By now you've probably at least heard of SAC Capital, the massive hedge fund founded and run by the eponymous Steven A. Cohen. It was indicted on Thursday for a decade-long insider trading scandal that the Justice Department has described as "substantial, pervasive and on a scale without known precedent in the hedge fund industry."
The facts of the case -- alleged by the government in multiple court filings, guilty pleas, and indictments -- are breathtaking. In short, it's alleged that the fund intentionally hired analysts and portfolio managers with reputations for insider trading, incentivized them to further cultivate inside information for the benefit of their respective portfolios, and obliged them to share the information with Cohen, who then used it to trade in a separate portfolio that he alone controlled. By doing so, SAC Capital is thought to have earned "hundreds of millions of dollars" in illegal profits and avoided losses.
As investors, there's a lesson we can learn from this. And, no, the lesson isn't that insider trading is bad. I mean, it is, but hopefully most of us already know that. Instead, as I read through the court filings describing SAC's insider contacts and the quality of information its traders had access to ahead of earnings announcements and other material events, it made me realize just how asymmetric the knowledge in the market truly is. In other words, any individual investor who thinks he can beat the market by speculating on things like earnings surprises is living in la-la-land.
Of the dozens of trades alleged in the various documents, the one that best demonstrates this is SAC's bet on the pharmaceutical giant Elan (NYSE: ELN ) in anticipation of the latter's Phase II trial results for a drug to treat Alzheimer's disease. I've mapped out the trade in the chart below.
During the first half of 2008, and based upon the advice of the doctor in charge of announcing the results, an SAC portfolio manager by the name of Matthew Martoma began constructing a massive stake in Elan, eventually topping out at 10.5 million shares. The move began to look particularly prescient when shares rose more than 10% following the June 17th release of the trial's top-line results.
By July, however, though unbeknownst to the rest of the market, it began to appear as if a more in-depth presentation on the results, scheduled for July 29, wouldn't be as well received. Consequently, following the receipt of the confidential test results as well as multiple conversations with the doctor responsible for making the presentation, Martoma decided to unload the position and instructed Cohen to follow suit. Over the span of five days between July 21-25, SAC sold its entire position for a gross take of more than $500 million and, not satisfied at that, proceeded to go short.
Suffice it to say, come July 29, well, the chart is pretty clear on the rest of the story.
My point here is simple. Many people who call themselves investors are of the opinion that they can outsmart the market by betting on short-term catalysts like earnings announcements or, in this case, the results of a pharmaceutical trial. The problem is that we can't, or at least, that we're at an extreme disadvantage in trying to do so. Unlike SAC, most investors don't have the means to compensate corporate insiders who are willing to share information ahead of time. And unlike SAC, many investors aren't willing to sacrifice their integrity, not to mention their freedom, to do so anyway.
Does this mean we don't have a competitive advantage -- an "edge," as the traders at SAC would term it? No. In fact, we have a powerful one. As my colleague Morgan Housel recently discussed, "I'm a long-term investor. ... The fact that you and I don't have to play these insane short-term games is the last remaining edge we have over Wall Street. And frankly, it's enormous."
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