Great Plays

you can win the stock-market game with dogged fundamentals--or use razzle-dazzle to go for the big score

I Want To Talk with you about great plays. Not stuff like The Night of the Iguana or The Frogs, though I'll grant there's some money in those, too--I'm talking about the kind of play where you dive into the third market and buy 40,000 Kodak, butterfly the July and October options, link the two with a pile of September silvers, hedge with market-index options and interest-rate futures, close out the whole thing an hour later and leave for the helipad $408,000 to the good.

Not because you're greedy; because life's a game. (As a currently popular T-shirt has it: Whoever Has The Most Things When He Dies. Wins. There's not much room to mince words on a T-shirt.)

A lot of people think that if they were just smarter, they could make a ton of money in the market. No. Smart alone won't do it. It's important also to be lucky, to have the right temperament and to have a good-sized stake to begin with. (The rich get richer, in part, because they can afford to take risks and to be patient.) It may also help to put in the hours. Not sitting in a broker's gallery eyeballing the ticker day after day--that won't help. Digging for something special.

Among the several methods:

1. What is loosely known as the Benjamin Graham approach, after the late father of fundamental analysis, in which you analyze balance sheet after balance sheet until you find a company selling so blatantly beneath its net-asset value that you need not even sample its products or interview its management to know it's a good bet--a situation much less prevalent today than just a year or two ago, which is why this proved so profitable for the folks who made the effort a year or two ago.

2. What might be called the arbitrager's approach, which consists of finding wonderful little lapses of logic in the prices of related securities and exploiting the bejesus out of them.

The first approach--hunting for value and then sitting tight--is widely known. The second--dancing around the edges of the game, looking for clever openings--is less often described. To quote Webster:

Ar'Bi. TraGe: Like when you see gold trading at $420 an ounce in London and at $422 in New York and you buy 1,000,000 ounces in London at the same time as you sell them in New York and you pocket the $2,000,000 spread. Like, man--it's fantastic.

Not everyone is adept at this sort of thing.

I called a classmate who will earn $500,000 this year as an institutional salesman (not selling institutions, selling to them--as contrasted with ''retail'' salesmen, who sell securities to ''the public''). He's smart--and quick. I said, ''Listen, Hotshot [not his real name], I need an example of something really brilliant you've done, something that involves a couple of different securities and some fancy footwork or a wrinkle. Give me an example of some great idea you've had and you'll be famous.''

He immediately grasped the concept, then fell silent. ''I know what you mean,'' he finally said, ''but I can't think of anything.''

''Oh, come on--just one idea!''

More silence.

''I can just see what you're going to write,'' he chortled. '''Been in the business 15 years, never had an idea.'''

The Warner Play: Buy The Stock, Short The Warrants

I start with this one because it's one of two I've thought of myself. (Been in the business 15 years, had two ideas.) It has to do with the stock of Warner Communications.

Warner hit an all-time high of 63 in 1982. It was not of much interest at that price, at least to me, because I've always been a sucker for the notion of ''buying low''--a discipline that of necessity precludes buying stocks at or near their all-time highs.

Not long afterward, Warner announced that its Atari division was in the tank and the stock dropped to 28 1/4.

In toying with the notion of buying some--at that price, it looked interesting--I remembered Warner warrants. A warrant gives you the right to buy stock at some specified price (55 in this case) for a given length of time (through April 30, 1986, in this case). Warrants are also called rights, because that's all they are: the right to buy stock at a certain price. They could be called options, too, for they operate in much the same way; only warrants are issued by the underlying company itself, while options are issued by bookies in Chicago, (continued on page 188)Great plays(continued from page 179) New York, Philadelphia and San Francisco (Also, options run for a maximum of nine months, while warrants generally do not expire for several years.)

The Warner warrant trades on the American Stock Exchange. I figured if it were cheap enough, it might be a better way to bet on Warner's future than simply to buy the stock. But what's cheap enough? What is the right to buy a stock at 55--when it's 28--worth? Clearly, that depends on how long the warrant has to run (the longer, the better) and how likely the stock is to shoot up in price.

My guess was that the warrant would be selling around 5. For $500, that is, you could purchase the right to buy 100 shares of Warner stock at $55 each through April 1986. For $5000, you could control 1000 shares. Buying 1000 shares outright, by contrast, would have cost $28,250.

I'm not saying I would have bought the warrants at 5, but that's about what I figured they were worth.

I looked in the paper (WrnC wt) and was astonished to find them, in fact, at 11 1/4. People were actually plunking down $11.25 to control shares of Warner stock that they could have owned for $28.25 in the wild hope that sometime this side of April 30, 1986, Warner would climb from 28 1/4 to well past 55. Which just goes to show there's no telling what folks will pay for little pieces of paper and a dream. But if it's hard to know what a warrant like this is worth with three years left to run, here's almost exactly what it will be worth on the morning of expiration:

If Warner stock is:

The right to buy it at $55 will be worth:

Only if the stock were above $66 a share would the right to buy it at $55 be worth more than $11 at expiration.

The stock, at 28 1/4, seemed perhaps undervalued. The warrant, at 11 1/4, seemed ridiculously overvalued. So here was the play: Buy the stock and short the warrants. (Going short, you will recall, means selling something you don't own. That would be larcenous were you not obligated eventually to buy it back--cheaper, you hope--to clear your account.) I called my broker and put in an order to short 1000 warrants at 11 1/4. Only when that transaction was completed (for it's always trickier to short something than to buy it) did I buy an equal number of shares of Warner common stock.

If the stock is 55 or below on April 30, 1986, the warrants will expire worthless, which means I won't have to pay anything to buy them back and clear my account. I'll be allowed to keep the full 11 1/4 points on the warrant--$11,250.

If the stock is above 55, the warrant will have some value--but the more the better! Grab a pad and pencil and consider the possibilities.

Let's say the stock is 66. Well, the warrant will be 11 or so (as it entitles you to buy a $66 stock for $55), and I won't have any profit from having shorted it. But that's OK--I will have made 38 points on the stock. Thirty-eight thousand dollars! I tremble in anticipation.

For every point Warner is above $66, I will lose a point on the warrant but gain a point on the stock, and so still have a 38-point profit overall. What's more, the gain will be long-term, while any loss on the warrant will be short-term (gains and losses from short sales are always short-term), and that can work to my advantage.

If Warner stock is exactly where it was when I did all this--28 1/4--then I make nothing on it, but the warrants expire worthless and I get to keep $11,250.

If Warner is someplace between 28 and 55, I'll make someplace between 11 and 38 points.

Of course, should Warner slump to 3, say, I'd lose a lot more on the stock ($25,250) than I'd make on the warrants ($11,250). But you've got to take some risk if you want to join the Pepsi generation. (Another risk, please note, is that the company could unilaterally extend the life of the warrants.) Nor, should the stock fall, does anyone say I have to sell it. The warrants expire, but the stock lives on.

The two-for-one reverse warrant hedge: More of the same

I was feeling quite pleased with myself for figuring all this out when I ran into Jeff Tarr. At Harvard, years ago, Jeff had launched Operation Match, the original computerized-dating service. Now he is one of Wall Street's most highly regarded arbitragers. We live in the same building, only he lives on a much higher floor. (The entire floor.)

''I've finally got one for you,'' I said, and I told my Warner story.

''Sure,'' he responded. ''We've done a lot of that, only we figure you should be shorting two warrants for each share of the common. It's a two-for-one reverse warrant hedge.''

I went home, took out my pad and pencil to see what would happen at various prices if I were short two warrants for each share of the common stock, and then called my broker to short more warrants.

Ala Moana: Take a gain on the stock, report a loss

Ala Moana would be worth mentioning even if it weren't a potentially great play, just for the volcanic passion of the name. But the idea was to buy the stock at 2 1/2 and sit pat. Simple as that. Ala Moana Hawaii Properties, as it's formally known and traded on the New York Stock Exchange, is in the process of liquidating itself. Wiser minds than mine have guessed that the liquidating dividend will be in the neighborhood of $4--although wise minds, I cannot stress too forcefully, have been wrong before. They further guess that it will come sometime before the end of the century. Perhaps even before the end of next year.

To turn $2.50 into $4 ain't hay, but what makes this play interesting, if it works, is that at the same time as one is turning $2.50 into $4, one may get to report a sizable loss. This is possible because: (A) The properties it's hoped will fetch $4 a share are on the books for a lot more; and (B) Ala Moana shares--never mind that they trade on the New York Stock Exchange--are not shares of stock but, rather, limited-partnership units. Ala Moana is not a corporation but a limited partnership. As such, profits and losses flow through to the partners.

It's a neat play, but for a rarefied crowd. Beware! The $4 may never materialize. Or a portion of it may well have been distributed by the time you read this. Nor is this--even if it works--the sort of thing you'd take to H&R Block. The legal and accounting fees could be significant.

For Jeff Tarr, such expenses are justifiable. His group owns 890,000 shares.

Pan am: Short the stock, buy the bonds

It is February 1983 and Pan Am is desperate for cash to carry it through to summer. Some people are buying the stock at 5, hoping for a recovery. Others are buying bonds E. F. Hutton has concocted--''Pan American World Airways, Inc., 15 Percent Convertible Secured Trust Notes Due 1998.'' They pay 15 percent a year interest, are convertible into stock at $5.50 a share and are secured by a bevy of Boeing 747s. The smart money is buying the bonds and shorting the stock.

Roughly speaking:

If Pan Am should recover (which seemed doubtful in February), the stock could soar--but the bonds, being convertible into the stock, would soar with it. A break even.

If Pan Am limped along and the stock (continued on page 274)Great Plays(continued from page 188) sat around 5, the bonds wouldn't move much, either--but would be paying 15 percent for your trouble. Not bad.

If Pan Am went broke, the stock would collapse, yielding a huge profit to those who had shorted it--but the bond, secured by those 747s, might retain much of its value. Bingo!

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The common thread in all of these plays is limited risk. His is a running, not a passing, game, Jeff Tarr says. Three yards at a time. (A friend who has run his $6000 trust fund up to $800,000 in 14 years puts it this way: ''All I try to do is make 30 percent a year. Anything after that is gravy.'') But the fellow I should really talk to about all this, Tarr says, is former MIT math professor Edward O. Thorp. Ed Thorp, Tarr says, wrote the book on this kind of thing.

Ed Thorp's Book

Ed Thorp's book, co-authored by fellow math whiz Sheen T. Kassouf and published in 1967, was called Beat the Market, A Scientific Market System. One should, of course, be highly skeptical of books with such titles, but Thorp's previous book, in 1962, was called Beat the Dealer. It was the one that showed the world how to count cards at blackjack.

''Wall Street is a bigger game,'' Thorp grins, sitting at the conference table in his Newport Beach, California, office, ''and you don't have to worry about anyone breaking your knees if you win.'' He and his partner in Princeton, James, ''Jay'' Regan, manage a nine-figure sum for private clients. Since forming Princeton/Newport Partners in 1969, they've averaged nearly a 20 percent annual return, less their own hefty profit share. (Compounded at 20 percent for 14 years, a dollar grows thirteenfold. Invested in the Standard & Poor's 500 index over the same period, with dividends, it would merely have tripled.)

Guided by a pair of Serious Computers, soon to be replaced by an Even More Serious pair, the partnership trades like crazy to exploit the glitches in the market. Brokerage fees run into the millions each year. Some 90 percent of their trades succeed, Thorp says, albeit on a modest scale. A few succeed on an immodest scale.

Resorts international: buy the warrants, short the stock

In 1972, stock in badly troubled Resorts International was 8, and warrants that entitled you to buy it at 40 were, understandably, cheap. But 27 cents? Thorp's model, weighing the length of time to expiration, expected interest rates and the volatility of the underlying stock, told him the warrants were worth $4. He bought all he could--10,800 of them--for a total outlay, including commissions, of $3200. But rather than risk even so modest a sum, he shorted 800 shares of the common stock to hedge his bet. Remember, we're talking arbitrage, not speculation.

A few months later, the stock fell to 1 1/2, so Thorp covered his short for a profit that more than paid for the warrants--which he kept.

Years passed.

Around 1978, he began getting calls from people who wanted to buy his warrants. They were offering $3 and $4--not bad for 27-cent warrants--but by then, Resorts was trading around 15, and Thorp's model told him the warrants were worth $7 or $8. So he bought more (and began shorting the stock again as a hedge).

He ultimately sold his original 10,800 warrants, purchased at 27 cents, for $100 apiece. ''All those guys in the Resorts casino counting cards,'' Thorp chuckles at the irony. ''We found an even better way.''

Market index futures: sell the index, buy its components

When futures contracts were first offered on the Standard & Poor's 500 in April 1982, investors were able, in effect, to go long or short the whole market--all 500 S&P stocks at once. But, especially at first, the prices at which those contracts traded were often a little out of whack.

If I were to show you a $5 bill and a roll of 100 20-cent stamps, you'd pretty quickly figure it was worth $25. You'd be unlikely to offer more; I'd be unlikely to accept less. But if I showed you 38,420 lire, 62 guilder, 2,000,000 yen and some peso-denominated traveler's checks and offered you the right to buy the whole works six months from now, you might be less certain what to pay. And, frankly, who would care if you paid a tiny bit too much? Ed Thorp's computer cares.

And Ed Thorp's computer was ready to run those calculations the moment S&P futures contracts began trading. Few other traders were quite so fast off the mark.

So from June to October 1982, Thorp's group busied itself selling (and buying) S&P futures contracts and buying (or selling) the stocks those contracts represented. The idea wasn't to guess which way the market was headed--quite the contrary. The idea was to exploit the inefficiencies of the market place. In effect, to buy $5 bills for $4.90 or sell them for $5.10.

This entailed truly extraordinary activity. Every time the command went out to sell overvalued S&P contracts, orders would also go out to buy corresponding numbers of shares of 265 different stocks. (Calculations showed that risk could be sufficiently reduced using 265 rather than all 500 of the stocks in the S&P 500.) The partnership was doing 700 trades a day at one point--generating more than one percent of the total New York Stock Exchange volume on some days--turning over, in all, something like half a billion dollars of securities over the four-month period. It meant tying up about $25,000,000 of the partnership's capital and racking up monumental brokerage commissions. But the four-month profit came to $6,000,000.

The game petered out as other players wised up. Now $5 sells for so close to $5, it hardly pays to play.

Bancroft convertible fund: razzle-dazzle

Can you stand one more?

Bancroft is a closed-end mutual fund--one of those rare mutual funds that, after it was sold to the public, closed its doors to future investment (most mutual funds will eagerly accept as much new money as people want to pitch into them). Its shares, representing tiny slices of the fund, trade on the American Stock Exchange. In theory, if a fund's portfolio is worth $50,000,000 and the fund is divided into 10,000,000 shares, each of them should be worth $5--right? Typically, though, closed-end funds sell at a discount.

So, pleased at the thought of buying $5 bills for $4, Thorp and Regan went into the open market and from July 1977 through July 1978 accumulated nine percent of all Bancroft's shares at a 20 to 25 percent discount from their net asset value.

To hedge against a general market decline, they sold short many of the very same securities Bancroft owned.

The thought was perhaps to persuade Bancroft management to convert itself to an open-end fund or to liquidate, either of which would allow shareholders to redeem their shares at full, undiscounted, value.

Meanwhile, a Florida bank holding company called Combanks had had much the same idea. It had purchased 11 percent of Bancroft (from Carl Icahn, yet another well-known arbitrager). So in September 1978, Thorp and Regan graciously agreed to sell Combanks their shares--at a ten percent discount to net asset value. Five-dollar bills they had bought for less than $4 each they were now selling for $4.50. Fat profit number one.

The following summer, they went back into the market and began buying up another five percent of Bancroft, still trading at a hefty 15 percent to 20 percent discount. They sold these shares not long afterward to financial conglomerate Baldwin United at a slim five percent discount. Fat profit number two.

Then Baldwin, which had also bought Combanks' holding and some others, got into a cash bind. So it sold the whole block of Bancroft--now fully 31 percent of all the shares outstanding--back to Thorp and Regan at an 11 percent discount. Five-dollar bills for $4.45.

Less than 90 days later, Thorp and Regan were successful in forcing Bancroft management, with which by then they had more than a little clout, to make a public tender offer for their shares at a mere one percent discount from net asset value. Fat profit number three.

(Had all Bancroft shareholders tendered--which it would seem to have been unquestionably in their interest to do--Bancroft management would have had to sell off its portfolio, distribute the cash and find other work. Interestingly, few shareholders other than Thorp and Regan tendered their shares. This may have had something to do with the fact that, where most tender offers are advertised with blaring enthusiasm, Bancroft management chose to make this one ... quietly.)

The Chrysler play: buy the preferred, short the common

This was my other great idea. I never actually got around to doing it, but it did seem awfully smart at the time.

There was Chrysler in 1981, $6 a share and headed for zero, and there was Chrysler preferred, also $6 but a very different animal. The preferred stock came with a $2.75 dividend--never to be raised or lowered--and the promise that if Chrysler ever fell behind in paying that dividend, not a penny could be paid to the common-stock holders until every cent due the preferred shareholders was paid. At the time, about $5 in preferred dividends had been omitted, and more was accruing every quarter. My thought was to short the common stock and buy the preferred.

Two things could happen:

1. Chrysler could go bust. In that event, the creditors might eventually get some small portion of the money owing to them, but there would surely not be enough to pay everybody off and have anything meaningful left over for the common shareholders. So the common stock would trade at next to nothing. The preferred stock would also be worth next to nothing, except that in bankruptcy, preferred stock gets in line ahead of common stock, so maybe it would be worth a little something after all. My gain from shorting the common stock should equal or exceed my loss on the preferred.

All in all, not a terrible prospect.

2. Chrysler could hang in there, catch an upswing in the economy and survive another cycle. How would the two securities act then?

Well, ultimately, the value in a common stock derives from the stream of dividends it will pay out over the decades. Yet before Chrysler could restore so much as five cents of the ten-cent-a-share quarterly dividend it had discontinued on the common in the summer of 1980, it would have to pay off the entire arrearage on the preferred stock, which would have been cumulating (as they say) inexorably at $2.75 per year.

So if Chrysler began to show marginal signs of health, the common stock might bounce a little (how high could it bounce under that Alpine debt, besieged by G.M. and Japan?), but the preferred might really mean something. There would be the prospect of a one-time payment of better than $11 a share (if it came, say, in December 1983) to clear up the arrearages, plus an additional $2.75 a year For the Rest of Time. Surely, under such circumstances, you'd have a valuable little piece of paper on your hands. Whatever it would be worth, it would be a heck of a lot more than the $6 you paid for it!

So what little you might lose covering your short in the common you would make up, very handily, on the profit and the dividends from the preferred. However well the common did, I figured--and I couldn't imagine its doing very well--the preferred would have to do better.

Obviously, two things were at work here to make my opportunity. The common was selling unrealistically high, at 6, bid up by unsophisticates excited by lacocca and prone to invest with their hearts rather than their calculators; while the preferred was selling unrealistically low, dumped by the folks who ordinarily do buy preferreds--white-shoe types who were not about to scuff those shoes with an issue as scruffy as this one.

3. I had not considered the third possibility, which was that Chrysler would do brilliantly, pay off its Government-guaranteed loan seven years early and show substantial signs of robustitude. As I write this, Chrysler preferred is up from $6 to $30.25 (and you can just taste the announcement that the dividend arrearage will be paid off), which is the part I had hoped would happen--a huge, long-term capital gain, plus the prospect of a huge, lump-sum dividend payment. What I did not expect was that Chrysler common would climb even higher, from $6 to $31. All told, I would have broken even, more or less, before some possibly advantageous tax consequence--and before considering the smarter things I could have done with that money. Like depositing it in a savings account.

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One could go on. Have we even mentioned options? Straddles? Spreads? No, we have not. But this sort of thing is more fun to read about when the dollars involved are one's own. However, the important point may not be that you or I should try playing these games but that we should appreciate the kind of pros we're up against when we do.

''There's no telling what folks will pay for little pieces of paper and a dream.''

''Ed Thorp's previous book was the one that showed the world how to count cards at blackjack.''