t known of anyone who canconsistently and accurately time the market. They might exist outthere, but I’ve never met one. Therefore, I stay fully invested. Youwant to focus on the strongest industry sectors and the strongeststocks, because the better, stronger companies should decline less ina bear market and come out of the starting blocks faster during therebound in a bull market.
Second, I want to be in the sweet spot of the “S curve,” which isthe point of maximum rate-of-change, acceleration, momentum. Iwant to own companies that are undergoing the greatest upward rateof change in earnings, sales, discovery, ownership change, brokeragesponsorship, and relative price strength.
There are five things that I specifically look for in stocks and asixth kind of overview theme if I can get it. You don’t have to haveevery one of these, but you need most of them:
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One, I want dramatically accelerating earnings. I am not interestedin a company growing trendline 30%. Most money managers wouldlove to own those things. I don’t. | want something going from 30%growth to 60% growth. Conversely, you might have a stock that’sgrowing 15% or 20%, but all of a sudden - because you've got thebig product, the big management change, the great service - this isgoing to drive those earnings so powerfully that it will substantiallychange the nature of the company. If you can capture that, you’vegot two things going for you. One, you have the increased price ofthe stock, because the earnings are going to go up 60% instead of30%. So you get 100% greater price appreciation because the earningsare going up higher. And two, if you’re right in your assessment ofthe company’s growth, you're going to get a multiple expansion. Themarket is going to say, wow, this isn’t a 30% grower anymore, thisis a 50% grower. So you get a higher multiple [price-earnings ratio].Two bangs for your buck. Our typical companies have been growingmaybe 10% annualized for the last five years, which is nothing towrite home about. But next year’s earnings should be up 50% to 60%on average for the companies in my portfolio.
Second, I want a strong balance sheet. No debt or virtually no debt.If there’s any debt, there’d better be good cash flow. Why do I wantthis? It comes from my Arthur Andersen experience. Young companieshave a tendency to get in trouble. They’re growing so fast that theyhave an insatiable appetite for working capital to fund their growth.As a result, they sometimes leverage up their balance sheets andmanagement gets in trouble. So, I want the operating leverage butnot the financial risk. That at least helps keep me out of trouble.
Third, I want a strong relative price strength. The concept is howwell is that stock acting in the market relative to all other stocks?Let’s say the median stock in the market has a relative strength of50. Most of the companies that I own are 80 and above, meaning thatthey are outperforming 80% of all stocks in the market.
Tanous:How do you measure that?
Johnston: There are services that can give you these measurements.But, basically, we’re not bottom fishers. We want stocks that are actingwell and breaking out to new highs. The importance of that is thatwe think that the market is remarkably efficient at ferreting out goodcompanies. The market seems to know. If a stock is acting well, it’s
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probably acting well for a reason - positive earnings surprises coming,new product announcement, etc.
Fourth, I want companies in industries that are doing well in themarket pricewise. If you look at the industry’s group rank, its in-dustry’s relative price strength, you want that to be doing well too,because it’s awfully difficult for any company to be doing well in anindustry that is doing poorly. I mean, you might have the lone rangerout there, but you really want your industry to be performing well.Remember, stocks are sold; they aren’t bought. It’s hard enough tofind companies that are interesting and exciting. If you have a sectorthat’s flat on its back, it might be the greatest company with thegreatest story ever, but when the institutional salesmen are out therecalling around trying to get your interest, the answer is likely to be,hey, forget it. I don’t want to own semiconductors; it’s a dead group.
Fifth is low institutional ownership. We want to be in the first waveof institutional buying, long before the majors are buying these names.We want the company’s sponsorship to be young and small withlimited brokerage coverage. We want to be ahead of the big buyingprograms of the majors that will undoubtedly follow, as other investorsdiscover what we already know - a potentially great company, a greatinvestment opportunity in the making.
Sixth, we like to focus on dominant investment themes - the dy-namic trends we identify early. This is not a criterion, since it’s notcompany specific, but it is important. We uncover a rapidly growingcompany that is exploiting an industry niche - maybe it’s an inven-tion, perhaps a change in government regulations. Other companieswill respond by altering their growth strategies to profit from the newopportunity and new companies will emerge funded by venture cap-italists. Before you know it, an entirely new industry is created beforeyour very eyes. These mini-industries have such powerful dynamicsthat they are essentially insulated from the broader economic changesimpacting the overall economy. These micro-industries are often re-cession-proof. The economy moves on the waves of innovation andlifestyle changes.
Tanous:Can you give us some examples?
Johnston: There are numerous, mini-industry niches experiencingdramatic growth. Starting with technology: the machine vision in-dustry, supply chain management software, data warehousing soft-ware, wireless cable, video conferencing, caller ID, flat panel display.
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In the health industry you have the kidney dialysis industry, genetherapy, orthopedic devices, bone growth stimulation, clinical researchorganizations, group practice management, patient care computing,emergency room outsourcing, and so forth. In the consumer area, therent-to-own industry, the pawn shops, book retailers, craft beerbrewing, in-line skating, snowboards, temporary staffing, privatizationof correction facilities. As you can see, the opportunities are still there.
Tanous: You know, as I heard you rattle off your criteria, Scott, yousounded suspiciously like a momentum investor. Would you callyourself a momentum investor?
Johnston: Define momentum investor and I'll be able to answerthe question. I began implementing this investment style in 1976,over 20 years ago. The elements of style have remained unchangedsince inception. You know, I doubt the term “momentum investing”was even around back then. If [ am a momentum investor, I musthave been one of the very earliest ones. You know, momentum invest-ing has the connotation of quickly jumping on and off trends. Youhave to be mindful of the big picture, the long term secular trends.It was the inflation of the 1970s, it was the consumer disinflation ofthe 1980s. I believe the themes for the 90s and the 2000s are the in-formation age and the graying of America. You don’t need to be ahotshot, gunslinger portfolio manager flitting from one idea to anotherto produce good returns, if you’re mindful of the big picture.
Tanous:Let me ask you a hypothetical. Let’s say you find a companythat has all the things you’re looking for. I’m the salesman and I knowexactly what you want so I’m pitching you this story and, bang, bang,bang, we're hitting all your criteria. Then at the end I say, Scott, bythe way, it’s selling at 42 times earnings. Do you care?
Johnston: No. The price-earnings ratio is not real important to us.How the hell do you put the right price-earnings ratio on a companythat is growing 50% or 60% a year? As long as that stock is actingwell and the earnings are coming through, it’s okay. Of course, thereare always cases where the price is beyond all reason, and we'll stayaway from those. But don’t worry about the P/E. Great companiesdeserve great earnings multiples.
Tanous:Okay. What else is important?
Johnston: We rarely buy a company without talking to manage-ment. That comes from my audit experience. First, you tap into thegreat minds at the research firms, who have known the company for
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years. But by talking to the company, too, you get an undertone. Howpositive or negative are they? You might discover that the last timethe analyst talked to them was three months ago, in which case youmight rethink your analysis. So you always talk to the managementof the company first, usually the CEO or the CFO or both.
In terms of visiting companies, we see maybe 30% or 40% of thembecause they come through San Francisco, where we are, but it’s notthat critical. IF you know how to ask the right questions of manage-ment, and you do that as part of your business, you don’t need tovisit the company. What you're doing is confirming what the analystis telling you.
Tanous:Let’s talk about your sell discipline.
Johnston: We have three criteria. First, we sell the stock if thereason for purchasing the stock is no longer valid. That’s generallybecause the company has lost its “window of opportunity.” You mighthave a company that’s got the greatest widget of all time - smaller,cheaper, faster, better. But you find out that they’ve got a glitch intheir production process, or maybe there’s a new competitor comingin, so they don’t own the market anymore. We sell the stock becausethese concerns generally lead to earnings disappointments.
Second, we sell if it gets way overvalued. Certainly, there is a strongcorrelation between a company’s underlying growth rate and thestock market’s valuation via the price-earnings ratio or the marketcap-to-sales ratio. Clearly, we try to find growth companies beforeother investors do, hopefully before the company’s prospects are fullyreflected in a high stock price. But if a big mutual fund loads up andshoots the stock price up, it may become way overvalued. We'll sellinto the buying frenzy, capture the profit, and come back later.
Third, and generally most important, we sell the stock if the relativeprice strength begins to diminish. If the relative strength begins toroll over, or if the industry group rank starts to get weak, that’s tellingus that something might be going wrong. We found out that stuffleaks out of companies. Analysts or other investors may suspect someproblems arising. The purchasing agent might be playing golf with abroker or something like that. If there’s going to be some disappoint-ment, the market will know that things aren’t going well. That wouldbe a reason for us to investigate, call the analyst, call the company.If it continues, we know the market is smarter than we are, so we'llsell out.
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Also the industry might come under a dark cloud. For instance, thehealth care stocks were very powerful until the Clinton Admini-stra-tion came in. When they started looking at health care, all those stocksreally underperformed. The concern was for the future profitabilityof the industry. Those earnings came through magnificently in 1993,but still the stocks performed very poorly. So, we were out of all ofthem until the cloud passed.
Tanous:Did you get back in?
Johnston: You bet. Big time. But not until the industry strengthbegan to lift, evidencing investors’ willingness to accumulate thestocks again. Regardless of your specific disciplines, the key pointwhen you run money, is that you have to be decisive. Whether it’s abuy discipline or a sell discipline, make a decision and act on it.There’s a terrific scene in the movie Wall Street that epitomizes thispoint. It captures the essence of what we are faced with every day -the rush, the adrenaline, the mandatory decisiveness, the urge to takeaction, don’t look back, and go on to the next one. In the movie,Gordon Gekko, played by Michael Douglas, has been buying millionsof shares of Bluestar Airlines at the $22 level, believing the stock isgoing to 30. But the stock has been drifting down all day. Gekko isin his big trading room office, high above Gotham City, and his brokeron the deal, Bud Fox, played by Charlie Sheen, calls him when thestock is at 16 1/2, representing an enormous loss, and says: “Twominutes to close, Gordon. What do you want to do? You decide.”Gekko knows he’s been had. He replies almost immediately: “Dumpit!”
I loved that. He’s got balls!
Tanous:I understand you'll also sell a stock if the company getstoo big. Why would you sell a company that’s a great company withgreat earnings that you’ve been right on, just because it got too big?
Johnston: Your value-added diminishes once a company gets thatlarge. At the larger size, its inherent growth rate has to drop; it’s alaw of nature. By then, if it’s a great company, it’s now an “institu-tional darling” and you’ve got seven or eight brokerage firms coveringit. We concentrate on finding the small company before it’s beendiscovered. I know that some small-cap managers keep their winnersgoing even as they grow to large-caps. We sell them when they gettoo large. Why? Because, as | said before, we want to be in the sweetspot of the “S curve”- the discovery, the momentum, the period of
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biggest change. Those are characteristics of smaller companies.Companies with a billion dollar market cap are generally not as dy-namic as the younger companies. So we’ll sell them out even thoughtheir prospects may be excellent.
Tanous:Let me ask about the firm. How much money do you haveunder management?
Johnston: About $540 million in small-cap assets. We’re lookingat managing about $750 million in small-cap, and then closing thatproduct. We want to stay a focused boutique. We want it to be funand not have a lot of administration. That will ensure client service.That’s as important to us as performance. Your clients should under-stand how and why you are managing their money. That needs to becommunicated from a principal of the firm.
Tanous:What’s your minimum account size?
Johnston: It’s $20 million now. A micro-cap limited partnershipfund will be introduced with a $1 million minimum.
Tanous:The risk side of the equation is the other part of the story.As we all know, there is no free lunch, and one of the things aboutyour management style is that it does appear to be volatile. What’syour average turnover?
Johnston: About 150%, which is in line with most other small-capmanagers. We are very, very active, but we have held positions forseveral years as long as earnings keep coming through. Our companiesare growing so fast that the market caps quickly rise beyond our buyzone. Our $1 billion maximum market cap mandate forces the selldecision.
Tanous:0n a standard deviation basis, your volatility is about doublethe market’s. I suppose that is consistent with aggressive small-capinvesting, but that’s the price you pay for this kind of performance,wouldn't you say?
Johnston: Here’s the thing. If you’re after companies with greatexciting products that are growing three or four times the rate of themarket, with big expectations, you're going to have disappointments.Small companies are prone to erratic earnings swings. It’s the natureof the beast. They are about discovery. They are under-owned, under-followed, thinly capitalized, and subject to big moves when institutionsfind out about them. Conversely, when something goes wrong, mosteveryone rushes to get out the doorway at the same time. Need I re-mind you that it’s a very narrow passageway? Higher risk equates to
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higher returns. Now over long periods of time - and I’ll note that in-vestors must have a long-term investment horizon to participate inthis sector - the small-cap indexes have shown very meaningful in-cremental returns over the large-cap indexes. But the point is thatsmall-cap stocks, by their nature, are volatile. It’s inherent in thatsector of the market, and investors are well-rewarded by this sector.
Tanous: What are some of the other tenets of your investment dis-cipline?
Johnston: Here’s a big one: If you’ve established a successful in-vestment discipline, don’t change it. Many money managers get intoa rough market period and they modify their strategy or make excuses,like we’re going to make this one exception. I say, don’t violate yourrules. If you strictly adhere to your discipline year-in and year-out,you ought to be successful. That’s how you stay on the right side ofthe distribution curve. Remember, we are operating in an inefficientarea of the market, which is small-caps. To me, large-cap stocks areboring as hell. They’re efficient and they’re boring! You’ve got tomake the macro call to be right. If you have information sources thatare adept at discovering interesting stories early on, you will findgreat companies early and you can consistently beat the market.
Tanous:! see. So small-cap stocks aren’t as well known as large-caps, nor as widely followed, and that, presumably, creates the ineffi-ciencies. How many stocks do you keep in your portfolio?
Johnston: We maintain 75 names in our portfolio. We don’t expandthat number. A lot of money managers put their toe in the water. Bythat I mean, instead of buying a full position for their portfolios,which for us is 1 1/2% of the portfolio, they’ll buy half-positions orquarter-positions. That’s going into it halfheartedly. I don’t subscribeto that. I think you own it and you love it, or you don’t buy it. Andyoure constantly reevaluating your 75 names. In order to buy a newname, you’ve got to kick out an old name. That imposes a discipline- to always focus on the strongest names in your portfolio. That helpskeep the performance up. You’re forced to make the buy and sell de-cision.
Tanous:Another manager I interviewed has the identical philosophy,Foster Friess [page 229] who runs the Brandywine Fund. He has avery colorful way of describing this philosophy. His analogy is to “pigsin the trough.” Fifteen pigs fit at the trough. The sixteenth comes
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along and nudges himself in. In the process, one of the original pigsis displaced and wanders off, presumably fat and happy.
Johnston: That’s great. What you're doing all the time is focusingon the very best companies, the very best names.
Tanous: What are some of your future plans?
Johnston: Simply keep my head down, stick to my knitting. Nograndiose expansion plans. Let things evolve in a timely manner. Oursingular focus is on providing the best returns for our clients andmaintaining strong communications with them, so that they under-stand our process. The rest should take care of itself.
Tanous:Before we conclude, I want to go back to the six investmentcriteria, plus the overview, that we talked about. I keep wondering ifthere isn’t something else involved?
Johnston: Yes, there is. It’s that the very best managers develop asixth sense where they just know that a stock is going to move.
Tanous:! asked that question of a lot of managers. I asked PeterLynch, for example, since his approach is so logical and simple. Ifthat’s the case, though, why isn’t everybody rich? I often wonder whatrole instinct plays.
Johnston: You develop a sixth sense, an instinct. We’re talking arthere, not science. Many have the ability, the training, the commitment,but few have the touch.
Tanous:When you go home at night, can you identify what it isthat makes you feel that way?
Johnston: | have no idea. It’s visceral. You just sense it. You knowthat a stock’s got all the elements to be a winner. It feels right; it’sready to move.
Tanous:But where did that sense come from?
Johnston: The story, the catalyst, the trading pattern.
Tanous:Let me ask the question another way, because we’ve got toget to the bottom of this. Ten years ago, did you have this sense?
Johnston: Yes.
Tanous:Did you have it 20 years ago, when you started?
Johnston: | had it 15 years ago. It took me five years to developit. You want fresh names and fresh stories. | don’t want to hear astory and have to say, yeah, we know that story. It was around a yearago. Give me freshness.
But you have to be open-minded to opportunities and listen forchanges. Look at oil stocks and energy exploration stocks. Most people
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who have been in the business a long time will say, I don’t want toown them. But the industry has changed. The typical growth stockmanager doesn’t own energy stocks now. But what about all this newtechnology in the industry? It’s worth looking at. Fresh names. Freshstories.
One final comment about purpose. This is a humbling profession,with minefields all over the place capable of destroying a good per-formance record built on years of hard work. Investment legendscome and go; you could be history before you even knew it. We allknow that if we consistently produce exceptional returns for our cli-ents, we can make an unconscionable amount of money in the invest-ment business. Whether the Guru was born with the gift, learned thegift, or perhaps some higher power intervened, one must ask, for whatpurpose? Is there more to life than making a lot of money for oneselfand others in this world? The Gurus are among the fortunate few. Iasked the question of purpose a long time ago. There is a source onthat subject that is right on the money, God Owns my Business, byStanley Tam. For me, the answer is in Malachi 3:10: [Malachi 3:10“Bring the full tithe into the storehouse, so that there may be food inmy house, and thus put me to the test, says the Lord of hosts; see ifI will not open the windows of heaven for you and pour down for youan overflowing blessing.” (The New Oxford Annotated Bible)]
An interesting story and an interesting fellow. I kept thinking aboutthe fact that Scott Johnston started as a broker, so he knows goodsalesmen from bad, and more importantly, he knows a good storywhen he hears one. I also thought a lot about his notion of a sixthsense. Okay, do you have it? And if so, how important is it? Keepthat in mind as you read through the other interviews. Is the sixthsense something we should look for, either in ourselves or in a moneymanager?
In one sense, it is great to have somebody like Scott Johnston totalk to about investments. In another sense, it’s a little frustrating,because only institutional investors will be able to use him, given hishigh minimums. I keep waiting for him to announce a new Johnstonmutual fund which most investors could buy.
But, for those who are interested in doing some homework, I thinkthat Scott’s ideas and management philosophy are so clear-cut andinviolable that many of you, especially those among you who like topick stocks yourselves, would be able to glean some useful ideas from
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him. For example, an amateur investor, guided by the principles Scottarticulates in this interview, might be able to find some of these out-standing companies and invest in them on his or her own. True, itwouldn’t be easy. You'd have to buy some research, and maybe developa contact or two at a regional brokerage firm. But the criteria heshared with us are easy enough to follow, if you have the patienceand persistence to do it. Of one thing there is no doubt: Scott John-ston’s prescription for buying undiscovered small-cap growth stockshas stood the test of time, making him one of the premier investorsof this genre in the country.
Postscript:Not long after our interview, Scott Johnston left Apodaca-Johnston and reactivated Sterling Johnston Capital Management, acompany he founded in 1985. With headquarters in San Francisco,the firm specializes in small-cap emerging growth equity management.The firm will dedicate 10% of its profits to religious and philanthropicorganizations.
148EUGENE FAMA
Eugene Fama grew up in Boston, a third generation Italian-Amer-ican. While an undergraduate at Tufts University, he excelled in ath-letics and majored in French - an inauspicious beginning for a futuregiant in the field of economics. But he also worked for a professorwho was trying to develop “buy” and “sell” signals based on pricemomentum. Although the theories the professor devised worked wellwhen applied to the past, they worked poorly when Fama tested themin real time. That puzzle, plus the skills that he acquired evaluatingstock market data, drew Gene Fama to business school. After earninghis doctorate at the University of Chicago, he joined the faculty therein 1963.
A simplified version of his dissertation, “Random Walks in StockMarket Prices,” was published in Institutional Investor magazine,provoking a stir. It was Gene’s article that introduced the still-contro-versial efficient market theory to the investment community. (Thereare many variations of the efficient market theory, but they all postu-late that stock prices promptly and fully reflect all public information.)Very few academics specializing in investment research have anyaudience in the investment community, but that article made GeneFama very well-known on Wall Street. But he is an academic andtechnical terms are used in this interview. We covered some of theseterms earlier in the book, but here’s a quick, but non-scientific, re-fresher course on some of the lingo:
Efficient market theory: The theory that holds that stocks are alwayscorrectly priced since everything that is publicly known about thestock is reflected in its market price.
Random walk theory: One element of the efficient market theory.The thesis that stock price variations are not predictable.
Active management: The practice of picking individual stocks basedon fundamental research and analysis in the expectation that a port-folio of selected stocks can consistently outperform market averages.
Passive management: The practice of buying a portfolio that is aproxy for the market as a whole on the theory that it is so difficultto outperform the market that it is cheaper and less risky to just buythe market.PETER J. TANOUS
Outliers and fat tails: In a normal, bell-shaped distribution of re-turns on investment portfolios, the majority of the returns, or data,can be found in the “bell,” or bulge, which centers around the weightedaverage return for the entire market. At the ends, both right and left,we find what are known as “outliers,” those returns which are eithervery bad (left side) or very good (right side}. Of course, few managersare either very good or very bad. Those returns on the right and lefttails are known as outliers since they live on the outlying fringes ofthe curve. Similarly, “fat tails” refers to larger than normal tails ofthe curve, meaning that there are more data on the extremes than youmight expect.
Tanous:How did you first get interested in stocks?
Fama As an undergraduate, I worked for a professor at Tufts Uni-versity. He had a “Beat the Market” service. He figured out tradingrules to beat the market, and they always did!
Tanous:! beg your pardon?
Fama: They always did, in the old data. They never did in the newdata [laughter].
Tanous:I see. Are you saying that when you back-tested the tradingrules on the historic data, the rules always worked, but once you ap-plied them to a real trading program, they stopped working?
Fama: Right. That’s when I became an efficient markets person.
Tanous:Okay. Let’s get into it. You’re known for your work on effi-cient capital markets. In fact, on Wall Street, the phrase “efficientmarket” is often attributed to you. I believe you and Ken French madethe point that stock market returns are, in fact, predictable over time.How does that jibe with the random walk theory?
Fama: The efficient market theory and the random walk theoryaren’t the same thing. The efficient market theory is much morepowerful than the random walk theory, which merely postulates thatthe future price movements can’t be predicted from past price move-ments alone. One extreme version of the efficient market theory says,not only is the market continually adjusting all prices to reflect newinformation but, for whatever reason, the expected returns - the re-turns investors require to hold stocks - are constant through time.[For example, we know that, since the ’20s, returns on the New YorkStock Exchange common stocks have averaged a little over 10% peryear.] | don’t believe that. Economically, there is no reason why theexpected return on the stock market has to be the same through time.
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It could be higher in bad times if people become more risk-averse; itcould be lower in good times when people become less risk-averse.
Tanous:So risk is the component that leads to how much you getpaid?
Fama: It could be just taste, too, you know. People’s taste forholding stocks can change with time. None of that is inconsistentwith market efficiency and it can give rise to some predictability inreturns. The predictability is simply based on the returns people requireto hold securities.
Tanous:But, in one of your papers, you did refer to the predictabilityof returns over time. Is that just the investor getting paid for the riskhe was willing to take? Is that the point?
Fama: It could be that or it could be that people are simply morerisk-averse in bad times.
Tanous:0n a related subject, I think you also said that fundamentalanalysis is of value only when the analyst has new information, whichwas not fully considered in forming current market prices. When Ihear that I say: Hey Gene, that’s the point! The analyst believes heknows something, or infers something, that other analysts don’t see.He sees an evolution taking place or he believes this company is doingbetter than people think, and that’s why he gets paid millions of dol-lars on Wall Street to pick stocks. What’s wrong with this thesis?
Fama: Well, not everybody can have that talent. In fact, as far asI can tell, not many do. The system is designed to make that verydifficult. By that, I mean that under U.S. accounting [and regulatory]systems, if you reveal anything, you have to reveal it to everybody.
Tanous:Fair enough, but what if the analyst is making a judgmenton the future prospects of the company. For example, the analystmight say; “the Street says this company is going to earn $0.82 pershare and I say it’s going to earn $1.10 because I’m seeing order flow,consumer demand, customers’ tastes for the product and what haveyou. Now, if the analyst is right, he’s worth the millions he gets paid.My question is: in your thesis, if he’s right, is he right because he’sso smart or just because he’s lucky?
Fama: For the most part, | think it is luck. The evidence is prettystrong that active management doesn’t really do better than passivemanagement.
Tanous:Except, of course, when we start talking about the so-calledoutliers, those managers, like the Gurus in this book, who have per-
151PETER J. TAN