Steve Watson – Small Cap Trading Strategy Investor/Trader

Last Updated on July 25, 2022

This post is about Steve Watson who appeared in Jack Schwager’s Stock Market Wizards. Watson has not been much in the public, and we know very little about his career after the year 2000 (when the Schwager interview was made). Steve Watson focuses mainly on small caps and has earned his nickname “small cap Steve”.

This article looks very briefly at the life and trading career of Steve Watson, and we end the article by taking some of the most interesting quotes.

• The 50 best trading quotes

Steve Watson’s life and trading career

Steve Watson did not know about the stock market until his time in college. He became interested in the market after taking an investment course during his study at Arkansas University.

After he graduated from college, he got a job as a broker in Dallas but soon realized it was a sales job, and he was no good at sales. By this time, Steve was already trying out his hands in the market, but he was a terrible stock picker and was a victim of the stock market crash of ’87.

He left his job in Dallas and moved to New York. He started working for an insurance company, doing credit analysis. He studied at Fordham University for a semester, got good grades, and transferred to business school at NYU.

After he graduated, Steve started working at Bankers Trust in the small-cap department. They were stocks he was familiar with, so he often stayed up till 3 am researching about them on Bloomberg.

Six months later, he quit and began working at Freiss Associates, which ran the Brandywine Fund. The fund grew exponentially and later became too large for the small caps Steve loved.

Steve resigned two years later and started his own hedge fund with $20,000 from his savings and another $700,000 from small-cap CFOs, whom he had given stock tips. He got a small office and a Bloomberg terminal without charge from someone who wanted to help him.

Steve managed two funds — a micro fund that invests in companies with a market capitalization of less than $350 million and a small-cap fund that invests in companies with a capitalization of $350 million to $1.5 billion. After four and half years of managing the two funds, his maximum loss was below 4 percent, equivalent to one month’s return after fees.

Steve’s approach was to invest in cheap companies with a PE of 8 to 12, which have growth potential. He could hold more than a hundred positions but never exposed more than 3% of his portfolio in any position.

Steve relied on information from third-party sources, an approach that is a good fit for his easygoing manner. He finds about companies that are recovering from poor performance before anyone else. It is made possible because of his constant talk with the companies. In addition to CFOs, his funds speak to customers, distributors, and competitors. However, Steve doesn’t approach CFOs whose stock he is shorting because they had discouraged him from shorting positions that later turned out profitable in the past.

Steve rarely uses charts for trading, because he believes everyone uses them, and there’s no competitive advantage. He uses the earnings estimates by analysts but not their research resources because it is biased by their client relationships. He loves insider buying.

His trading style involves selling when a stock’s price has doubled or tripled, and the PE is close to 20. This approach usually misses the big winners but also gives him protection during a market decline. If Steve sees a stock price does not move to the upside after buying, he will exit his position and move on to the next good trade. His net long position is usually less than 50 percent of assets and sometimes below 20 percent.

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Steve Watson trading strategy quotes

You have to be willing to accept a certain level of risk, or else you will never pull the trigger.

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My first and most important lesson about the stock market is: Stick to your own beliefs.

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Do the research and believe in your research. Don’t be swayed by other people’s opinions.

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Invest without emotions. If you let emotions get involved, you will make bad decisions.

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You can’t be afraid to take a loss. The people who are successful in this business are the people who are willing to lose money.

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I’m a perennial bear….Thank goodness we have been able to make money anyway.

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If you can’t summarize the reasons why you own a stock in four sentences, you probably shouldn’t own it.