AHMET OKUMUS – From Istanbul to Wall Street Bull

When Ahmet Okumus was sixteen years old, he visited the trading floor of the recently opened Istanbul Stock Exchange and was mesmerized. He was fascinated by trading, which on the Istanbul exchange resembled speculating far more closely than investing. It wasn’t long before his initial enthusiasm became an obsession, and he began cutting classes regularly to trade stocks on the exchange.

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Okumus knew that he wanted to become a money manager and realized that the country that offered the greatest opportunity for achieving his goal was the United States. In 1989, he immigrated to the United States, ostensibly to attend college but with the firm conviction that this was just a stepping-stone to his true career objective. Using a $15,000 stake from his mother, Okumus began trading U.S. stocks in 1992. This original investment had mushroomed to over $6 million by early 2000, an average annual compounded return of 107% (gross returns). In 1997, he launched his first hedge fund, the Okumus Opportunity Fund.

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I interviewed Okumus at his Manhattan office, a distinctly unimpressive space. Coming off the elevator, I was greeted by a receptionist who did not work for Okumus but who clearly was shared by all the tenants on the floor. Okumus’s office was small, badly in need of a paint job, and outfitted with ugly furniture. The single window offered little visual relief, providing a claustrophobic view of the side of the adjacent building. The office had one redeeming feature: it was cheap—actually, free (a perk for commission business). Okumus is evidently proud of this. Talking about how he got great deals on everything from his office space to his accountant, he says, „It’s my nature. I love to get good deals. I don’t pay up.” It is a comment that is equally fitting as a description of his trading philosophy.

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At the time of my interview, Okumus shared his small office with his college buddy, Ted Coakley III, whom he brought in to do marketing and assorted administrative tasks. (A subsequent expansion in staff necessitated a move to larger quarters.) Coakley’s faith in Okumus is based on personal experience. In college, he was Okumus’s first investor, giving him $1,000 to invest (in two $500 installments)—an investment that grew to over $120,000 in seven years.

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Prior to 1998, Okumus’s worst year was a gain of 61 percent (gross return). In 1998, a year when the S&P rose by 28 percent, he finished the year with only a minuscule 5 percent gain. I began my mid-1999 interview by questioning him about his uncharacteristically lackluster performance in 1998.

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* Readers unfamiliar with options may find it useful to consult the  short primer on options in the appendix.

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What happened last year?

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It all happened in December. At the start of the month, 1 was up 30 percent for the year. I thought the rise in Internet stocks was a mania. Valuations had risen to levels we had never seen before. For example, Schwab has been publicly traded for over ten years. At the time I went short, the ratios of the stock price to the valuation measures—sales per share, earnings per share, cash flow [earnings plus depreciation and amortization] per share, book value per share—were higher than they had ever been before. [As he talks about these events, the pain of the experience is still very evident in his voice.]

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What levels were these ratios at?

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As an example, the price/earnings ratio was at 54 to 1. In comparison, at prior price peaks in the stock, the ratio had been anywhere from 20 to 1, to 35 to 1.

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The valuation measures were at record highs and getting higher all the time. What made you decide to go short at that particular juncture?

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Insiders [company management] were selling heavily. In Schwab, insiders always sell, but in this instance, the insider sales were particularly high.

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Out of curiosity, why are insiders always net sellers in Schwab?

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Because the company issued a lot of options to management, which get exercised over time.

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What happened after you went short?

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The stock went up 34 percent in one week and was still going up when I finally covered my position.

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What other Internet or Internet-related stocks did you short in December 1998?

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Amazon.

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How can you even evaluate a company like Amazon, which has no earnings and therefore an infinite price/earnings ratio?

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You can’t evaluate it in any conventional sense. However, I had an idea of what price it shouldn’t be, and Amazon was at that level. When I went short, Amazon’s capitalization [the share price multiplied by the number of shares outstanding] was $17 billion, which made it equivalent to the fourth largest retailer in the United States. This seemed absurd to me.

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Also, book sales fall off sharply during the first quarter following the heavy Christmas season sales. I thought the prospect of lower sales in the next quarter would cause the stock to weaken. When I went short, Amazon was up ninefold during the prior year and fourfold during the previous two months.

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At what price was Amazon trading when you went short?

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I didn’t actually go short. I sold out-of-the-money call options. [In this transaction, the option seller collects a premium in exchange for accepting the obligation to sell the stock at a specific price above the market price.*] Since the options I sold were way out-of-the-money, the market could still go up a lot, and I wouldn’t lose. I thought I might be wrong and the stock could go up some more, but I didn’t think the stock would go up that much.

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What was the strike price of the options you sold?* Where was the market at the time?

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The stock was trading around 220, and I sold the 250 calls. The stock could go up another 30 points before I lost any money on the trade.

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How much did you sell the options for?

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I sold them for 1 Vs, but there were only three days left until expiration. I figured the stock was not going to go up 15 percent in three days. The day after I went short, one of the prominent analysts for the stock revised his price projection, which had already been surpassed by the market, from $150 to $400. Overnight, the stock moved from 220 to 260, and one day later it nearly reached 300. The options I had sold for l’/8 were selling for 48. [Options trade in 100-shareunits. Therefore, each option he had sold for $112 was now worth $4,800.]

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How much did you lose on that trade?

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The trade killed me. Amazon cost me 1 7 percent of my equity, and Schwab cost me another 12 percent.

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Had you used this type of strategy before—selling out-of-the-money calls?

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Sure, but these types of price moves were totally unprecedented. There are a lot of Internet stocks that are up twenty- or thirty fold during the past year, but I’m not touching them. I’m just sticking to what I know best: fundamentals and value.

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What lesson did you learn from this entire experience?

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Not to short Internet stocks [he laughs}.

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Any broader lessons?

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Don’t get involved when there is too much mania. Just stick to things that have some predictability. You can’t forecast mania. If a stock that should be selling at 10 is trading at 100, who is to say it can’t go to 500.

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*The strike price is the price at which the option buyers could buy the stock by exercising their options. Of course, they would exercise their options only if the market price was above the strike price at the time of the option expiration.

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What was your emotional state during this entire experience?

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The funny thing is that I was already upset at the start of December because the year was almost over, and I was up only 25 percent, which was my worst year ever. After I took the loss on Schwab and Amazon and was barely up for the year, I was devastated. I remember going to Bloomingdale’s with my girlfriend and not being able to stay in the store because every time I saw a price sign, it reminded me of the stock market. After ten minutes, I just had to leave. For about a week after I got out of these trades, I couldn’t look at the Investor’s Business Daily section that showed how the market was doing to date.

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Was this your worst emotional experience in the market?

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Absolutely. It was by far the worst experience; I had never felt like that before.

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But when I look at your track record, I see that December 1998, when you lost 16 percent, was only your second worst month and was far eclipsed by August 1998, when you lost a staggering 53 percent. How come August 1998?which seems so much worse on paper, doesn’t register on your emotional barometer?

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The reason my August 1998 decline was so large was that I was caught 200 percent long during the month’s big stock market decline. Even though I was down much more during August, I was confident in the fundamentals of my stocks. They were just selling at ridiculously low valuations. The price/earnings ratio of my portfolio was only 5. Some of the stocks I was long were even selling below net cash—you never see that. I knew the stocks I held were absolute bargains and that they couldn’t stay that low for long. I wasn’t worried about their going down much further. In contrast, in December I lost money because I was short Internet stocks, and there was no way to know when they would stop going up.

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So the difference between August and December was your confidence   level:   In  August  you   felt   completely   confident, even though you lost much more, and in December you felt out of control.

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Exactly.

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Even though you recovered August’s entire huge loss in only two months, do you consider it a mistake to have put yourself in a position of being 200 percent long during a bear market?

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Yes. This led to one of the three changes I made to my trading rules at the start of 1999. The first, which we discussed before, was don’t participate in mania. The second was never to have more than a 100 percent net position, either long or short. [In August   1998Okumus had been 200 percent long and 0 percent short, or 200 percent net long.]

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What was the third change in your trading rules?

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I started using options for the specific purpose of reducing downside volatility.

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Was this change a response to investor feedback? Were some of the investors who were impressed by your net returns scared off by the volatility in your returns, especially the 53 percent decline in August 1998?

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Yes, the rule changes I made were definitely influenced by investor feedback.  Investors told us that they didn’t want month-to-month volatility. Consequently, I started focusing much more on month-to-month performance. Before, when I was managing money for only myself, my family, and a few clients, my sole goal was long-term capital appreciation. It was as if I were running a marathon and only concerned about my finish time; I didn’t care about the individual split times. Now that I am managing much more money for investors who are concerned about the monthly numbers, it’s as though I’m running a  marathon,   but  everyone   is  paying   attention  to   every hundred meters. As a result, even though my main goal is still long-term capital appreciation, I’m focusing a lot more on the monthly numbers because I want to grow the fund much larger.

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How did you first get involved in the stock market?

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I was always interested in finance and currencies. As a kid, I would read the sports page of the newspaper, just like my friends, but 1 also read the financial page. In 1986, they opened the Istanbul Stock Exchange. The newspapers didn’t even have a stock market column until 1987. When they did start reporting stock prices, I noticed that the prices changed every day. It got my attention. I figured if you were smart, you could make money off of this because there had to be a reason why prices were changing.

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At first, I just followed prices in the paper. Then I realized that the stock exchange was close to my school. One day, I skipped school to go down to the exchange and see how it worked.

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Describe the Istanbul Stock Exchange.

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It’s completely modernized now, but at the time there was a bar across the middle of the room, which separated the spectators from the floor brokers. In the front of the room there were boards with bid and asked prices for each stock.

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How many stocks were traded on the exchange at the time?

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About thirty.

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Was there one floor broker for each stock?

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No, the floor brokers worked for different brokerage firms; they could all trade in any stock.

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How did you interact with the broker if you wanted to buy or sell a stock?

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You would yell, „Hey, come here.”

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How big was the exchange?

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Oh, about ten times bigger than this office [translation: extremely small].

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How long did you watch the market before you made your first trade?

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I watched it for a few weeks. One of the stocks, a construction company, which I knew was constantly getting new contracts, went down almost every day. This didn’t make any sense to me, so I decided to buy some shares. The broker warned me not to buy the stock, assuring me that it was headed lower. But I bought the stock anyway because I knew it was a good company. Within two weeks after I bought it, the stock doubled. That experience really got me hooked. I said to myself that logic works. I realized that stocks moved for a reason, and I was determined to find the reason.

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At the time, there was no market research whatsoever. I started doing my own research. The Istanbul Stock Exchange published sheets that showed current and previous year revenues, earnings, debt, and a few other statistics. No one paid any attention to these numbers. Since there were no books or articles available on the stock market, I just tried to interpret the statistics logically.

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For example, if a company made $20 profits for every $100 in sales, I assumed it was a good company; if it only made $2 profits on every $100, I figured it wasn’t so hot. I looked at the shares outstanding and the amount of profits, and I calculated what I thought the stock should be selling at. In effect, I created the price/earnings ratio for myself. When I came to the United States to attend college, I discovered that the price/earnings ratio and the other statistics I was looking at were the basic data people used to analyze stocks.

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Did you continue to be net profitable  after your first winning trade?

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I did pretty well. Within a year or so, the people at the brokerage firm I was using started listening to me for advice. During this time, the stock market in Turkey went down from 900 to 350 and then back to 900. During the big decline, I managed to more than hold my own, and then when the market went back up, I did very well.

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How were you able to make even a small profit during the phase when the stock market was going down sharply?

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The stock market in Turkey is very speculative. The exchange has a 10 percent daily price limit. [The maximum permissible daily price move (up or down) in each stock was limited to 10 percent. Typically, when a market reaches limit up, trading will virtually cease, as there will be many buyers, but few sellers. An analogous situation would apply when the market is limit down.] Daily price limits are very common. I had a rule that I would buy a stock if it went down the daily limit three days in a row and then sell it on the first short-term bounce.

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In   other   words,   you   were   taking   advantage   of speculative excesses. Do you still trade that way?

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No, I trade on the fundamentals.

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Say you select a stock because you like the fundamentals. How do you decide when to begin buying it? Do you still wait for a sharp sell-off before you buy it?

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Not necessarily. I have an idea of the value of the stock in my head, and when the stock goes low enough relative to that price, I’ll buy it. For example, say I believe a stock has a value of $35. In order to give myself a wide margin of safety, I might buy it if it goes down to $20.

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Do you always wait for the stock to reach your price before you buy it?

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Definitely. I am never in a rush. I wait patiently until the stock gets to my number.

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Using that approach, I assume you miss a lot of stocks.

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Certainly, but my main goal is to make money on every investment, not necessarily to catch every trade. I don’t have to make a lot on each trade, as long as I make something. Since 1992, 90 percent of my trades have been winners.

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What percent of the stocks you research and decide to buy actually come down to your price?

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Not many, maybe 10 to 20 percent. I follow what the other value managers in the industry are doing, and I know why they buy the stocks they do. I’m much stricter on my entries than they are. They may be willing to buy a company at sixteen times earnings, whereas I’m not willing to pay more than twelve. „Buy low and sell high” is something a lot of people say but very few people do. I actually do it.

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When did you come to the United States?

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I came here in 1989 to attend college. The funny thing is that when I came to the United States, the Turkish stock market, which had gone from 900 to 350 and back to 900 while I was trading it, went from 900 to 4,000 in six months. I was very upset.

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Did you  come just  to   attend  college,   or   did you   have  any thoughts of trying to stay permanently?

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My intention from the very beginning was to become a fund manager in the United States. This is the biggest market, and in the United States the sky is the limit, whereas in Turkey, the opportunity is very limited.

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Did you ever look at the United States stock market before you came here?

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No, but from the first day I arrived in the United States, I started to focus on the U.S. stock market. I wanted to learn what made stocks move.

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How did you start?

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By reading as much as I could.

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What books did you find most beneficial or influential?

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I very much liked Stock Market Logic by Norman Fosback. For one thing, that book taught me to focus on insider trading [buying and selling by a company’s senior management and board of directors], which has become an important element in my approach. I also found books on Warren Buffet’s methodology very useful.

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What aspect of Warren Buffet’s methodology appealed to you?

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The concept of determining a stock’s value and then buying it at a discount to that number in order to allow for a margin of safety.

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What other books did you find useful?

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One Up on Wall Street by Peter Lynch gave me an appreciation of the importance of common sense in stock investing. Peter Lynch also pointed out that your odds in a stock are much better if there is significant insider buying.

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How do you measure whether insider buying is significant?

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I compare the amount of stock someone buys with his net worth and salary. For example, if the amount he buys is more than his annual salary, I consider that significant.

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So you’re looking at a breakdown of insider buying statistics, not just the total numbers.

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I am very detailed. I don’t think there is one other person who is more focused on insider activity than I am.

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What else is important in interpreting insider trading activity?

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You have to make sure that insider buying represents purchases of new shares, not the exercise of options.

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Is insider buying an absolute prerequisite, or will you sometimes buy a stock you like that reaches your entry price target, even if there is no insider buying?

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Most of the time I won’t. I want to see the insiders putting their money in their own company. Of course, if management already owns a significant portion of the company, they don’t have to buy more. For example, insiders already own about 65 percent of the shares in J. D. Edwards—a stock I currently like—so I don’t need to see any additional buying. In contrast, in some companies, insiders only own about 1 percent of the firm. In companies with low insider ownership, management’s primary motivation will be job security and higher bonuses, not a higher stock price.

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Do you do your research by computer or manually?

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Manually. I think that’s the best way because you learn much more.

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What is the universe of stocks that you are following?

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Anything on the Big Board and Nasdaq.

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How many stocks is that, roughly?

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About ten thousand.

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How can you possibly do research on ten thousand stocks manually?

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I spend a hundred hours a week on research. I follow all the stocks that I have researched at one time or another during the past eleven years, which is a substantial number. I also pay close attention to stocks making new fifty-two-week lows. A good company that I’ve identified from previous research does not have to make a new low for me to get interested. If it is down a lot, even if it doesn’t hit a new low, I’m on it.

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How are you aware of all the stocks that have witnessed significant declines?

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Besides  looking at the list of new fifty-two-week lows,  the Daily Graphs chart book contains about half the stocks I  follow, and I review it weekly to see which stocks have declined a lot.

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So you’re always looking at stocks that have done poorly.

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Always. I usually don’t even consider buying a stock unless it’s down 60 or 70 percent from its high. In the seven years I have traded U.S. stocks, I have never owned a stock that made a new high. I think that must be a pretty unusual statement.

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Are you implying that when you flip through the charts, you only pay attention to stocks that have been moving down?

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That’s correct, with one exception: If the stock has been moving sideways and the earnings have been moving up, I might pay attention.

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Then are all the stocks you buy at or near recent lows?

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Not all. If it’s a company that 1 know well and the fundamentals are very strong, I might go long, even if the stock is significantly above its low. For example, Microchip Technology is currently at $35, which is well below its high of $50, but also well above last year’s low of $15. Even though it’s well off its low, I’m still selling puts in the stock because their business is improving tremendously.

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Selling puts represents a bullish position. The seller of a put receives a premium for the obligation to buy a stock at a price called the strike -price during the life span of the option. This obligation is activated if the option is exercised by the buyer, which will happen if the stock price is below the strike price at the option expiration.

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For example, assume that a stock is trading at $13 and that a put option on the stock with a $10 strike price is trading at $1. If the stock is trading above $10 when the option expires, the seller will have a $1 profit per share (a $100 profit per option contract, which represents 100 shares). If the stock is trading below $10 at the option expiration, the option will presumably be exercised, and the seller of the option will be required to buy the stock at $ 10, no matter how low the stock is trading.

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Okumus, who typically sells puts with strike prices below the current market price (called out-of-the-moneyputs), will earn a profit equal to the option premium paid by the option buyer if the stock declines modestly, remains unchanged, or goes up. However, if the stock declines by a wide margin, he will be obligated to buy the stock at an above-market price (the strike price) at the time of the option expiration.

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What motivates you to sell puts in a stock instead of just buying the stock?

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Any stock that I sell a put on, I am happy if they put me the stock [exercise the put option, requiring Okumus to buy the stock at the strike price]. I don’t sell a put on a stock unless I would be happy to own the stock at the strike price.

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For example, I’m currently short some $10 puts on J. D. Edwards, which is trading near $13. I hope they put me the stock because I would love to own it at $ 10. If they do, I’ll still have the premium, and if I buy the stock at $ 10, I know I will make money.

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But most of the time when I sell puts, the market never declines enough for the option to be exercised. This, of course, is okay too because I still keep the premium as a profit.

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In other words, selling put options is an alternative way for you to be buying stocks. If it doesn’t go down to the strike price, you still earn the premium, and if does go down to the strike price, that’s also fine because that’s the price you would have bought the stock at anyway.

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Exactly. By selling puts, I am getting paid by the market while I’m waiting for the stock to come down to my price. Also, for some stocks, it may only be possible to make money by selling puts as opposed to buying the stock.

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For example, value stocks have been very much out of favor in recent years. There are stocks that are trading at only five to six times earnings. The earnings are growing, insiders are buying, and the stocks are just sitting there. At the same time, the S&P is going up like crazy. You can’t make money by buying these stocks, but you can by selling the puts. If you sell put options, you don’t have to be right about the stock going up; all you need in order to make money is for the stock not to go down by much.

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Let’s say that there is a stock trading at 35, and you decide you would like to be a buyer at 30. Why not always sell the 30 put and collect the premium, since if it went to 30, you would buy it anyway? This way, you would always make the premium as a profit, whether the stock went down to 30 or not.

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Because you always have to consider your opportunity costs. If I sell puts, I need to put up margin against the position. Sometimes the premium I could collect for selling the put wouldn’t justify tying up the money needed for the position. I could do better investing that money elsewhere.

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Let’s go back to when you arrived in the United States. You said earlier that you started researching the U.S. stock market when you first came here, which also approximately coincided with the beginning of college. How did you allocate your time between studying for college and studying the stock market?

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On average I would say 35 percent school and 65 percent stock market, but the stock market percentage kept going up over time. By the beginning of my senior year, I was devoting 90 percent of my time to the stock market, and I quit school altogether.

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Weren’t you at all reluctant about quitting college a year before you were going to get your degree?

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No, because I just couldn’t wait to get started. Also, I was a finance major, and my teachers knew a lot less than I did about the stock market and investing.

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What did they teach you in college about the stock market?

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They teach you theories,   and theories  don’t work most  of the time.

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For example?

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The efficient market hypothesis [the concept that the market immediately discounts all known information], which in my opinion is ridiculous.

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Why is it ridiculous?

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Because different market participants will do research of varying quality. The market price will reflect the average assessment of all investors. If you can do research that most other people do not, you might be able to discover something that most of the rest of the market doesn’t know and benefit from that knowledge. There are a lot of things that I know about my companies that most other investors don’t. Therefore, my evaluation of these companies is not going to be the same as theirs. Why then should a stock always trade at the right price level?

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When you buy a stock, do you know where you want to get out before you get in?

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Certainly. I always have a target price at which I will get out, assuming the  fundamentals  haven’t  changed.   If the   fundamentals  get stronger, however, I might raise my target.

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What is this target based on? Is it some specified percent gain?

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Yes, a percent gain.

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What percent?

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It depends how cheaply I buy the stock, but on average 20 to 25 percent.

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What you are doing sounds like the exact opposite of Peter Lynch, who says you should go for a „ten-bagger” [buystocks that you think can increase tenfold]; you’re not even going for a double, or even close to it.

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I never go for home runs. That’s why I. should do well in a bear market.

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I assume that when you sell a stock, you look to buy it back when it dips.

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Certainly, as long as the fundamentals don’t change.

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But don’t you often find yourself taking a moderate profit on a stock, and then the stock never dips enough to give you a chance to repurchase it?

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That happens a lot of time, but I don’t worry about it. My main goal is not to lose money. If you can make money consistently, you will do just fine.

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Most of your trading history has been with a small amount of money. Now that you have started a fund and are doing well, that amount will increase dramatically. How will trading much larger sums of money affect your approach?

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It won’t change anything. The stocks I buy are all well-known names with lots of liquidity. This is deliberate. When I first started, my attitude was that I had to think big. Therefore I made sure to adopt a style that could be used with much larger sums of money.

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The period during which you have traded has coincided with one of the greatest bull markets in history. What happens to your approach if we go into a major bear market?

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I hope we get a bear market. All the momentum players will get lulled; all the Internet players will get killed; all the growth players will get killed; the value players, however, will do okay. The companies that I buy are already in bear markets. They are trading at five to six times earnings. They don’t have room to go much lower. Remember, the stocks that I buy are already down 60 to 70 percent from their highs.

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Okay, I could see why you would lose a lot less in a bear market than investors using other approaches. But if the  S&P  index comes off 20 or 30 percent, I would assume that your stocks would go down as well.

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That’s fine, I’ll just hold. I know the value of my companies. I don’t second-guess myself when 1 make an investment. A lot of other money managers have rules about getting out of their stocks if they go down by some specified amount, say 7 percent or 10 percent. They have to do that because they are not sure about what they are buying. I do tremendous research on any stock that I buy, and I know how much it is worth. In fact, if a stock I buy goes down 10 percent and the fundamentals haven’t changed, 1 might well buy more.

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But if you never use any stop-loss points, what happens if a company you buy goes bankrupt? How much of an impact would an event like that have on your portfolio?

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It will never happen. I don’t buy any companies that have even a remote chance of going bankrupt. I buy companies that have a good balance sheet, a high book value, consistent business track records, good management, and large insider buying ownership. These are not the type of companies that go bankrupt.

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How do you know when you are wrong in a position?

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If the fundamentals change and the stock no longer meets my criteria for holding it at the current price.

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What if the price is going against you,  but the fundamentals haven’t changed?

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Then I will just buy more.

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How many different stock positions do you typically hold at one time?

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About ten. Simple logic: My top ten ideas will always perform better than my top hundred.

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What is the maximum amount of your portfolio that you would allocate to a single stock?

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At this point, the maximum I would hold on any single stock is about 30 percent of the portfolio. It used to be as high as 70 percent.

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That sounds like an extremely large maximum position on one stock. What happens if you are wrong on that trade?

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I make sure that I know the fundamentals and that I am not wrong.

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But there may be some reason for a stock going down that you don’t know about.

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No.

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How can you say no for sure?

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Because I know the companies I buy. For example, if I buy Viasoltat $7, a company that has $5 per share in cash and no debt, what is my downside—$2?

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What is your approach on the short side?

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I look for stocks that are trading at a huge multiple to earnings. However, after my experience with Internet stocks last year, I’ve added a rule that there has to be a catalyst. Now, regardless of how extremely overvalued a stock may be, I won’t sell it until there has been a catalyst for change.

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So another mistake you made in shorting Amazon and Schwab last year, besides selling into a mania, was selling without a catalyst.

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Exactly. Even though those stocks may be overvalued, the direction of the fundamentals is still strong. Although Amazon is not making any money, they continue to grow their revenues and meet their sales targets. As long as this is the case, the market is not going to sell the stock off sharply.

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It seems it would be very difficult for you to apply your methodology to the short side. On the long side, you are buying stocks that have already declined sharply and are trading at prices that represent strong value. In other words, you are buying at a point where your risk exposure is relatively low. In contrast, when you are shorting a stock, no matter how high you sell it at, there is always an open-ended risk, which is the exact opposite of your buying approach. How can you even approach the short side?

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I make sure that the fundamentals are broken before I go short. Even if Schwab today were trading at a hundred times earning, I wouldn’t short it as long as the trend in the fundamentals was still improving. I would wait for the fundamentals to start deteriorating.

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But you might get another mania that drives the stock higher, even though the fundamentals are deteriorating.

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Once the fundamentals get broken, market manias get broken as well. For example, there was a mania in Iomega a few years ago. Once the fundamentals started to break down, the mania ended.

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But how do you deal with the problem of unlimited risk?

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All my longs are long-term investments, but my shorts are usually short-term precisely because of the danger of unlimited risk.

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How would you rate the quality of Wall Street research?

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Not very good.

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For what reason?

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Most analysts don’t have a logical reason why a stock should be at a given price. As long as the company does well, they don’t care what the price is. Typically, if a stock reaches their target, they will just raise the target, even though the fundamentals haven’t changed.

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We have seen an incredible bull market during the 1990s. Is the magnitude of this advance justified by the fundamentals?

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For two reasons I think we are witnessing the biggest financial mania ever in the stock market. First, the stock market price/earnings ratio is at a record high level. Second, the average profit margin of companies is at its highest level ever.

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What do you mean by profit margin?

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The amount of profit per sales. For example, if the profit margin is 20, it means the company is making $20 in profits for every $ 100 in sales.

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Why then is a high profit margin a negative?

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Because there is virtually no room for further improvement.

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What do you read?

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Everything, including financial newspapers and magazines, tons of company reports, and all sorts of trade journals. The trade periodicals I read depend on my existing and prospective positions. For example, last year I owned a company that was making products for urinary disorders, so 1 read Urinary Times.

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What is the specific checklist you use before buying a stock? The stock must meet the following criteria:

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The company has a good track record in terms of growing their earnings per share, revenues per share, and cash flow per share.

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The company has an attractive book value [the theoretical value of a share if all the company’s assets were liquidated and its liabilities paid off] and a high return on equity.

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The stock is down sharply, often trading near its recent low. But this weakness has to be due to a short-term reason while the long-term fundamentals still remain sound.

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There is significant insider buying or ownership.

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Sometimes a company having a new management team with a good track record of turning companies around may provide an additional reason to buy the stock.

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What are the trading rules you live by?

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Do your research and he sure you know the companies that you are buying.

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Buy low.

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Re disciplined, and don’t get emotionally involved.

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What are your goals?

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My goal is to be the best money manager in the industry. After the fund reaches its ten-year anniversary, I hope to have the best track record for the prior ten years, nine years, all the way down to five years. Anything shorter than five years could indicate someone who is just lucky or using a style that is temporarily in favor with the market.

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Okumus has developed a trading style that assures he will miss 80 to 90 percent of the winning stocks he identifies and typically realize only a small portion of the advance in the stocks he does buy. He also brags that he has never owned a stock that has made a new high. These hardly sound like characteristics of a great trading approach. Yet these seeming flaws are actually essential elements of his success. Okumus has only one overriding goal: to select individual trades that will have a very high probability of gain and a very low level of risk. To achieve this goal he has to be willing to forgo many winners and leave lots of money on the table. This is fine with Okumus. His approach has resulted in over 90 percent profitable trades and a triple-digit average annual return.

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Okumus’s bread-and-butter trade is buying a stock with sound fundamentals at a bargain price. He looks for stocks with good growth in earnings, revenues, and cash flow, and significant insider buying or ownership. Strong fundamentals, however, are only half the picture. A stock must also be very attractively priced. Typically, the stocks Okumus buys have declined 60 percent or more off their highs and are trading at price/earnings ratios under 12. He also prefers to buy stocks with prices as close as possible to book value. Very few stocks meet Okumus’s combination of fundamental and price criteria. The majority of the stocks that fulfil] his fundamental requirements never decline to his buying price. Out of the universe often thousand stocks Okumus surveys, he holds only about ten in his portfolio at any given time.

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One element of market success frequently cited by Market Wizards, both in this volume and its two predecessors, is the age-old trading adage: Cut your losses short. Yet Okumus’s methodology seems to fly in the face of this conventional wisdom. Okumus does not believe in liquidating a stock position because it shows a loss. In fact, if a stock he buys moves lower, he may even buy more. How can Okumus be successful by doing the exact opposite of what so many other great traders advise?

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There is no paradox. There are many roads to trading success, although none are particularly easy to find or to stay on.  Cutting losses is important only because it is a means of risk control. While all successful traders incorporate risk control into their methodology, not all use cutting losses to achieve risk control. Okumus attains risk control by using an extremely restrictive stock selection process: He buys only financially sound companies that have already declined by well over 50 percent from their highs. He has extreme confidence that the stocks he buys have very low risk at the time he buys them. To achieve this degree of certainty, Okumus passes up many profitable trading opportunities.  But because he is so rigorous in his stock selection, he is able to achieve risk control without employing the principle of cutting losses short.

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One technique Okumus uses to enhance his performance is the sale of out-of-the-money puts on stocks he wishes to own. He sells puts at a strike price at which he would buy the stock anyway. In this way, he at least makes some profit if the stock fails to decline to his buying point and reduces his cost for the stock by the option premium received if it does reach his purchase price.

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Okumus is very disciplined and patient.  If there are very few stocks that meet his highly selective conditions, he will wait until such opportunities arise. For example, at the end of the second quarter in 1999, Okumus was only 13 percent invested because, as he stated at the time, „There are no bargains around. I’m not risking the money I’m investing until I find stocks that are very cheap.”

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Sursa: The Stock Market Wizards Conversations With America’s Top Traders – Jack D. Schwager

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