Whitney Tilson’s email to investors discussing his thoughts on portfolio management; excerpt from the rise and fall of Kase Capital.
Q2 2021 hedge fund letters, conferences and more
Catastrophic Portfolio Management
The investors I discussed in yesterday's e-mail who lost their shirts trading Pershing Square Tontine Holdings Ltd (NYSE:PSTH) were guilty of catastrophic portfolio management.
It's a subject I'm very familiar with, as it was this, not bad stock-picking, that was mostly responsible for the poor returns that ultimately led me to close my hedge funds in 2017.
I discuss what happened in this excerpt from my forthcoming book, The Rise and Fall of Kase Capital:
When I got into the business, I thought all I had to do was find cheap stocks and be a good stock-picker.
It was only through hard experience that I came to learn that stock-picking is only half the battle. The other 50% is managing your portfolio, which can create or destroy as much value as the stocks you own. If you're a poor portfolio manager, things can really start to go haywire.
To borrow a baseball analogy, your batting average matters a lot less than your slugging percentage. It's not how many of your picks are right... It's how much money you make when you're right versus how much you lose when you're wrong.
Early in my career, I was so inexperienced that I didn't really understand what it meant to be a portfolio manager.
I simply bought the cheapest 10 or 15 stocks I could find and didn't hold much cash. The thought of short-selling never occurred to me. I was only vaguely familiar with what an option was, and I didn't know a thing about trading on margin.
On occasion, I developed conviction about something like the dot-com and housing bubbles and took some steps to adjust my portfolio accordingly.
But at the end of the day, I was just a plain old bottom-up stock picker on the hunt for a dozen or so cheap stocks, and that was it.
Learning From Mistakes
Had I just stuck with this simple approach, I would have done well. Instead, I strayed from that approach. Over time, I made terrible mistakes in every aspect of portfolio management. Here's what I learned...
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Be Careful With Exposure And Margin
Banks and brokerages are generally delighted to lend you money. If you have $100 in your account, they might lend you $50 so that you can buy $150 worth of stocks. This can magnify your profits... but also your losses.
Worse yet, they keep a close eye on your account. If your losses start to pile up, they can give you what's known as a "margin call," forcing you to quickly sell and raise a certain amount of cash (or they'll do it for you).
Per the example above, let's say you have $150 invested and your account falls by 33%. You've lost $50 and your account is now worth $100. But the amount you owe the bank is still $50... so in reality, you've suffered a 50% loss, since you now only have $50 of your original $100 in capital remaining.
A bank is happy to lend you $50 on $100 of equity, but not $50 on $50. Long before your account shrinks by 33%, you're going to get a margin call. That can be a real disaster because you're forced to sell immediately, usually at the exact moment you want to be buying.
This is what happened to me in 2011 when I was running my hedge fund. My business partner and I had allowed our exposure to creep up to 136% long by 63% short that summer. In July and August, the European debt crisis caused turmoil in what had been very complacent markets. In a matter of weeks, the S&P 500 fell nearly 20%. Our fund fell even more than this because we were trading on margin, and some of our stocks got hit especially hard.
Normally, that would have been OK. We had a strong stomach for volatility. In fact, we embraced it because it gave us good opportunities to both buy and sell at attractive prices.
Thus, we were eager to take advantage of the sell-off. (Our instincts were correct, as the markets swiftly rebounded.) But at precisely the time we wanted to back up the truck, we were instead forced to sell because we got a margin call in August.
Our fund got crushed, falling 13.9% that month. In total, from July through September, we were down nearly 26%, almost double the loss of the S&P 500. It took us years to dig ourselves out of the hole we had created.
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Limit Your Number Of Positions
The next tenet of proper portfolio management is limiting the number of positions you own.
At our peak, we were wildly overdiversified, with 41 long positions and 87 short positions. Even two experienced investors like us couldn't possibly have had a deep knowledge of – and closely tracked – that many positions.
As I've written previously, you don't need to own more than 10 or 20 stocks to be reasonably diversified, while also being concentrated in your best ideas.
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Size Positions Carefully
Another mistake we made was position sizing.
In general, I've found it's best to put no more than 5% or 6% in even the bluest of blue-chip stocks. For smaller, off-the-beaten-path stocks, I recommend sizing them even smaller, in the 3% to 5% range.
In our case, we had oversized positions in some of the riskiest companies in our portfolio, most notably a 14% position in clothing retailer JC Penney, an 8% position in satellite company Iridium Communications, and a 5% position in Spanish media firm Grupo Prisa.
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Resist The Temptation Of Investing In Options Or Private Companies
Making matters worse, in addition to being wrong on the three stocks I just mentioned, we owned nearly half of our JC Penney position in the form of call options and all of our Iridium position via warrants.
The latter was especially deadly... At the end of 2011, Iridium's stock was trading at $7.71. The warrants had a strike price of $7, so they were 71 cents "in the money." They traded above this level (at $1.72, reflecting the time value of the warrants) but tended to move almost penny for penny in line with the stock. Thus, modest moves in the stock price led to big moves in our 8% warrant position.
We didn't dabble too much in private investments, fortunately – but what we did do, we regretted. In 2008, we set up a small side fund to invest in the stock and warrants of special purpose acquisition companies ("SPACs"). This worked out OK, but it wasn't worth the trouble, and later, it saddled us with two of our worst investments ever (Iridium and Grupo Prisa).
In 2011, we invested in a side fund that hedge fund manager Kyle Bass of Hayman Capital Management had set up to bet on rising interest rates and a weakening Japanese yen. Over three years, he doubled our money, but the move came with a lot of volatility and total illiquidity, and it forced us to delay sending K-1s to our investors.
Lastly, later that year, we invested in a privately owned insurance company. After a promising start, it turned into an unmitigated disaster, incinerating our capital and giving me plenty of gray hairs along the way.
It's easy to get lured into making any number of dangerous bets with your money. The vast majority of investors would be better off never touching options or investing in private companies. But if you do, be sure to do your due diligence and size your positions carefully.
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Resist The Urge To Over-Trade
As we got into a hole, we ramped up our trading, churning the portfolio. Our goal was, of course, to turn around performance. In reality, we only made things worse.
Countless studies show that the less trading you do, the better your returns are likely to be. Here's a funny story that underscores this point to an extreme...
Nearly two decades ago, my sister set up a retirement account at the company she worked for at the time. Every two weeks, she had money withdrawn from her paycheck and automatically invested in the S&P 500 Index.
Then she switched jobs and forgot about the account, so she didn't make a single trade or investment decision for more than 15 years.
She recently switched jobs again, which reminded her to check that old account. She contacted her former employer's human resources department and discovered that it had compounded into a small fortune.
The irony is, had she remembered she had the account all along, she probably would have done something dumb like sell and go to cash at the market bottom in 2009.
In a future e-mail, I'll cover the last part of this chapter: When to add to, hold, trim, or exit your positions.
Best regards,
Whitney
P.S. I welcome your feedback at [email protected].
