Strategy: 20 investing rules from hedge fund legend

Published Tue, Mar 29 20166:00 AM EDTUpdated Tue, Mar 29 201610:01 AM EDT

Editor's note: Pro Strategy is a column on how to use the strategies of the smartest minds on Wall Street to generate quality investment ideas. Back in the 1990s investors avidly passed around Dan Benton's Goldman Sachs memo with 20 rules for technology stock investing. The maxims became legendary as he turned into the best technology hedge fund manager in the world by the end of that decade. We'll show that his rules are still relevant today and can be applied to generate new long and short ideas. Benton started his Wall Street career as an influential PC analyst at Goldman Sachs from 1988 to 1993. He then joined Dawson Samberg as a technology portfolio manager and later became president of Pequot Capital, the successor firm. By the time he started Andor Capital in 2001, he managed the most successful tech-focused hedge fund in the world with $7.5 billion in assets. The funds Benton managed from 1994 to 2001 had annual returns of 53 percent, compared to the S & P 500 's 13.3 percent return, according to The Wall Street Journal . Here are the 20 investing rules Benton wrote at Goldman Sachs that many believe led to his success. Momentum 1. Sell technology stocks when estimates are being reduced. 2. Buy technology stocks only for positive earnings surprises. 3. Positive earnings surprises occur when revenue and earnings growth are accelerating, when average selling prices are rising, and when gross margin and operating margin are rising. 4. Most technology stock ideas are product-cycle stories. 5. New product cycles often lead to earnings surprises; product cycle transitions usually lead to earnings disappointments. 6. Technology stocks also do well when companies rebound from periods of poor execution. Valuation 7. Value investors don't make money in technology. There are few "cheap" technology stocks. 8. Don't buy on relative P/E, P/B, P/R, particularly when estimates are falling (see Rules 1 and 2). Seasonality 9. Technology stocks perform poorly in the summer. 10. Seasonal slowdowns cause secular concerns. 11. Second-tier companies do poorest in the weakest seasonal period and provide anecdotal evidence of an industry slowdown. Management 12. Reorganizations without restructuring charges usually lead to earnings disappointments within two quarters. 13. One-quarter problems exist (but only if caused by supply constraints). 14. Management usually appears weakest at the bottom of a product cycle. 15. Insider selling doesn't matter; management gets new stock options every year. Old World/New World 16. Traditional mainframe and minicomputer companies are in secular decline. 17. It is increasingly difficult to differentiate companies that sell microprocessor-based computers. 18. Execution is the most important distinguishing factor in a standards-based world. 19. It is hard to forecast execution. Summary 20. Don't forget Rule 1. Source: Goldman Sachs Read More Pro Strategy: Fitbit may outrun the shorts Even though the rules were written long ago, many investors agree they are still relevant today. "Dan has many valid guidelines regarding investing in technology stocks," TIAA managing director and equity portfolio manager Stephanie Link said in an email. "The importance of innovation is critical in this sector." The de-emphasis on valuation as a driver of a tech stock's direction is similar to how billionaire Stanley Druckenmiller invested last year . And the most important rule on the list clearly is "sell technology stocks when estimates are being reduced" as it is repeatedly mentioned and also ends the memo as the "Summary." The rule helped Benton thrive when the dot-com bubble burst in 2000 as he returned 35 percent that year versus the Nasdaq composite 39 percent decline by short-selling technology stocks with declining earnings estimates. When Wall Street analysts start cutting their outlooks for technology firms it is often because a multi-quarter product cycle is ending, which has a serious negative impact on future earnings power. GoPro investors could have protected themselves from larger losses if they followed this rule six months ago. As the 2016 average earnings estimate started falling from $2.14 earnings per share to a negative 68 cents, the company's stock price followed suit. "I actually have a lot of rules similar to Benton's in my models. Estimate revisions get a huge weighting, including dumping positions with new low estimates," Belpointe strategist David Nelson wrote in an email. "This has saved my clients a lot of money." In addition to earnings estimates, the primary focus of Benton's rules is finding new technology product cycles to generate profitable investment ideas. Nvidia may have the best product cycle story of 2016 with its dominance of the vibrant PC gaming graphics card market, as virtual reality and eSports trends explode. "Our strategy is to create specialized accelerated computing platforms for large growth markets that demand the 10x boost in performance we offer," Nvidia CEO Jen-Hsun Huang said in the Feb. 17 earnings release. "Nvidia is at the center of four exciting growth opportunities - PC gaming, VR, deep learning, and self-driving cars." Even amid the worst double-digit PC market decline in history last year, according to IDC, Nvidia's PC gaming business is thriving. The company's gaming graphics card business grew 21 percent year over year in the most recent quarter and it dominates the market with 81 percent market share, according to Mercury Research. The global PC gaming market will increase from $25.6 billion in 2015 to $26.7 billion in 2016, according to Newzoo, a market research firm. More than 80 million people are playing multiplayer online battle arena (MOBAs) eSports games like "League of Legends" and "DOTA 2" on PCs, according to Nvidia. "eSports is really not just for competition, but drive the dynamic of sharing and social. Those kinds of factors continue to drive our gaming business," Huang said on the Feb. 17 earnings call, according to a FactSet transcript. Baird estimates eSports will grow from $300 million of revenue in 2015 to $1 billion in 2018 and almost $2 billion in 2020 growing at a 46 percent annual rate driven by a viewership of 200 million people. The audience is projected to triple their engagement, watching 6.6 billion hours or 26 hours per viewer by 2018 according to IHS. Similar in potential, the virtual reality era began this week as Facebook 's Oculus Rift VR headset started shipping Monday. Pacific Crest anticipates in three years 3 to 7 percent of PC gaming users will adopt virtual reality, which will add up to $1.3 billion in annual sales to Nvidia. "Virtual reality is expected to drive a new segment of growth for Nvidia, given the need for high-end graphics cards (e.g., Nvidia GeForce GTX 970/980) to render dual images in high resolution," Pacific Crest's Michael McConnell wrote in note to clients Feb. 17. Nvidia's next-generation graphics architecture code named "Pascal" is slated to launch in 2016. According to a company presentation last year, the new technology will offer a big leap in performance over previous generational improvements. If the company is able to achieve these aggressive technical milestones, it will drive a large upgrade cycle, leading to positive earnings surprises and a higher share price. A result that would make Dan Benton proud. Read More Pro Strategy: 'Grand Theft Auto' stock is a steal

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Editor's note: Pro Strategy is a column on how to use the strategies of the smartest minds on Wall Street to generate quality investment ideas.

Back in the 1990s investors avidly passed around Dan Benton's Goldman Sachs memo with 20 rules for technology stock investing. The maxims became legendary as he turned into the best technology hedge fund manager in the world by the end of that decade. We'll show that his rules are still relevant today and can be applied to generate new long and short ideas.

Benton started his Wall Street career as an influential PC analyst at Goldman Sachs from 1988 to 1993. He then joined Dawson Samberg as a technology portfolio manager and later became president of Pequot Capital, the successor firm.

By the time he started Andor Capital in 2001, he managed the most successful tech-focused hedge fund in the world with $7.5 billion in assets. The funds Benton managed from 1994 to 2001 had annual returns of 53 percent, compared to the 's 13.3 percent return, according to The Wall Street Journal.

Here are the 20 investing rules Benton wrote at Goldman Sachs that many believe led to his success.