Residency Lesson #2: Stay Within Your Circle of Competence

I cannot find the exact quote, but Jim Rogers said something to the effect of, “You can learn more from a week of trading hog futures contracts than you can from three years of b-school.” I could not agree more. In my opinion, the only way to truly define your circle of competence is to invest your own capital in a variety of ways – stocks, bonds, options, futures, margin, deep-value, asset-based, cash flow-based, liquidations, merger arbitrage, spin-offs, recaps, buyout rumors, coat-tailing, small caps, mid caps, large caps, in various sectors/industries, and through some type of a market cycle. I began following the stock market virtually at the top in 2007, watched Lehman Brothers nearly topple the global financial system in September 2008, and invested through a generational market bottom in March 2009 up through the current all-time highs…I’m not sure I could script a better environment in which to develop my circle of competence!

OUTSIDE THE CIRCLE

Market Timing. As I detailed in Residency Lesson #1, I was highly successful in proving to myself over the past 5.5 years that I am a TERRIBLE market timer. Over the last two years in particular, I spent far more time than I would like to admit reading the tea leaves of investor sentiment charts. Due to my Buffett “upbringing”, I A) was extremely focused on outperforming in a downturn, and B) love going against the crowd – and as investor sentiment charts climbed to highs indicating extreme optimism, I continued to average up on my market short bet. Turns out I was the pansy at the poker table. To say the least, it requires far more than looking at market sentiment to determine market riskiness. In order to free my mind of market worry so that I can focus 99% of my time on stock picking, I came up with the Market Mosaic (detailed in Residency Lesson #1), a slow-moving, long-term-oriented model for assessing general market risk. It incorporates a “weight of the evidence approach” by looking at valuation, market trends, and economic & monetary conditions. It is by no means perfect – i.e. it will not allow me to avoid most if any 10 to 20% market corrections – but it should allow me to avoid large-scale bear markets that take several years to recover from.

Macro Trading. Beginning in 2011, I began expressing my general market negativity through macro-based trading instruments – specifically, the long Treasury bond and precious metals via the TLT, GLD, SLV and GDX exchange-traded funds. As QE2 wound down toward the middle of 2011, I took the opposite view of Bill Gross, who believed Treasury yields would rise as the market’s largest buyer was stepping out of the market. I believed yields would decline as “risk-on” behavior exited the market alongside the Fed. Unfortunately I was correct in my macro belief – this new-found belief in my macro trading ability led me to exit stocks, short the market, and buy bonds & precious metals in late 2011 after the ECRI came out with its recession forecast. I aggressively bought stocks through August and September of 2011, and after the rally into the ECB’s LTRO announcement, I thought I was in perfect position to take advantage of ECRI’s recession with the portfolio outlined above. I was ecstatic to be a position to not only beat the market on the way down but to CRUSH it via significant gains in bonds and precious metals. Clearly this did not work out. I am relatively quick to change my mind once I am wrong, so I adjusted the portfolio mid-way through 1Q12.

My macro trading was not yet finished, however. Market sentiment toward precious metals reached a low in the middle of 2012, and with a rising equity market I again thought I could express my negative market disposition via PMs. My position was quickly validated with a violent post-QE3 announcement rally, and I continued to hold upon the belief open-ended QE would be hugely bullish for the metals. However, not two weeks after the QE3 announcement PMs began the months-long slide they continue fighting today. Not long after the decline began I determined that I had no real insight into trading precious metals, and exited the position – if only I had maintained this mindset…

As 2013 began with a strong equity market rally, signs began to emerge that the year was shaping up similarly to 2011 – the Fed began discussing “tapering”, commodities were declining along with Treasury yields, and stocks began to wobble. I thought, aah this is perfect – long bonds and short stocks was the trade for 2011…I was correct then, so why not put the same trade on now. Goodness, it’s painful actually writing this down. It’s embarrassing how long it took me to learn that I HAVE NO IDEA HOW TO TRADE MACRO INSTRUMENTS. The insanity continued in the middle of 2013 as I loaded up on beaten-down gold mining stocks via the GDX ETF. I nearly caught the exact short-term bottom for the GDX, as it climbed rapidly in the low $20s to almost $30 per share – again, my macro “skills” were validated and I continued to hold on the belief stocks had nowhere to go but down and previous metals nowhere to go but up. We all know how that turned out…

My inner macro investor officially died in 2013 – may he rest in hell.

Shorting. This was a relatively quick and easy lesson learned. I have never really had an affinity for shorting, but I have dabbled enough to know it is outside my skill set. 1) I tend to add aggressively to high-conviction positions when they go against me, a trait that does not lend itself to short position management. 2) I cannot stand small position sizes, so I find it more of an annoyance than anything if I were to have fifty 2% short positions. 3) If I am shorting primarily to manage my net exposure to market risk, I would rather just short the market directly; otherwise, I’m just making a company-specific bet on a stock going down, which has far less upside and far more factors working against than just general long positions. Yes, in a market downturn low quality issues will get creamed – but trying to short low quality through the mid-90s, for example, likely did not work out all that well. My uneducated guess is that shorting low quality names over a full market cycle does not beat even a merger arb strategy through the cycle.

Options. I hate options. I hate them with a burning passion. They do not fit my mind’s eye. They eat up margin. You can’t average down. They requiring timing your position, which I hate. And like they say about short sellers, I don’t see many options traders floating around on yachts and/or running multi-billion dollar portfolios.

Deep Value. If the two primary doctrines of the Value Investment religion are “Deep Value” and “Wonderful Businesses”, I tend to fall in the more “reformed” latter category. Two key Buffett principles I keep in mind: 1) time is the friend of the wonderful business, the enemy of the poor, and 2) declining businesses are worth less than you think. Faced with the choice of a wonderful business at 15 times earnings when its fair value is 20 times earnings (i.e. 75% of FV), or a dying business at 50% of book and 5 times declining earnings, I will choose the wonderful business all day long. Putting my “event” hat on though, often times the mediocre businesses are fertile ground for corporate action, allowing the last puff of the cigar to be had in an expedited manner, which is critical in adhering to Buffett’s “time is the enemy of the poor business” principle.

I would like to emphasize that the Deep Value doctrine is nothing to scoff at – far from it actually. I follow certain investors that are absolute geniuses at buying beaten down 52-week low list names – they have stunning ability to mentally handle the stock price of a crappy business decline 25 to 50% while adding all the way down. And that’s what it takes too investing in those names – quite often the big money on deep value names is made by averaging down aggressively, since there is large risk of a “take-under”. Take Dell for example. Southeastern Asset Management had a cost basis in the high teens if not the low twenties, and the company ended up going private below $14. SAM lost out, but I know some deep value guys who were buying aggressively as the stock price dipped below $10, thus a $13+ take-out price worked out well for them.

For me, it comes down to the psychology of investing in deep value names – I mentally have a difficult time averaging down on a business that is in decline or at best in rough shape. When a wonderful business like Nike sells off to an attractive level due to a poor gross margin quarter, I will buy hand over fist no questions asked (which I did in early 2011 – of course I sold far too early…). But when a name like Supervalu – a seemingly “cheap” stock but with a huge competitive headwind – declines 25%, more than likely it’s not due to Mr. Market’s foul mood, but rather Mr. Market’s appropriate assessment of SVU’s terrible long-run business prospects. However, once private equity firm Cerberus recapitalized SVU at a $3.30 stock price (down over 50% from when SVU looked “cheap”), SVU turned into an interesting event-driven situation (unfortunately I was involved at $7, got out at about break-even, then passed at $3.30 when Cerberus bought in…).

INSIDE THE CIRCLE

Drawdowns. For whatever reason, I have a bizarre, almost masochistic, ability to mentally weather drawdowns. I almost prefer to see something decline so that I can buy more versus watch it go up and wrestle with when to sell. Also, I find it to be a competitive rush to challenge Mr. Market as he sends a stock and/or the portfolio spiraling downward.

My first major drawdown came right off the bat when I began investing in December 2008. I was heavily invested in Harley Davidson (HOG) and American Express (AXP), which drove my portfolio down nearly 40% by the March 2009 low. Though I mentally handled this decline, ironically it helped fuel my desire to hedge market risk so that I would be in better position next time the market declined to load up on cheap stocks. As I have detailed in previous posts, my desire to hedge the market ultimately taught me Peter Lynch’s lesson that “more money is lost waiting for a decline than is lost in the actual decline.”

The second major battle with Mr. Market came in mid-2011 with my investment in Clearwire Corporation (CLWR) (now owned by Sprint). I began buying at around $4 in early 2011 with the thought that the spectrum-constrained US telecom industry would ultimately be forced to buy CLWR spectrum. While my thesis eventually played out with Sprint buying CLWR out for $5 per share (though far lower than my estimated $10 fair value…), the road to the buyout was anything but smooth. Soon after I purchased my initial stake, the stock declined to the low $3’s. I continued to average down, but ultimately got to a position size far too large to sleep comfortably at night. If memory serves me, I believe I sold out at around $3.30 after the stock popped on a rumor it would collaborate with China Mobile. I felt more than justified getting out of the stock at that price as the stock went on to make two separate trips to penny-stock land. Where I went wrong was not getting back into the stock when it was rumored that DISH wanted to buy it. While buying on rumor is typically not a profitable strategy, this was a company I knew well and it was being pursued by two companies (Dish and Sprint). The stock price itself began to behave very strongly around $2 and climbed steadily to the $3 range that DISH initially offered. I knew Sprint needed the asset and would not just let it go for $3. It was a wide open slam dunk that I simply threw out of bounds. The CLWR situation taught me to A) not buy deep value, asset-based names without a catalyst, and B) better manage position sizing with volatile names in order to leave room to average down.

Concentration. I have never understood the “comfort” associated with diversification. Whether you have ten 1% positions that decline 20% or one 10% position that declines 20%, your portfolio is still down 2%. My comfort in a position comes from the quality of the operation, the valuation and any associated catalyst. I see no need for excessive diversification unless one is investing in a broad range of “deep value” names with material risk of permanent impairment. If you study the returns achieved over time by great investors, they are achieved primarily through large positions in high conviction bets. As Buffett/Munger have repeated ad nauseum, the majority of Berkshire’s intrinsic value is made up of several key decisions made throughout the life of the Company – Geico, Coke, Wells Fargo, to name a few. Over the past 5.5 years, I have demonstrated to myself that I have the mental ability to handle a concentrated portfolio, which I believe will aid in my quest to beat the market over time.

Leverage. Leverage, in all its forms, is absolutely vital for getting ahead in life. Buffett and Munger both used monetary leverage in their hedge fund days, and at Berkshire – while they largely shun the debt form of leverage – they have built up a massive source of zero-cost leverage in the form of insurance float. Buffett utilized client capital to leverage his investment prowess into a rapid accumulation of performance fees, while Munger teaches that one should leverage history so not to repeat the mistakes of times past. Munger also encourages piggy-backing on others’ ideas in order to leverage groundwork already laid.

I use monetary leverage not to goose returns, but rather to provide diversification while maintaining concentrated positions sizes – in other words, I will not lever up a five position portfolio 2x, but rather add five additional positions for 2x total leverage. Obviously Mr. Market can ravage a levered portfolio, thus my “Market Mosaic” is absolutely vital in determining when a levered portfolio is appropriate. For example, though my “Market Model” went to a BUY signal in October 2008, the declining economy, tight monetary conditions, declining 200dma and the market below the 200dma would have kept the portfolio not even fully invested. I believe my ability to handle drawdowns and a concentrated portfolio go hand in hand with my ability to handle monetary leverage.

While it is highly dangerous to buy a stock merely because a “guru” bought it, I strongly believe that folding others’ research into your own investment mosaic is an extremely effective way to achieve scale economics with your investment process. In a nutshell, I like to leverage the work of others in order to take the extreme negative case off the table. For example, with a situation such as MBIA (MBI) that had (up until 2013) a legal component attached to it, I simply did not have the resources to conduct due diligence on the likely outcome of the various court cases, thus I relied upon the work of Bruce Berkowitz, who had hired various legal experts to analyze MBI’s chances of winning its various put-back cases. It was easy to conclude that MBI was extremely cheap on a price/book value basis, but the legal expertise provided by Berkowitz’ team acted as the margin of safety, ensuring that the book value was achievable (MBI had put-back receivables on its balance sheet that if unrealized would have rendered the stock expensive).

In today’s day and age of social media, investment blogs and seemingly monthly investment conferences, there is an untold amount of deep research out there available for the taking. It is my job to determine what research is credible and fits into my natural mental models and investment mosaic. While some may view the investment landscape as too efficient to outperform due to the extreme amount of publicity surrounding all of the top investment ideas, my view is that the more folks you get looking at a particular stock the more likely you are to find group think in both directions. Take AAPL for example – likely the most followed stock on the planet, yet it declined from $700 in mid-2012 to below $400 in 2013, and is now back up to around a split-adjusted $700.

Events. I consider my core expertise to be analyzing event-driven investments. Take Hess Corp (HES) for example – it bottomed in mid-2012 in the low $40’s, languishing as a low-FCF, asset-rich firm with an empire-building management team. While the stock was optically cheap on a NAV basis, with poor management and little in the way of cash returns, I deemed it to be not as cheap as it looked with the potential for it to be “dead money” for an extended period of time. The stock began to recover as management began to get the hint it needed to slim down its operations, and in early 2013 the hedge fund Elliot Management took a large stake in HES, declaring it severely undervalued with a price target upwards of $150. With management actively looking to break up the company and a large investor on the board overseeing the break-up, I established a position in the high-$60s. While some may view this as merely following an activist, I view the activist’s involvement in this situation as a catalyst in that they would keep management on track. There are many activist involved in many different situations that I don’t even think twice about avoiding. For instance, Value Act’s involvement with MSFT and Relational’s involvement with HPQ presented no clear catalyst, in my opinion.

Sara Lee’s break-up/special dividend announcement in early 2011 is another example of the quintessential investment opportunity I look for. No activist was involved whatsoever at the time I established a position – in fact, Third Point revealed in its letter following the announcement that it had taken a stake.

Flexibility. One of my favorite un-cited quotes is that the hallmark of a great investor is having loosely-held strong opinions. I am a voracious consumer of information, and am not at all afraid to change my opinion when the facts change. I was a huge market bear going into mid-2013, but when David Tepper gave his “My Cousin Vinny” interview on CNBC, I began to reconsider my position. Treasury yields and commodities had been falling, indicating a deflationary environment, yet Tepper was on CNBC pounding the table on that fact that the economy was on the verge of a veritable explosion of greatness. I had to reconsider how we could have a large equity bear market with the economy getting better. While I was a slow learner, I eventually developed the “Market Mosaic”, which is probably the best example of my mental flexibility.

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