A series of annual letters of Michael Burry’s Scion Value Fund.

H/T @BluegrassCap

Get The Timeless Reading eBook in PDF

Get the entire 10-part series on Timeless Reading in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues.

To the Members of the Scion Value Fund:

For the fiscal year ended December 31, 2000, encompassing the entire two months of the Fund’s existence to that date, the Scion Value Fund;s net asset value increased 6.63% after expenses and contingent fee allocations. The gross performance of the Fund was 8.24%.

It is my opinion that the most stable, cost-effective, and eternal alternative to the Fund is the S&P 500 Index, and hence this index should be used as a benchmark. I propose the S&P 500 as a benchmark not because the character of its securities closely matches the character of the Fund’s investments – I have yet to find an index that can do this - but rather because one may invest in the S&P 500 with great ease and tax efficiency. Moreover, the S&P 500 has shown an incredible resiliency by outperforming the great majority of money managers as well as most other indices over a great number of years.

During the two months ended December 31, 2000, the Fund’s net performance bested that of the S&P 500 by 14.08%. Let me be the first to tell you that this is no small anomaly – it is a quite large anomaly. Over periods greater than 5 years you should rightfully expect the Fund to beat the S&P 500 handily, but in these first two months the Fund certainly overreached. I trust that you will not hold me to this standard every two months henceforth.

During the period just ended, the Fund acquired neither short positions nor options contracts. As well, the Fund neither wrote calls on its positions nor borrowed exorbitant sums of money to enhance returns. The Fund instead has remained quite simply long stocks and on balance has held a small cash position.

No member need write a check as a result of this year’s activities. Scion Capital will fold its bill for these last two months into its bill for the 2001 fiscal year. As you are aware, Scion Capital does not charge a quarterly asset-based fee and instead relies entirely on its performance as your manager. Finally, no member will owe taxes on this year’s profits, as a small tax-loss is built into the aforementioned gain. You should expect your K-1 tax forms to arrive separately and in timely fashion.

Scion Value Fund - The Portfolio

In order that this Fund’s performance escape the randomness of return that defines much of the investment management industry, it is imperative that I as manager respond only to the value of an individual investment when making capital allocation decisions.

Value is far from the only potential input in the typical portfolio manager’s investment process, however. Throughout the universe of public and private funds, managers are measured quarterly against one index or another, defined by statistics, and corralled into this category or that category so that fund of funds, pensions, and other institutions can make comforting – if not necessarily prudent - asset allocation decisions. Such forces restrict and otherwise harm the manager’s ability to invest intelligently and are entirely deleterious to performance. Managers who respond to such inputs fight an uphill battle.

The Fund is structured to allow its manager to ignore these secondary inputs. The less definition offered, the less positions revealed, the less statistics applied – all the better for the portfolio that aims for these supra-normal returns. Hence, the Fund’s individual portfolio positions may not be revealed except at the discretion of the manager.

Scion Value Fund - Hedge Fund Defined?

Private investment funds such as the Fund are nearly always lumped into the category of “hedge fund.” Common hedging techniques include shorting stocks, buying put options, writing call options, and various types of leverage and paired transactions. While I do reserve the right to use these tools if and when appropriate, my firm opinion is that the best hedge is buying an appropriately safe and cheap stock. This is not the prevailing opinion, however. Hence, according to a common interpretation of this Fund’s activities, the charter investors in the Fund – myself included – entered November invested in a hedge fund that was, by all convention, completely un-hedged.

What happened? The stock market promptly morphed into a minefield. During the single month of November, the technology-laden Nasdaq Composite Index – the best performing market measure of the last several years – experienced a 22.9% loss of value. The Russell 2000 – a measure of small companies with market values averaging just under $600 million – stumbled 10.40%. The S&P 500 fell 8.01%, and the Dow Jones Industrial Average finished off 5.07%.

While striking, these statistics likely do little justice to the potential risk for those investors holding concentrated portfolios. Indices are not about stock picking. Concentrated portfolios – those holding less than 25 stocks or so – are entirely about stock picking. And there were tremendous devaluations in widely held issues over the course of November as well as December.

During this time, the Fund was comfortably positive. The main accomplishment of the Fund, in my opinion, was not grossing 8.24% in two months but rather avoiding such debilitating devaluations as affected the indices and many widely held stocks during that month. While I cannot proclaim that my stock-picking ability is responsible for the gain – the size and most probably the direction of that gain is almost surely a random short-term fluctuation in our favor - I can with some confidence assert that my strategy is entirely designed to avoid and otherwise minimize the price risk in individual securities. As a result, I would argue that it is the lack of a loss in a month like November that represents the most reproducible and the most potent characteristic of the Fund. It is a tenet of my investment style that, on the subject of common stock investment, maximizing the upside means first and foremost minimizing the downside. The deleterious effect of permanent capital loss on portfolio returns cannot be overstated.

Some basic math elucidates this point. When planning for a double, every dollar in excess cost amounts to two dollars in excess gain required. Every dollar saved amounts to the same two dollars in excess gain already realized. And it goes without saying that a 33.3% loss requires a 50% gain just to attain breakeven. On the flip side, 33.3% saved on the buy price makes a 50% gain back to the price of first consideration. On a percentage basis – and it is on this basis that we must evaluate each and every decision - lost dollars are simply harder to replace than gained dollars are to lose.

This focus on a margin of safety in each and every investment is what should make the Fund special. But for the unwieldy nature of such a term, “fund of well-conceived investments” might make an apt handle. Whether or not the Fund ought to be called a hedge fund is an individual decision grounded only in semantics.

Scion Value Fund Expenses

The most significant potential weakness of the Fund is its expense ratio. You do not earn a return unless the annual return exceeds expenses. I do not earn an income unless your annual return exceeds 6% net

1, 2  - View Full Page