I asked the investor if he knew what March 10, 2000 stood for or if he’d heard of “Black Monday.” He didn’t know either, but he guessed they were “auspicious dates” since I singled them out. I said “For some.” “I know but one sure tip from a broker. It is your margin call.”(Jesse Livermore, How to Trade in Stocks.)

The Reserve Bank of India (RBI) has been tightening credit at least in part to assuage the disintermediation (hemorrhaging) that has occurred over the last few years. But this has not slowed down the demand to borrow funds for the purpose of investing. There is ample availability of cash. India is lending at margin interest rates between 10.5% and 16%. And the local investors are lined up to borrow. These rates are for what they call “Loans against Scrips.” In other words, these are collateralized loans! Initial margin on scrips is between 10% and 15% of the market value. They must really be bullish: when they can’t borrow versus their scrips, they borrow unsecured amounts at interest rates as high as 24%.

The National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) determine which scrips have loan value. Together, they have created a list of about 400 scrips which they call the “A Group” which are marginable. Initial margin for commodity futures is typically 6% of notional value, but can be expanded due to increased volatility. Such is the case with the metals. Initial margin for silver is 12%, for example. It has not slowed down the interest in the metal.

Yet the FMC has tried another method for curbing volatility in commodity futures trading. On May 10, 2006, the FMC instructed the MCX and the NCDEX to reduce the level of the maximum daily price fluctuations across several commodities. These upper and lower circuits, known as limit moves in the U.S., have been reduced from 6% and 3% to 4% and 2%, for the first circuit breaker level and the second level respectively, once trading is resumed from a mandatory 15-minute break.

Meeting the demand for information on investing are two new financial news channels which have launched in the past few months. Joining NDTV and CNBC-18 are “Times Now” (a news channel from Time of India) and “IBN Live” (joint venture between CNN and IBN). The advertising rupees must be there. According to the securities regulator, the Securities Exchange Board of India (SEBI), there are 10 different stock exchanges in India. They are regulated by SEBI as is the trading and listing of scrips. They act much like the SEC here in the U.S.

U.S. investors typically utilize a master/feeder structure for making equity (scrips) investments in India as a foreign institutional investor (FII). The feeder fund may be based in such tax efficient jurisdictions such as Cayman or BVI (as LPs), which in turn would invest in a master fund based in Mauritius (as a company expressed as “Ltd”). The latter would make direct investment into India as an FII. This is true for equity investment only. Non-Indians are currently precluded from trading in local commodities.

Indians, like U.S. investors, are obsessed with gold and crude oil, especially since the financial TV channels have added gold and crude oil prices to the scrolling ticker on the TV screen. They love the “internationally-linked” commodities because they trade seemingly all day. No one had spoken about channa (chick peas) when they traded at historical levels.

To that point, the exchanges have made commodity data more readily available. The Multi Commodity Exchange (MCX) has a day session and a night session so that the contract can trade in parity with other markets such as LME and the COMEX divisionof NYMEX. All trading is done on the screen though, there is no outcry market. But that is only for this exchange.

The MCX currently lists four different gold contracts and the NCDEX lists one. One has ample liquidity and the others act as “spoilers,” like in politics. My guess is that if they did away with the “also rans” you’d get better liquidity in the one.Accordingly, we study volume and open interest daily to look for pockets of liquidity. Getting into a position is easy, getting out is another story.

According to the NCDEX Web site, “the NCDEX is a nationlevel, technology driven de-mutualized on-line commodity exchange with an independent board of directors and professionals not having any vested interest in commodity markets. It is committed to provide a world-class commodity exchange platform for market participants to trade in a wide spectrum of commodity derivatives driven by best global practices, professionalism and transparency.” The NCDEX is one of three national multi-commodity exchanges.

Forget going long gamma or vega, you can’t do it yet. Currently there are no puts or calls traded on commodities. Options on futures were on the agenda for the FMC meeting on June 8, 2006, as is a discussion on stock index futures and the participation of mutual funds in commodities. Not much has been released on the discussions. For further updates visit www.myiris.com.

There are, however, derivatives on equity scrips, as well as a phenomenal single stock futures (SSF) market that is very mature and robust. In fact, selling SSF is the only short selling that is allowed right now. Only delivery-based trades are allowed. FIIs that wish to “lend” securities must only do so through an approved intermediary that will do so in accordance with the stock lending scheme of SEBI. (Source: Nishith Desai &Associates)

Commodity trading is dominated by hedgers and small speculators, but the trading is mostly retail, broker-assisted accounts. I would expect the volume of contracts traded and open interest to increase dramatically once the government allows the trading of options on futures and once they allow banks and foreign investment in commodity futures. Commodities are regulated by the Forwards Market Commission (FMC) www.fmc.gov.in/Default1000.html.

India has a whopping 21 regional commodity exchanges and three national multi-commodity exchanges. Perhaps, similar to the U.S. a few decades ago, some of them will either fold or merge with one of their counterparts, especially given that most of the markets are not connected electronically. Out of these the MCX, NCDEX and NMCE are large exchanges and MCX is the biggest among them. (Source: FMC) Many of the exchanges are highly specialized. They only trade one commodity contract. An example of this is the Ahmedabad Commodity Exchange Ltd. which trades solely castor seeds. Castor seeds are ground to create castor seed oil which is used to make everything from plastics, to components for shatter-proof glass to cosmetics and related products.

One can understand how this exchange came into existence in 1952. Although China and Brazil produce castor seeds, a full 40% of the world’s output is created in Gujarat, the state where the exchange in located. This is not unlike how the exchanges in the U.S. came to be. They are centralized meeting places where participants can buy and sell risk and get price discovery.

Training of personnel for futures commodity trading is also on the rise. India has its equivalent to the Series 3, called “NSE Commodity Module.” The NSE stands for “National Stock Exchange.” It was reported in the Business Standard, a Mumbai-based newspaper, the Forward Markets Commission may sign a memorandum of understanding with the U.S. Commodity Futures Trading Commission for information sharing and training programs.