A Fascinating Look at Dr. Michael Burry’s Investment Strategy

A Fascinating Look at Dr. Michael Burry’s Investment Strategy by John Szramiak was originally published on Vintage Value Investing

Dr. Michael Burry was one of the heroes of Michael Lewis’s book The Big Short: Inside the Doomsday Machine, which tells the story about how he correctly predicted the credit and housing bubble collapse in 2008 and decided to bet against Wall Street, earning billions of dollars in the process.

In the 2015 film adaptation of Michael Lewis’s book, Michael Burry was played by Christian Bale. Apparently Christian Bale captured Michael Burry’s personality – as a socially awkward but clearly brilliant investor – perfectly (Bale was even wearing Burry’s actual clothes in the movie). And Michael Burry is part of the reason why both the book and the movie were so good – his personality and his bet on the housing crisis in 2008 and 2009 are fascinating.

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While The Big Short focuses on Michael Burry’s bet on the housing crisis, which is what he’s most famous for today, Burry was actually an incredibly talented investor before that. In fact, I think the story of exactly how Dr. Michael Burry got started investing in the first place is just as interesting as his big short.

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Dr. Michael Burry’s Story:

You see, in the late 1990’s, Michael Burry was just doing his residency in neurology at Stanford Hospital and Clinics. While off duty at night, Burry would focus on his hobby: investing. He also discussed his ideas on his own blog, in early internet chat rooms, and on other message boards and sites, including Silicon Investor and MSN Money.

Mind you, Michael Burry was a self-described value investor from the beginning, at a time when value investing couldn’t have been less popular. But Burry did well investing for his own account, and the ideas he discussed online gained him a small following on these early message boards. After he finished his residency, Michael Burry decided that he was going to start his own hedge fund. Joel Greenblatt – a famous value investor who had been reading (and profiting) from Burry’s posts – promtly contact him, offering Burry a million bucks to help seed Burry’s new fund.

Eventually, Michael Burry made his famous subprime trade and went from a completely unknown (but very successful) stock picker to one of the most famous fund managers in the game. And the rest is history.

I recently stumbled across one of the original articles that Michael Burry wrote in 2000 for MSN Money. Feel free to download a copy of this article below:

In the article, Dr. Michael Burry describes his investment philosophy and exactly how he went about picking stocks. Basically, Burry is a big time value investor and follows many of Ben Graham’s and Warren Buffett’s strategies, including:

  • Invest with a margin of safety
  • Perform bottoms-up, fundamental analysis
  • Look for great stocks in disfavored industries
  • Portfolio management is as important as picking stocks

Of course, Michael Burry’s put his own spin on their ideas. I’ve broken down Burry’s investment strategy in more detail for you below.

Margin of Safety

 

Dr. Michael Burry is a true Graham-and-Dodd style value investor. According to Burry:

“I really had no choice in this matter, for when I first happened upon the writings of Benjamin Graham, I felt as if I was born to play the role of value investor.

Burry believes that it’s critical to understand a company’s value before laying down a dime. His main goal is to protect his downside so that he can prevent a permanent loss of capital. Consequently, all of Burry’s stock picking is 100% based on the concept of margin of safety (see my article: What is Margin of Safety?).

Michael Burry says that if you focus on intrinsic value and invest with a margin of safety, then you don’t have to worry about specific, known catalysts (an event which causes investors to finally recognize a stock’s true intrinsic value, and causes the stock’s price to “pop”) before you make an investment. According to Burry, “sheer, outrageous value is enough.”

Bottoms-Up, Fundamental Research

 

Michael Burry says that his “weapon of choice as a stock picker is research.” Burry doesn’t care about the level of the stock market, and he has no restriction on potential investments: they can be large cap stocks, small cap, mid cap, micro cap, tech or non-tech. It doesn’t matter – as long as Burry can find value in it, it becomes a candidate for the portfolio. That being said, Burry says he’s found that out-of-favor industries provide great opportunities to buy shares of best-of-breed companies at steep discount.

So how does Burry find value investing opportunities?

He uses stock screeners to screen through large numbers of companies by looking at the EV/EBITDA ratio (acceptable ratios for Burry vary with the industry and its current position in the economic cycle).

If a stock passes his loose screen, Burry then looks harder to determine a more specific price and value for the company. This involves looking at true free cash flow and taking into account off-balance sheet items.

Burry tends to ignore price-earnings ratios and thinks that return on equity is both deceptive and dangerous. Burry prefers minimal debt.

“Rare Birds”

 

Michael Burry also invests in what he calls “rare birds.” These are mostly asset plays, but also include arbitrage opportunities and companies selling at less than two-thirds of net value (net working capital less liabilities; i.e. Ben Graham’s net-net stocks, or companies that are selling for less than their liquidation value).

Burry also mixes in the types of companies favored by Warren Buffett – companies with a sustainable competitive advantage, as demonstrated by longstanding and stable high returns on invested capital – if they become available at good prices. These can include technology companies, if Burry is able to understand them. However, like the other rare birds Burry invests in, Buffett-style investments are hard to find, so Burry considers these longer-term investments.

Portfolio Management

 

Dr. Michael Burry believes that portfolio management is just as important as stock picking. Good portfolio management requires an investor to answer several essential questions: What is the optimum number of stocks to hold? When to buy? When to sell? Should one pay attention to diversification among industries and cyclicals vs. non-cyclicals? How much should one let tax implications affect investment decision-making? Is low turnover a goal?

Burry says that in large part, the answers to these questions are “a skill and personality issue, so there is no need to make excuses if one’s choice differs from the general view of what is proper.” Here is how Burry manages his portfolio:

What is the optimum number of stocks to hold?

“I like to hold 12 to 18 stocks diversified among various depressed industries, and tend to be fully invested. This number seems to provide enough room for my best ideas while smoothing out volatility, not that I feel volatility in any way is related to risk. But you see, I have this heartburn problem and don’t need the extra stress.”

When should you buy a stock?

“As for when to buy, I mix some barebones technical analysis into my strategy — a tool held over from my days as a commodities trader. Nothing fancy. But I prefer to buy within 10% to 15% of a 52-week low that has shown itself to offer some price support. That’s the contrarian part of me.

When should you sell a stock?

“Tax implications are not a primary concern of mine. I know my portfolio turnover will generally exceed 50% annually, and way back at 20% the long-term tax benefits of low-turnover pretty much disappear. Whether I’m at 50% or 100% or 200% matters little. So I am not afraid to sell when a stock has a quick 40% to 50% a pop.”
“And if a stock — other than the rare birds discussed above — breaks to a new low, in most cases I cut the loss. That’s the practical part. I balance the fact that I am fundamentally turning my back on potentially greater value with the fact that since implementing this rule I haven’t had a single misfortune blow up my entire portfolio.”

 

Investing is Neither Science nor Art… It’s a Scientific Art

 

Finally, Michael Burry warns that fundamental analysis isn’t infallible – sometimes the market never reflects true intrinsic value, sometimes other investors have more information than you do, sometimes you might make a mistake. But fundamental analysis is at least a way of putting the odds on your side.

Michael Burry concludes with this:

“In the end, investing is neither science nor art — it is a scientific art. Over time, the road of empiric discovery toward interesting stock ideas will lead to rewards and profits that go beyond mere money. I hope some of you will find resonance with my work — and maybe make a few bucks from it.”

Summary

In summary, Dr. Michael Burry’s investment strategy can be described as follows:

  • Invest with a margin of safety. Michael Burry’s main goal is to protect his downside so that he can prevent a permanent loss of capital. Consequently, known catalysts are not necessary; sheer, outrageous value is enough.
  • Perform bottoms-up, fundamental research. Michael Burry doesn’t care about the level of the stock market, and he has no restriction on potential investments: they can be large cap stocks, small cap, mid cap, micro cap, tech or non-tech. It doesn’t matter, as long as Burry can find value in it. That being said, Burry has found that out-of-favor industries provide great opportunities to buy shares of best-of-breed companies at steep discounts.
  • Screen through large numbers of companies by looking at the EV/EBITDA ratio. Acceptable ratios vary with the industry and its current position in the economic cycle.
  • Intrinsic value is determined by free cash flow. If a stock passes this loose screen, Burry then looks harder to determine a more specific price and value for the company. This involves looking at true free cash flow and taking into account off-balance sheet items. Burry tends to ignore price-earnings ratios and thinks that return on equity is both deceptive and dangerous. Burry prefers minimal debt.
  • Michael Burry also invests in “rare birds” – mostly asset plays, but also arbitrage opportunities and companies selling at less than two-thirds of net value (net working capital less liabilities, i.e. Ben Graham’s net-net stocks, or companies that are selling for less than their liquidation value).
  • Burry also mixes in the types of companies favored by Warren Buffett – companies with a sustainable competitive advantage, as demonstrated by longstanding and stable high returns on invested capital – if they become available at good prices. These can include technology companies, if Burry is able to understand them. Burry also classifies these types of Buffett-style investments as rare birds, and – when found – believes they are deserving of longer holding periods.
  • Michael Burry believes that portfolio management is just as important as stock picking:
    • Number of stocks to hold: Burry likes to hold 12-18 stocks diversified among various depress industries. This allows him to focus on his best ides while smoothing out volatility (not to reduce risk, but to reduce personal stress).
    • When to buy: Burry uses some rudimentary technical analysis to determine when to buy a stock – specifically he prefers to buy within 10-15% of a 52-week low that has shown itself to offer some price support.
    • When to sell: Burry’s turnover generally exceeds 50% annually. He’s not afraid to sell if a stock has had a quick 40% or 50% pop. Burry will also sell a stock if it hits a new low. While he acknowledges potentially turning his back on greater value, Burry says this prevents any on stock from blowing up his portfolio.
  • Investing is neither science nor art… it’s a scientific art. Finally, Michael Burry says that fundamental analysis isn’t a sure-fire way of succeeding in the stock market – but it does at least put the odds on your side.

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Ben Graham, the father of value investing, wasn’t born in this century. Nor was he born in the last century. Benjamin Graham – born Benjamin Grossbaum – was born in London, England in 1894. He published the value investing bible Security Analysis in 1934, which was followed by the value investing New Testament The Intelligent Investor in 1949. Warren Buffett, the value investing messiah and Graham’s most famous and successful disciple, was born in 1930 and attended Graham’s classes at Columbia in 1950-51. And the not-so-prodigal son Charlie Munger even has Warren beat by six years – he was born in 1924. I’m not trying to give a history lesson here, but I find these dates very interesting. Value investing is an old strategy. It’s been around for a long time, long before the Capital Asset Pricing Model, long before the Black-Scholes Model, long before CLO’s, long before the founders of today’s hottest high-tech IPOs were even born. And yet people have very short term memories. Once a bull market gets some legs in it, the quest to get “the most money as quickly as possible” causes prices to get bid up. Human nature kicks in and dollar signs start appearing in people’s eyes. New methodologies are touted and fundamental principles are left in the rear view mirror. “Today is always the dawning of a new age. Things are different than they were yesterday. The world is changing and we must adapt.” Yes, all very true statements but the new and “fool-proof” methods and strategies and overleveraging and excess risk-taking only work when the economic environmental conditions allow them to work. Using the latest “fool-proof” investment strategy is like running around a thunderstorm with a lightning rod in your hand: if you’re unharmed after a while then it might seem like you’ve developed a method to avoid getting struck by lightning – but sooner or later you will get hit. And yet value investors are for the most part immune to the thunder and lightning. This isn’t at all to say that value investors never lose money, go bust, or suffer during recessions. However, by sticking to fundamentals and avoiding excessive risk-taking (i.e. dumb decisions), the collective value investor class seems to have much fewer examples of the spectacular crash-and-burn cases that often are found with investors’ who employ different strategies. As a result, value investors have historically outperformed other types of investors over the long term. And there is plenty of empirical evidence to back this up. Check this and this and this and this out. In fact, since 1926 value stocks have outperformed growth stocks by an average of four percentage points annually, according to the authoritative index compiled by finance professors Eugene Fama of the University of Chicago and Kenneth French of Dartmouth College. So, the value investing philosophy has endured for over 80 years and is the most consistently successful strategy that can be applied. And while hot stocks, over-leveraged portfolios, and the newest complicated financial strategies will come and go, making many wishful investors rich very quick and poor even quicker, value investing will quietly continue to help its adherents fatten their wallets. It will always endure and will always remain classically in fashion. In other words, value investing is vintage. Which explains half of this website’s name. As for the value part? The intention of this site is to explain, discuss, ask, learn, teach, and debate those topics and questions that I’ve always been most interested in, and hopefully that you’re most curious about, too. This includes: What is value investing? Value investing strategies Stock picks Company reviews Basic financial concepts Investor profiles Investment ideas Current events Economics Behavioral finance And, ultimately, ways to become a better investor I want to note the importance of the way I use value here. It’s not the simplistic definition of “low P/E” stocks that some financial services lazily use to classify investors, which the word “value” has recently morphed into meaning. To me, value investing equates to the term “Intelligent Investing,” as described by Ben Graham. Intelligent investing involves analyzing a company’s fundamentals and can be characterized by an intense focus on a stock’s price, it’s intrinsic value, and the very important ratio between the two. This is value investing as the term was originally meant to be used decades ago, and is the only way it should be used today. So without much further ado, it’s my very good honor to meet you and you may call me…