able, then president of the Rock Island and PacificRailway Company. The house is built of Ashlar, a soft peach colored,PETER J. TANOUS
rough-faced stone. It has a pitched roof, tall chimneys, dormer win-dows, and a turret. Inside, Richard Driehaus has decorated the man-sion with his favorite artwork and bric-a-brac. The Art Nouveau decorcompetes with the Victorian furniture for attention. The occasionalsounds of intricate, working, antique clocks and a grand piano canbe heard. Driehaus has an apparent love of stained glass, and thehouse is replete with striking and colorful panels and artifacts fromwhich streams of light cast multi-colored hues all around. His collec-tion of Tiffany lamps is exquisite and is complemented by severalTiffany windows. We met at the mansion for our interview. RobertBuchen, one of Driehaus’ senior executives joined us.
Tanous:How did you first get interested in stocks?
Driehaus: | started as a coin collector. When I had enough money,invested in the market. Initially, I bought two stocks - a conservativestock and an aggressive stock. The aggressive stock, Sperry Rand,went down and the conservative stock, Union Tank Car Company,was very dull and boring. When those stocks didn’t perform, I wentto the library and began reading all the magazines, newspaper articlesand investment advisory letters that I could. During that time, I sub-scribed to various investment advisory services. One of those wasJohn Herrold’s “America’s Fastest Growing Companies.”
By subscribing to that service I saw that Herrold had made somerecommendations that had gone up several thousand percent - com-panies like American Home Products, Baxter Labs, Abbott, and AvonProducts. He attributed the enormous gains in these stocks in thefifties to their sales and earnings growth. That made a lot of sense tome. He had a chart showing the compound growth rate of the earningsand the stock price over a ten year period. I became very interestedin that approach. I wanted stocks that were growing as fast as thosecompanies were when they were originally recommended. Thosecompanies had gone from relatively small companies to relativelylarge companies. You could take a 20% growth rate for an AvonProducts in 1950, with maybe sales under $100 million, and, by theearly sixties, sales were over $1 billion. That’s how I got very inter-ested in stocks, and in particular smaller, and mid-size companiesthat were showing sharp earnings gains.
Tanous:Jeremy Siegel makes the case for stocks in his book, Stocksfor the Long Run, about as persuasively as anyone. He goes back to1800.
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Driehaus: That’s a good point. What’s the long term? A generation?Longer? The 1800s are a good vantage point because the industrialrevolution started then. If we went back to the 5th Century, the declineof Rome, to the 12th century, or the beginning of the Renaissance,that was probably the right time for value type investments. If youwere born on a farm, you stayed on the farm and you married thegirl next door. There was little circulation of ideas.
Man has been on earth for about 200,000 years and it is only inthe last 200 years that we have really improved our standard of living.Michael Rothschild, in his book, Bionomics - Economy as an Ecosys-tem, makes a startling comparison. If we collapse these 200,000 yearsdown to a 24 hour day, in the first 23 hours or so, we were justhunters and gatherers. Then from about 11 PM to 11:58 PM, peoplesurvived by subsistence, farming and crafts. As Rothschild puts it, allof modern industrial life has unfolded in the last 90 seconds. We arenew to change and change is new to us.
Tanous:Since you mentioned the industrial revolution, some of themanagers I talk to, particularly those who follow the technology sector,truly believe that what is happening in technology today is the modern-day equivalent of the industrial revolution. Do you agree with that?
Driehaus: I absolutely agree. That’s why the market has taken off.When I was going to school at DePaul University, we studied the greateconomists. One of them was Joseph Schumpeter. He asked whatcaused economic growth. It wasn’t governments, it was the entrepre-neur and the new industries he was developing that powered growth.The automotive industry stimulated the roaring twenties, which be-came the engine for America’s technological boom. So, I think thatif you apply Schumpeter today, the technology sector is the new en-gine. This industry only began in the late 50s, with the introductionof the transistor, so we’re only thirty-five to forty years into it. Thepoint is that the difference between the time of the discovery and thetime of the impact was delayed for a while. The real impact of theelectronic revolution only started to show up in the 80s when seriouscomputation power became available to the average individual. Thenthe electronic revolution went from a capital good to a consumergood. And that is what stimulated worldwide growth.
Tanous:! read an interesting statistic recently. A kid with a SonyPlay Station video game today has more computing power than NASAdid when it first put a man on the moon.
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Driehaus: Unbelievable, but true.
Tanous:Richard, to change the subject slightly: What’s the key toyour investment philosophy?
Driehaus: Discipline. It’s not so much finding and buying thewinners, it’s the ability to retreat, to sell. That’s the hardest thing todo. The question is not how many winners or losers you have, buthow much do you make on your winners and how quickly do youcut your losses. Seventy percent of your trades could be losing trades,but if the winning 30% are large enough to overcome the losses youcould still show great returns.
So, one of our maxims is cut your losses short. I use a war analogy.If you were engaged in a military campaign, first you try to winphilosophically - not mano a mano. Then, if you can’t win philosoph-ically, you try to win strategically like the British did when they sur-prised Napoleon. For example, if | were building tanks, I’d make themwith bright back-up lights so if I needed to reverse, I could do itquickly - a strategic retreat. The idea is not to lose men or equipment.This is not a game of muscle, it is a game of survival. Live to fightanother day. Long term, battles are won philosophically. Sun-tzu, thefamous Chinese military tactician, was always quick to reverse andwin in a more intelligent way.
Tanous:How do you relate this to your investment philosophy?
Driehaus: On a tactical basis, we are a real bottom-up player. Ifeach stock were like a tank, we’d be quick to reverse and changecourse if it was not working. In the Iraq war, our generals complainedthat they wished they had more information on the front line. So welook at each stock like a little tank. We let them be independent butwe watch them moment by moment. Things change. So if we needto change course, we do.
Tanous:This speaks to your information flow. I'd be interested inwhere you get your ideas.
Driehaus: We spend a lot on idea flow and information flow. Wewere probably one of the first to use a local area network system inthe mid-80s. This allows us to access information from many differentsources and create a central base of information. We’ve gone fromone to six people here who do nothing but information systems. That’sabout a third of our investment staff. A couple of years ago, whenwe started marketing, we used to say that we spend a very high per-centage of our revenues on information technology. While the per-
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centage has gone down as revenues have increased, the amount wespend on information technology has continued to rise at an acceler-ating rate.
Buchen: Let me take you back through the history of our informa-tion process. Back in the early ’70s, Richard, as a research broker,provided ideas to a mutual fund. We had someone come in everySaturday, and sometimes Sunday, to cut and paste information thataffected the fund. Every Sunday night Richard would come in andreview the portfolio, industry by industry. For example, he wouldlook at the health care industry and review every company for bothfundamental and technical information. As a result, on Mondaymorning he knew in his head where everything was, what the trendswere, what was going up and what was going down. And he did thatfor twenty years.
But technology has changed the entire process. Now, with the punchof one button, he can look at fifteen different pieces of informationon one page. We still get all the information, but it has gone fromwhat Richard did early on, which was to outwork everybody, to atechnological input that is virtually instantaneous. The work ethic isvery strong and remains the same. But technology has made it allhappen more quickly.
Tanous:By reputation you are what people in my business refer toas a momentum investor. In fact, to many professionals, you areconsidered the father of momentum investing, which might be definedas identifying and buying stocks in a strong upward price move andstaying with them as long as the upward move continues. Now, youhave all this information at your disposal. What is it exactly thatyou're looking for?
Driehaus: We are looking for earnings growth, earnings accelera-tion. After all, momentum investing is an acknowledgment that thingsin motion tend to stay in motion. We say that the most successfulcompanies are those which have been able to demonstrate strong,sustained earnings growth. We look for many different variations ofearnings growth. We look for accelerating sales and earnings. Welook for positive earnings surprises. We look for sharp upward earn-ings revisions. And, finally, we look for a company that is showingvery strong, consistent, sustained earnings growth - like a Starbuckswhich looks very enduring.
But we don’t just look at earnings growth. We have to see how that
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earnings growth relates to the stock, its group within the market - itssector, and how it relates to other ideas that are out there. It’s not anabsolute criterion. It’s this question: how will this earnings growth,and positive change, impact the stock, especially relative to the marketexpectations out there? The company could show very strong earningsgrowth.
Take Oxford Health. Earnings were up about 90% yesterday. Earn-ings were actually a penny higher for the quarter than expected. Butthe company also said that their profit margin might start to shrink.So while enrollments were very good, and the top line was very good,there were cost constraints that suggested that investors should focuson the lower end of expectations for the succeeding quarter. So wesold most of our stock yesterday and the rest today. The stock wentdown from 80 to 69 yesterday and it is off another four points today.That’s down 20% in two days.
Tanous: Your interpretation of that information, if I understand youcorrectly, is this: the earnings actually came out better than anticip-ated, but with a little cautionary note that maybe, just maybe, thecompany would be on the lower end of expectations for the nextquarter. And that was it.
Driehaus: They were guiding the Street lower. Right.
Tanous:And that sent a clear message to you.
Driehaus: Right. Obviously, this stock was held by a lot of growthinvestors. So even though we liked the stock long term, we reactedto what the market environment was saying. We sold.
We react to events much quicker than other investors. That’s partof our approach. We like positive surprises and upward earnings revi-sions and greater than expected gains. This was the opposite: a com-bination of some deterioration in their cost ratios and the fact thatthere were probably not going to be any more positive earnings sur-prises. Since we are active traders, we sold the stock. I think Sun-tzuwould have done the same. Now it could still be an attractive longterm situation, but we tend to be more active investors. I would rathererr on the side of discretion, even if we miss some of the upside. Wecan always get back in later.
Tanous: When you listen to this philosophy it makes a lot of sense.Richard, you make a lot of sense, but so do hundreds of other peoplewho don’t have your record. I want you to tell me what you think is
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different about your approach and why others who try to emulate itdon’t succeed.
Driehaus: Could be a number of things. One is my belief that, overthe long term, what I am doing will work. Some people, when thingsget difficult, tend to shift styles, or raise cash, or do things that theyconsider safer.
Let me give you an example. In 1994, we had a tough first half.We were down over 20% in our small-cap funds. We diversified out.We bought some stocks that had good futures but were a little moredefensive. At the time, all the best names, the high tech stocks, thehealth care stocks, the retail stocks, which all had good growth ratesand were also among the best companies in America, happened to beamong the worst performing stocks, so we didn’t want to own them.In that environment, a lot of people raised cash, or went real defensive.They bought utilities, for example. But soon after that, right after theJune 1994 quarter, the market came back toward technology. Wewent right back and concentrated on some of the names we had soldearlier that were now recovering. As a result, we recovered dramatic-ally.
Buchen: At the beginning of the second quarter fof 1994], we had66 stocks in the portfolio. This is a half billion dollar portfolio. Sowhat Richard does when times are bad is spread himself out. We wentto 88 stocks at the end of the second quarter. We had a conferencecall with all of our clients on July 11 [1994]. Richard said in thatconference call: This market is turning. I sense it turning. I think itwill be led by technology. We went from 88 names down to 47 bythe end of the third quarter. We went from 25% in technology to 75%in technology.
Driehaus: That’s why we recovered so much. We tend to concentrateon our most successful names. The other answer to your question,Peter, is that I’m submersed in the process. You can’t look at thisacademically and just look at the numbers. You really have to be in-volved and feel what’s going on. The time and effort I devote to thisallows me to be more sensitive to changes and to react to thosechanges. Now, since the changes are constantly ongoing, this alsorequires a lot of stamina.
A couple of observations. People aren’t as involved with the marketas they should be. It’s not just knowing the individual stocks. It’sknowing how that stock fits into its group and what’s happening
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within the market as a whole. Too many people are too narrowly fo-cused. I love bigger pictures. I think what makes us successful isknowing what’s going on in the larger context.
I’ve been managing money for over 25 years. | can remember 1973-1974, the worst decline in my thirty years in the business. Everybodythought they needed more information on each company, so the tomesand the research reports kept getting bigger and bigger, and peoplesuffered still bigger losses, because they never reacted to the fact thatwe were going into a bear market. The point is that you have to havesome sense of what kind of market you’re in, too. So sometimes thereis a time to retreat and let cash build. Markets are often more psycho-logical than they are practical. You can’t keep holding onto ideashoping and praying that they will turn around. There is a time to re-treat and sell, even though we are not market timers.
Tanous: Would it be fair to say, then, that your success is a combin-ation not only of being able to identify earnings growth, but also beingable to put this into the context of a market environment? In otherwords, the July 11, 1994 conference call you told us about was pres-cient timing. Do you recall what it was that you saw that convincedyou that the market was turning?
Driehaus: It’s just my following the market and following individualstocks. It’s more the individual stocks; that is the bottom-up approach.We had sold all of the companies that we thought had good outlooks,but were declining in price. 1994 was a very difficult time because itwas a year of contradictions. We had the best companies in America,but they were the worst stocks. There are times when our style is outof favor, and this was definitely one of those. After the first half ofthe year, I could see our style beginning to work again as some ofthe stocks we had sold earlier started reversing and turning up. AndI said, we have to get back in, so that’s what we started to do. Wereversed our position and bought back stocks we had recently sold.And that’s what a lot of money managers don’t do.
Tanous:I suppose that makes your style more volatile than mostmoney managers.
Driehaus: Yes, we do have volatility, but in general our volatilityis on the upside. We’re more up than down. And when we're up, we’reup in greater measure than when we’re down. It is important to un-derstand that upside volatility is not a negative. It works to our ad-vantage.
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[Driehaus’ July 11 call was prescient, but the record also gives agood example of the volatility in his strategy. In the first half of 1994,his composite performance was down 25.5%. Then, from July 1994to the end of 1995, his composite rose a stunning 64%.]
Tanous:Give us some examples of your trading strategy.
Driehaus: Recently, the technology sector has bifurcated. It’s notall going up like it was in the first nine months fof 1995]. Some ofthe semiconductor companies and some of the commodity-typecompanies have been selling off, even though they have been report-ing good numbers and the multiples are relatively low. The stockshaven’t been acting well so we sold those stocks.
Now we're concentrating on a few sectors like the internet area, inparticular the companies that do the specialized chips - like for video.One is C-Cube, a great situation for us. We held this stock in our mid-cap portfolio. It was our largest holding. They reported a positiveearnings surprise. We bought this stock very aggressively within avery short timeframe. We went to a full position within three days.The stock was about 49 and the market volatile. Our average cost isabout 51. Today, the stock is up another 2 3/4. So, just two weeksafter we bought it, the stock is trading at 75 3/4 while the other techstocks are getting killed.
Tanous:Let me go back to my point and my question. What youperceived in this stock is what you perceived in the others. Acceleratingearnings growth...
Driehaus: It was accelerating, true, but it was more the positiveearnings surprise plus the outlook for this type of chip for which theycan’t meet demand. The area is just exploding. This was one of thegood examples. Oak Technology is another.
Buchen: There is an old investment adage: Buy Low, Sell High.Richard believes that far more money is made by Buying High andSelling Higher.
Driehaus: Exactly.
Tanous:This leads to the classic debate about the “right” priceearnings ratio. What is the “right” price earnings ratio?
Driehaus: The answer is: there is no right price earnings ratio. It’slike asking: how many angels can dance on the head of a pin? It de-pends on the weather on the pin, how slippery the surface is, youknow! And what if the angels want to dance somewhere else? Inother words, that is an impossible question. There is no right answer.
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The market is too dynamic for that. I think when you look at priceearnings ratios that way, you are looking at it too statistically. Thatdoesn’t mean you ignore valuations completely. All I am saying isthat there is no absolute level. That is what creates inefficiencies andopportunities.
There’s a popular concept out there known as “GARP,” Growth atthe Right Price. But we don’t always know what the “right” price is.When you are in such an early, embryonic phase of development,you can’t pick a right price for the right stock. I remember, years ago,when a company called MCI was finally going from a loss to a profit.We started buying the stock around 9 or 10 for one of our institutionalaccounts. The client made about 10 times on his money. After thestock doubled, it was trading at 100 times earnings. But these werereported earnings at a very early stage of development. It became areal winner. But you might say 100 times today’s earnings could betoo high in some cases and, maybe it’s too low in other cases. That’swhat people don’t recognize. One hundred times could be high or lowdepending on where you are in that company’s income stream. Thenyou make a judgment as to the duration and rate of growth of thatincome stream. We look at these income streams very early. For in-stance, right now, we are very excited about the internet companies.The internet is becoming a mass consumer item. We’re buying com-panies in that field because they’re beginning to show positive earn-ings surprises, like Spyglass.
Tanous:...and Netscape?
Driehaus: Actually, we didn’t buy Netscape, but it’s been a wonder-ful one. That’s one where we said it was too high and we were wrong.That stock’s gone 50% higher. But they also came in with positivesurprises. Now they make money, rather than lose money. We didn’tbuy Netscape, but we bought others and we’re adding to these posi-tions. We bought Spyglass, which had a positive surprise. This veryday we’re adding to our position in UUNET Technologies becausethey reported a strong sequential gain and reported a profit whenthey were supposed to lose money. Take UUNET as an example [heshows us a chart]. This is a $2 billion capitalization company, so it’sgot pretty good size. As you can see, all the stock trends, monthly,weekly, daily, are positive.
Tanous: What is the source of this data?
Driehaus: This is our own internal product [the page has several
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charts on it]. You can’t just read one chart. You need to look at sev-eral charts from, perhaps, different perspectives: monthly, weekly anddaily.
Buchen: We buy the raw data and write programs to break it downinto various time frames. That gives us a landscape view rather thana snapshot view. Let me give you another example. Ascend Commu-nications is the largest holding in our small cap portfolio. It’s up850%. We've held it for little over a year.
Driehaus: It lives up to its name!
Buchen: | went to a client presentation recently. Their consultanthad put together an analysis of our portfolio. It said that our growthrates were 12% and our average price earnings ratio was 46 timesearnings. | said I wanted to comment on that. I said the consultantis doing the right things, but he is doing them differently from theway we do them. If you look at Ascend and its trailing 12 monthsearnings, it is selling at 175 times those earnings. That would scareanybody! But if you look at the next 12 months, it is selling at 15times those estimated earnings. Within nine months after our firstpurchase, the Wall Street estimates for the current year had doubled.There is tremendous drive in this company.
Driehaus: And it still looks like a good buy today. It is making alltime highs.
Tanous: Would you say that this is a particularly good example ofyour approach?
Driehaus: This company is not growing at 50% or 70%. It’s morelike a 200% or 300% rate, compared with the previous year. And evensequentially [from quarter to quarter], it is growing at close to 50%.The sales in the last quarter were about $40 million compared to $10million. That’s incredible.
Tanous:It seems to me that the price earnings ratio is really afunction of the accuracy of your projections. You are not buying onpast multiple; you’re buying on multiples of future earnings. So thequestion is: how accurate are your projections of those future earn-ings?
Driehaus: It is interesting that when things change they don’tchange randomly. They change and stay in the new pattern for awhile. So when a change occurs - and this is where the momentumtheory works - the change tends to be more enduring than the Street,or even the companies, anticipate.
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For example, these positive earnings surprises that are occurringin the Internet area are, we think, the very beginning of a long termtrend. We think that the estimates on these companies are generallylow, and this will lead to positive developments in companies like C-Cube, Oak Technologies, and Trident. When these changes lead topositive earnings surprises, the Street doesn’t evaluate it right. Theresearch analysts raise their estimates, but usually only by the amountof the gain or the earnings surprise. They don’t really catch the secularchange that is going on.
Tanous: When you say the estimate is too low, Richard, how muchare you relying on fundamental analysis by Street analysts, or otheranalysts? What leads to your convictions?
Driehaus: Partly my experience. I’ve seen, in the past, that whencompanies report very positive surprises the analysts were almost alllow. The analysts seem to prefer to be conservative, rather than accur-ate, although they’re improving. But when you are at a fulcrum, orturning point, both the analyst and the companies can underestimategrowth. That is what is occurring in the semiconductor area. What’sthe right price for a D-RAM company? There have been some earningsdisappointments at some of these commodity-like companies. Wedon’t know the answer, so we have avoided the conflict. We go toareas where the outlook is more assured. The two things I’ve learnedabout the market are that you don’t know how high a stock can go,and that you don’t know how low a stock can go. That’s the point.The market is constantly full of surprises both on the upside and thedownside. This is the reality of the market on a day-to-day basis.
To get back to why we are successful, one of the reasons is that westay abreast of what we are doing. So why am I better? I probablystay in it more. A lot of people like to play the piano. But can youteally become a virtuoso? It’s like the Olympics. Practice, practice,practice. Remember the old saying: the harder I work the luckier Iget? Or: success is 99% perspiration and 1% inspiration? Success re-quires an addiction to what you are doing and it takes a lot of time.This market demands commitment. That’s why some have quit.
Tanous:! understand you recently married, Richard. Congratulations.The next question is: should your investors start worrying?
Driehaus: No! Kristyna is very practical and lets me put in my timeat work! But I do worry about replicating our success and trainingyounger portfolio managers.
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Tanous:! think it’s a fact that there aren’t a lot of people like you.
Driehaus: It does requires stamina and dedication. And the staminais very important. And discipline is part of the stamina. You can’tlook at a stock and say everything is okay and it will come back. Itdoesn’t. William Blake said: execution is the chariot of genius. Inother words, doing things well day in and day out. And there areothers here who manage money and do it well. Bill Andersen managesour international portfolio. He has been here ten years and his per-formance ranks in the top one percentile. Mark Genovise has beenwith me 12 years. His small-cap portfolio was up 75% in 1995. Andthat’s with no leverage.
Tanous:This leads me to a question I wrote down that puzzles me.Keep in mind that, as a consultant, I spend my waking hourssearching for investment genius. When people think of the grandmasters of our trade, they think of Warren Buffett, Peter Lynch, MarioGabelli, Michael Price, among others, but the name Richard Driehausseldom comes up outside purely investment circles. Your record isevery bit as good as many of the others, so why are you not betterknown?
Driehaus: I had an arrangement with a mutual fund companywhich, for various reasons, required that I keep a low profile andprovide my advice to them on an almost exclusive basis, and I did.It was very profitable, but it was limiting. We all became uncomfort-able with the relationship after a time. By the early 1990s, it was timeto go our separate ways. The arrangement was discontinued in 1993.Since 1991, I have been building our own advisory business, but fo-cusing on larger clients. Our average account size is around $15 mil-lion.
Tanous:As you know, one of the great debates in our industry isthe debate of active versus passive investment management. Peoplelike Rex Sinquefield will show you data that suggests it is very difficultto beat the market actively. You’re better off just buying the market,whether small-cap, mid-cap, or large-cap.
Driehaus: We think Rex is looking at the subject academically,and, academically, he is right. But in reality, he’s wrong a lot of thetime.
Tanous:But he’ll say that Richard Driehaus is the exception to therule. He and Warren Buffett and a few others are the statistical aber-rations that confirm the basic data.
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Buchen: That’s right! We don’t disagree with that. You look for theaberration because that’s where you find the oil!
Driehaus: Okay, we’re the anomaly. And that’s what people shouldbe looking for - the anomaly. Rex has been finding things like a Jesuitwould. In other words, you can’t out-argue them because they’respeaking the truth. But it’s not the whole truth. St. Thomas Aquinassays look for all the truths. There are different ways to look at things.There is not just one truth.
Tanous:Only St. Thomas Aquinas did it by setting up straw dummiesthat were pretty easy to topple. I don’t think you have that luxury.
Driehaus: What we are looking for is strong results as part of astrong philosophy and an ability to implement that philosophy. If ourphilosophy was flawed, it would have failed long ago. You can’t keepon doing well if your philosophy is flawed. It has to be correct.
Tanous:As you know, many of the academics, and also people likeRex Sinquefield, believe in the efficient market hypothesis. Everythingknown about a stock is in the price. On the other hand, there mustbe a moment in time after a positive earnings surprise occurs, whenthe market is temporarily inefficient. After all, it’s going to take timeto disseminate that information and time before it gets reflected inthe price. In this case, it will presumably be a higher stock price,given the good news. Is your philosophy not, in fact, based on beingfirst with that news and acting on it before everybody else does?
Driehaus: We are quicker to react than most managers.
Tanous:How much does the Driehaus performance depend on that?
Drie