SAC — Transcending luck

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SAC Capital Advisors LP is in trouble. The hedge-fund, one of the most successful and admired in terms of year-over-year results, is under assault by the Federal Bureau of Investigation, the Securities and Exchange Commission, and the Manhattan U.S. Attorney’s office, which has taken umbrage at the fact that a number of former SAC employees have been convicted of or pleaded guilty to criminal charges related to insider-trading.

Lately, according to a February 14th, 2013, Wall Street Journal article by Michael Rothfield and Jenny Strasburg, a former analyst at SAC has told investigators that he was pressured by his manager to gather inside information on technology stocks.

This sort of statement, of course, is the holly grail for the authorities, who are working aggresively to prove that the bechavior by SAC employees were linked to instructions and actions by the hedge fund’s senior management and its primary owner, Mr. Steven A. Cohen (yes, that is where the SAC name comes from.)

As the pressure from the authorities has mounted, SAC’s willingness to settle any charges or pending charges appears to have increased, culminating in a settlement agreement with the Securities and Exchange Commission on March 15th, 2013, whereby SAC will pay a $616 million penalty to settle two insider-trading cases.

As usual, the settlement didn’t include any admittance of guilt, and, unfortunately for SAC, there are no indications that the settlement will cause the authorities to decrease its presure on SAC and Mr. Cohen or that the settlement will decrease the rate of redemptions on SAC’s funds, which I am sure is considerable and accelerating.

SAC has been spectacularly successul, generating annual returns averaging nearly 30% over two decades, fostering endless articles about the skills of the fund and Mr. Cohen who has been a press darling for a long time.

Wall Street Journal points its finger

This luck and the underlying skills are now under scrutiny by the press, and yesterday the Wall Street Journal published an article detailing its investigation into SAC’s approach and luck/skill ratio based on review of six years of regulatory filings. The article, written by Tom McGinty, John Carreyrou, and Michael Rothfield, can be found here.)

And SAC and Mr. Cohen have been truly skillful and/or lucky — uncannily so, in fact, having, for instance, made 186 significant investments (mostly starting from having zero or near-zero positions) that were followed by single-day stock jumps of 15% or more in the following quarter, along with a stock gain for the quarter of at least 10%, following news such as stellar earnings reports, takeover offers or drug-trial announcements.

The description of these trades by the Wall Street Journal reads like a trader’s wish list. For instance:

In 2007, SAC positioned itself for a potential surge in the stock of Equinix Inc., EQIX +0.45% a data-center operator. Two SAC units, which hadn’t reported owning any Equinix shares in the previous quarter, bought 858,100 shares that summer, which SAC’s filings show were valued at $76.1 million on Sept. 30, 2007.

A month later, on Oct. 30, Equinix released financial results and projections that beat expectations. Instead of a four-cents-a-share quarterly loss predicted by some analysts, it reported profit of 12 cents a share. At the end of the next day’s trading, Equinix shares were worth 32% more than when SAC reported its position.

Two years ago, SAC made a big bet on telecommunications firm Global Crossing Ltd., one of dozens of timely pre-takeover bets in the period examined.

SAC hadn’t reported owning the stock in three years, but at the end of the first quarter of 2011, it said it held nearly 500,000 shares valued at $6.8 million.

During that first quarter, according to a chronology Global Crossing later filed with the SEC, the company secretly rekindled stalled discussions with a competitor, Level 3 Communications Inc.

Although executives of both companies had at times expressed willingness to merge with a competitor, a review of six months of published references to the companies found no sign of any market speculation about an imminent deal involving either company.

On April 11, 2011 — a week and a half after the quarter in which SAC invested — Level 3 announced it would acquire Global Crossing. By the end of that day, Global Crossing shares were worth 79% more than when SAC reported its investment on March 31.

The Wall Street Journal is, of course, a professional news organization, so its article goes to great lengths to dissect its analysis in all possible ways, including those most favorable to SAC, discussing, for instance, occasions where the record shows that substantial investments by SAC were followed by substantial drops in the per share price for the equities invested in.

Regardless of the Wall Street Journal’s careful journalism, the impression that we are left with is that SAC and Mr. Cohen has been spectactularly lucky or skillful, bordering on a degree of luck and skill that is statisticly improbable to be found on the planet earth. Moreover, since the investigation by the Wall Street Journal is based only on reported holdings, which are only required by the end of each quarter, we are left with a feeling that the trades reviewed constitute only the top of the iceberg.

On of my stockphrases (more about these here) is “You are either stupid or criminal… pick your poison.”

Along the same lines, if extra-ordinary luck and skill by SAC and Mr. Cohen is not the answer to the riddle of SAC’s fantastic and sustained performance, crime probably is.

If SAC and Mr. Cohen’s performance is the function of a crime, you can be sure that the authorities are going to figure it out — after all they have had plenty of practice over the last years, and seem to be getting quite good at it.

Proving that SAC’s and Mr. Cohen’s performance is function of criminal behavior, however, is probably complicated, since the issue, of course, is that it is possible for an organization to have an institutionalized behavior that is completely undocumented in policies and procedures. In fact, it is my experience that in many organizations there are institutionalized behavior that is contrary to the documented policies and procedures.

It is important to understand that such conflict between actual behavior and documented procedures is not limited to trading and investment companies — although I am pretty sure it is common there — but is also manifest in large software organizations where two relities tend to exist: One reality that is complient with laws and regulations and one reality that is consistent with the pursuit of bookings and revenues at all costs. The idea behind the existence of these two realities is, of course, that a company is able to show that it is fully compliant with the letter of the law, while it benefits from its employees inspired violations.

I will wager that the SAC matter will get worse, and I am guessing that a couple of years from now there will be no SAC. Also, unless something dramatic changes, I think Mr. Cohen is headed for lots of trouble. Certainly, with the authorities’ recent track-record of expanding insider trading investigations into charges and obtaining convictions against the principals, the odds are heavily stacked against Mr. Cohen.

Overall the learning lesson from the SAC matter is, I believe, that although soft cheating is possible and can generate outstanding results, it is a losing stretegy because the truth will out and — eventually — the chain of incriminating testimony by employees and co-conspirators will amount to the same thing as a boatload of direct written evidence.

Moreover, the underlying Archilles heel of this sort of soft cheating is that the resulting long-term extra-ordinary performance stands out a sort thumb and that once you start on a path of consistent long-term extra-ordinary performance you cannot break away from it. This is the lesson that Mr. Bernard Madoff learned the hard way, and that I suspect that Mr. Cohen and SAC may very well be about to learn — unless, of course, history will show them to just having been uncannily lucky or skillful.

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