Buffett, Lynch, Morales? Q&A with Gil Morales

With great interest I have followed the recent debate on Seeking Alpha on fundamental versus technical analysis.

Peter Lynch and Warren Buffett are often cited as examples of extremely successful money managers who believe technical analysis is hogwash. There are, however, a bevy of talented individuals who have significantly outperformed both Lynch and Buffett, using technical analysis.

Peter Lynch managed the Fidelity Magellan Fund [FMAGX] from 1977 to 1990 where he achieved a compound annual growth rate [CAGR] of about 29%.

Warren Buffett is Chairman of the Board and Chief Executive Officer of Berkshire Hathaway (BRK.A) (BRK.B). Since 1962, Berkshire Hathaway stock has returned a CAGR of about 25%.

One of the strongest performance records of which I am aware has been achieved by Gil Morales. From January 1st, 1998 to December 31st, 2005 Mr. Morales achieved in his personal account a return of 10,904.25%. This would correspond to 5,572.04% net of standard 2%/20% hedge fund fees. This represents a CAGR of 277.40% or 242.88% net of fees.

Gil Morales is the Chief Executive Officer of Gil Morales and Company LLC, a Los Angeles-based registered investment advisory firm, and publisher of The Gilmo Report.

The following is a Q&A with Gil Morales:

(Gil Morales - GM; Stephen Sinclair - SS)

SS: Thank-you for taking the time to speak with me today. There are many investors who may not be familiar with your name. Could you tell me how your career began, where you have worked and your experience as a money manager?

GM: I started out at Merrill Lynch in Beverly Hills, CA in June 1991, a propitious time to start in the business. In 1994 I moved over to PaineWebber where I began to focus on managing client accounts using William J. O’Neil’s CAN SLIM® investment methodology. I quickly achieved Chairman’s Club status as a million-dollar producer at PaineWebber, and in 1997 Bill O’Neil recruited me to join his firm, William O’Neil + Company, Inc. as an internal portfolio manager and as Vice President and manager of his institutional services group which advised a clientele consisting of over 500 institutional investors, including many of the well-known mutual funds, pensions funds, hedge funds, and banks. This is where I began my career as a bona fide portfolio manager, running a portion of O’Neil’s proprietary assets, essentially the firm’s own money. In that sense, I suppose you would call me a proprietary portfolio manager. The O’Neil account that I ran grew over 2,100% from November 1997 to October 2005.

SS: Your personal account achieved a CAGR of 277.40% or 242.88% net of fees. These results significantly outperform both Warren Buffett and Peter Lynch during their best performing years. Do you think the comparison I have made between your results and Buffett and Lynch is fair?

GM: Yes, and no. Yes in the sense that as a money manager you have your own methodology and the results you achieve prove the soundness of that methodology over time, as well as your skill level in the implementation of that particular methodology, No, in the sense that they employed far different styles in their approaches. I’m more of a trader, both of them were more buy and hold types of investors running much more diversified portfolios. I use a concentrated method whereby I may only be invested in as few as 2 to 6 names at a time, using full margin. This is how you are able to throw up the big performance numbers, and if you are stuck in a large portfolio of 200 positions you simply can not run as hard. So Buffett and Lynch employed styles that did not allow them to run as fast nor as hard as I have been able to do when conditions were in my favor. Also, they sit through corrections and bear markets, whereas I wil be in cash or I may be selling short.

SS: Buffett and Lynch both manage(d) very large amounts of capital. Lynch had the added constraints of mutual fund regulations. It is my impression that you have managed smaller, though still significant, amounts of capital than Buffett or Lynch. Is the liquidity and flexibility available to smaller investors an advantage?

GM: Without a doubt. The smaller your account, the harder you can push it because you are only a couple of mouse-clicks away from being fully invested and then also exiting your positions when general market conditions turn against you. In this era of ECN-based trading, I like to think of my nimbleness in the market relative to asset size as the “mouse-click factor.” In this era of ECN-based trading, it becomes a matter of how many mouse-clicks it takes you to enter your positions and then exit them. If you are running a $500K account, obviously you can quickly move in and out of positions without concerning yourself with slippage or even the liquidity of the stock you are buying. A small account can traffic in stocks that trade less than 500,000 shares (or around $40 million average daily dollar volume). These days, I’m running asset sizes that necessitate sticking to liquid “big stocks,” like say a GOOG, POT, AAPL, RIMM, or FSLR, for example – stocks that trade many millions of shares in a day and there in which it is extremely easy to move in and out of large positions of anywhere from 50,000 to 500,000 shares.

SS: Who would you identify as major influences in your money management techniques?

GM: Well, the bottom line is that I would be nowhere in this business if not for the guy who taught me pretty much everything I know about trading stocks, Bill O’Neil. Bill is in my view the true “greatest investor who ever lived,” given that his CAGR over a very long period of time extending back into the late 1950’s is over 40%, and he has dealt with some very large asset sizes. O’Neil is a very humble man and a truly outstanding teacher, and the opportunity to work side-by-side with him for 8 years was a rare privilege for which I will always be grateful.

Other influences stem from the books I’ve read, particularly those who also influence O’Neil, including the great “boy plunger” Jesse Livermore, the father of stock charting Richard Wyckoff, and Nicholas Darvas, who originated the concept of chart bases or, as he termed them, “boxes” and the implications these have for the health of one’s stock holdings.

SS: How do you use fundamental analysis in your stock selection? What metrics do you follow?

GM: I am looking for highly profitable companies, as expressed by their return on equity and profit margins, showing large increases in quarterly and annual earnings and sales. ROE should be in excess of 15-16%, and the higher the better. GOOG, for example, when it began its run in August 2004 had an ROE in excess of 87%. I like to see quarterly earnings and sales growth of at least 20%, but preferably much higher than that, say 100% or more. The biggest factor in my stock selection is understanding a company’s position as an innovator. I’m looking for companies that are at the cutting edge of what is going on in the economy with a critical product or service that is selling like gangbusters. This is what I call the “Big Stock” factor, and when a company is a leader in its industry with products and services that are at the forefront of what is driving growth in the economy and in its particular sector at any given time then institutional investors (e.g., mutual funds, pension funds, etc.) will have to own that stock. It is their buying power that drives a long-term price move, because they will tend to have a 3-5 year horizon when they buy a stock. Strong buying by quality institutional investors with an outstanding track record is a key characteristic I look for in any stock I’m interested in, because that is where the big money is made. AOL in 1998-1999, QCOM in 1999-2000, AAPL in 2004-2007, GOOG in 2004-2007, RIMM in 2003-2007, these are what I call “big stocks,” in the sense that they are institutional “must own” stocks.

SS: How do you use technical analysis in your stock selection? What indicators or patterns do you use?

GM: I use weekly charts primarily to discern systematic accumulation on the part of institutional investors who generally do their buying over a period of days and sometimes weeks. These patterns show up in the weekly charts, and there are a number of general patterns I am looking for that are tip-offs that institutions are accumulating a particular stock. Some of these patterns have well-known names such as a “flat base,” “cup-with-handle,” “base-on-base,” “ascending base,” and so on, and each has a particular constructive characteristic to it with respect to its implications vis a vis steady accumulation by institutions. I like to initially purchase stocks as they are emerging from a proper, constructive base consolidation, preferably one that was formed during a bear market or market correction, and I want to buy them at the starting point in their price moves. As an example, if you look at Oracle Corp. (ORCL) in late October 1999 you will see that the stock emerged from a “base-on-base” formation and rocketed over three-fold in very rapid fashion over the next five months. Apple Computer (AAPL) emerged from a flat base in late August 2004 and nearly tripled over the next five months or so. This is where I’m trying to buy these stocks, and the types of moves I’m looking for. I use logical pullbacks to moving averages, as well as breakouts from secondary consolidations that form in the midst of an uptrend, to add to my positions.

SS: How do you manage risk?

GM: I have very few eggs in my basket, first of all, and I watch them very carefully! I use a standard stop-loss of 6-7% on any initial position, and once I am up 20% or more on a stock, I never allow my average cost to get to a point where the stock is not trading at least 20% above that average cost. If the stock starts coming in, I trim any portion of the position I purchased at higher prices to bring my average cost down and bring the position back in line with respect to my average cost. I use a LIFO method of accounting to keep track of my cost basis.

SS: Do you think an average investor's equity portfolio has the potential to outperform an average mutual fund or index fund?

GM: Without a doubt. I believe most investors can do quite well following O’Neil’s methodology, known as CAN SLIM®, and learning to use the outstanding tools that O’Neil provides to the public, such as Investor’s Business Daily and the O’Neil technical/fundamental research service known as Daily Graphs®. In my view, these are very much empowering tools for individual investors that can literally change one’s investing life. I know they certainly did that for me.

SS: Thanks again for joining us today and sharing your insights, Mr. Morales.