The more hard lessons you can learn vicariously rather than through your own hard experience, the better.
– Charlie Munger
I recently came across this Forbes article [The 34-Year-Old Hedge Fund Manager Who Bet Everything On A Stock That Tanked] discussing about a doomed hedge fund due to heavy concentrated bets. In short, the fund invested over 85% of AUM in a single name, Walter Investment Management [WAC], and the stock suffered a 95% slump since its investment in 2015. Per this fund’s SEC 13F filing, WAC seems to be the only US long position it holds currently. Given the significant size and the drastic drop of stock price, regardless other non-US longs or other shorts, the WAC position will possibly wipe the whole fund out.
Out of curiosity, I further researched Baker Street and its founder Vadim Perelman. It appears that Perelman is a strict value investor, following legendary investors like Warren Buffett, Howard Marks & Seth Klarman’s doctrines closely. Before the WAC position, Baker Street had also played a concentrated bet on Sears Holdings (SHLD). More detailed info can be found on this Barron’s article.
Some resources and interesting reads:
- Baker Street Capital’s investor presentation
- Sears Holdings pitch
- Walter Investment Management pitch
- Activist letter to Swift Entergy [SFY]
- April’s Fool joke activist letter to Berkshire Hathaway
Based on these writings, Perelman certainly appears as a talented and diligent investor (also with sense of humor for the sake of the Berkshire joke). However Buffett would hardly approve his approach as intelligent investing (remember the oracle of Omaha’s 2 rules: Rule No. 1 is never lose money. Rule No. 2 is never forget Rule No. 1.) This drives me to think what went wrong to lead a talented value minded investor to such a flunk.
Trying to put myself in Perelman’s shoes, here are my further thoughts and some lessons I learned from this case study:
- In The Game: The most important thing for any person who wants to build a life-long career in investing is to keep remembering: you have to be in the game. No matter how much conviction you have on a single idea, you have to size your position appropriately so that even you suffer maximum loss expected (or worse, unexpected), you still are “in the game”, and can take the loss and move on. On the other hand, if you are called out by blowing up your fund, it is a permanent damage to your reputation. This is very different than Silicon Valley (Perelman graduated from UC Berkeley, according to his LinkedIn profile, atmosphere from where may or may not affect his mindset), where you can still start over freshly even with series of start-up failures. The reason is because the society will benefit from, thus will encourage more tries of inherently risky innovation which could create significant value if only small portion of them succeeds. On capital stewardship however, one failure (I mean on fund level, not position level) is a strikeout just as you won’t trust the bank who couldn’t keep your safe deposit box safe for only once. Think it differently, an investor will inevitably be wrong on individual ideas, but you don’t want the mistake on one idea to ruin your whole career. Even though some might be able to start over with new funds, it would extremely hard for them to raise assets to their previous level. John Meriwether (of LTCM) is a good example.
- Concentration vs. Diversification: Many value investing greats have emphasized the importance of taking concentrated bets. However, “concentration” is a subjective term and obviously different people could have different interpretation of it. We can probably safely call a 200+ name portfolio “diversified”, but how many names exactly would constitute a “concentrated” portfolio? I typically hear two types of answers from institutional managers. One is 30-40 names and the other is 10-15 names. It all depends on the shop’s capacity, specifically the capacity to follow all the positions closely and to generate new ideas with in their circle of competence. Thus, typically the 30-40 names shop would have 1-3 PMs and 1 or two analysts supporting each PM (e.g. Seth Klarman); and the 10-15 names shop usually is a single PM structure with a few or sometimes no analyst/s (e.g. Bill Ackman, Monish Pabrai, & Michael Burry). However, concentrated in a single business, like Baker Street did, is never heard of in value investing world (Buffet’s personal holding of Berkshire Hathaway doesn’t count here because that’s a holding company of many underlying businesses), as the adverse outcome, even with remotest possibility (which is still larger than 0), could significantly impact the survivorship of the fund. It is simply not prudent if it’s managing money on behalf of clients. For individual value investors like me, I would suggest the best range of positions would be 10-15 given individual’s limited capacity and going further down from 10 may not work for the best (until you read my next point).
- Sit-on-Your-Ass business VS. Turnaround business: Being said in my last point, I’m also aware of a few gurus achieved incredible performances, albeit are exceptions to the 10-15 positions rules. For example, Charlie Munger publicly disclosed he held 1/3 of his liquid wealth in a single company Costco [According to his statement from recent Daily Journal annual meeting], to which he also serves as an independent director. And we also have Norbert Lou, manager of Punch Card Capital, who typically heavily holds only 2 to 3 names (US names only since 13F requires only US listed securities to be reported). According to the most recent 13F filing [Link here], currently Lou holds 1/3 (this is the position size divided by the total reported regulatory assets in latest ADV form, thus is in percent of both US and non-disclosed foreign holdings, same below) of portfolio in Berkshire Hathaway [BRK.A] and another 1/3 in Baidu [BIDU], then about 12% in Wells Fargo warrants [WFC-W]. Historically, Lou used to hold over 60% in Berkshire Hathaway. So what these two legends did differently than Baker Street? My take is that the nature of the business is totally different. Using Munger’s own term, I would call likes of Costco [COST], Berkshire Hathaway [BRK.A] and Baidu [BIDU] “Sit-on-Your-Ass” business, because they are proven great business with probably the widest moats. While, Sears [SHLD] & Walter IM [WAC] are in-trouble businesses, which the managers hope to turn around. If you think about the probability of the downside, in-trouble businesses generally have much higher probability of permanent capital loss than the “Sit-on-Your Ass” ones. One could argue “Sit-on-Your Ass” business still carries risk of permanent capital loss even though it is extremely small (think holders of Kodak in 80s). That is true, the point however is that for great businesses to deteriorate, it take time, thus the investor would have sufficient time to rethink the business competitiveness and react to changes. Unfortunately, the deterioration for in-trouble companies would be much faster, sometimes even overnight, usually leading not enough time to react at all.
To sum up, the valuable take-away for me is: a) size my positions appropriately to make sure I stay in the game even with the worst outcome, b) bet heavily however no less than 10 ideas and c) if you really want to bet so heavily (more than 10% of the portfolio), better to bet on the Sit-on-Your-Ass businesses.