Mar 23, 2014

Weak Shorts, Weak Longs – My Mistakes of 2013

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Preface

“I like people admitting they were complete stupid horses’ asses. I know I’ll perform better if I rub my nose in my mistakes. This is a wonderful trick to learn.” – Charlie Munger

A lot of things went right in 2013. My portfolio handily beat the S&P’s stellar performance. But I don’t want to focus on that. This post is about the mistakes I made, and the lessons I’ve tried to learn. For those who don’t want to read the whole post, I’ve summarized the take always below:

1. Be careful not to let an edge turn into an ego trip. ONLY take a position when you have an edge.

2. Learn to do nothing. Never be afraid to walk away from an investment. As WB puts it, wait for the fat pitch!

3. Once you get what you were looking for from a catalyst, cover your ass!

4. Short selling is very hard.  Be very picky and never bet too much.

Meta Analysis Disclaimer

There is a lot of noise in any given year or even years investing results, so much so that even with the benefit of hindsight it can be difficult to say what was a mistake and what was correct. Acknowledging that, let’s just say I’m going to go over mistakes that fall into the known mistakes category, and ignore the unknown mistakes category – and even more troubling – I’ll ignore the possibility of these trades I label mistakes actually were correct ex-ante.

Debt Ceiling – Distinguishing Edge From Ego

This first mistake is a very clear example of how to behave when you have an edge and how not to behave when you don’t. When the S&P sold off in the fall of 2013 due to concerns about the government’s ability to pass the debt ceiling, (again) I was closely monitoring the situation. At one point it was 11pm EST and news stories began to appear on Twitter and the Wall St. Journal stating that the house was very close to reaching some sort of compromise. One look at the level of S&P futures told me that the market either hadn’t incorporated the information or chose to disbelieve it. Though I believed in congress’ ineptitude, the deadline for a deal was fast approaching and I judged it likely that there was some truth to the news reports. Realizing that a breaking story happening outside of regular trading hours actually offered a small investor such as myself an advantage, I felt I had enough of an edge to merit backing up the proverbial truck, and so I did. I bought as many S&P mini-futures as a safely could. Over the course of the next day the market rallied nearly 20 points and I made profits worth about 20% of my equity.

This entire rally happened on the back of no concrete deal. Merely the hint that something was close to being agreed upon. Now this is where I made my big mistake. Somehow, someway I got it into my head that this yet to be seen agreement would disintegrate due to the usual partisan squabbles. Now it’s one thing to conjecture something, but it’s another to make trade out of it. Honestly, and embarrassingly, I think that instead of attributing the money I had just made to a well timed play on shaky information, I started to believe that I was George Soros re-incarnate. So of course, I gave back all the money I had just made when the market continued to rally and I was stopped out.

What I’m trying to take away from this mistake is how easily edge can lead to ego and how dangerous that is. George Soros says the market is always wrong but that he’s always fallible too. To me those two statements are like an equation that has to balanced because if it doesn’t you wont be in the game for long. Taking a big position when you believe you have an edge is justified so long as the security is liquid and you can cap your downside. Taking a big position when you have no edge is just a road to ruin. In short, I need to be careful that I don’t let luck or even a brief edge creep into ego. Hopefully getting burned once will be enough.

HLF – Weak Shorts, Weak Longs

“ Cause it’s so hard to do and so easy to say, but sometimes, sometimes you just have to walk away.” – Ben Harper

Herbalife, oh herbalife, how many hours have fallen by thy name? They should use this stock as a case study at Harvard business school because I think everyone involved is crazy, myself included. I became interested in this stock like everyone else because of the controversy surrounding it. So I took the time to watch Mr. Ackmann’s presentations, read long and short opinions on the interweb, and looked at the financials. Net, net I came to the erroneous conclusions that it made sense to be short the stock going into the end of the year, and the firm’s audit report deadline. I lost money shorting the stock because of horrible position management. That said, I believe there is a broader lesson to be drawn from Herbalife, a lesson that is more about choosing the proverbial table you play at then how a given hand goes while your there.

I said I was intrigued by the controversy surrounding the stock, and what I’ve come to conclude is that the controversy was legitimate. The longs were vulnerable to the possibility of the marketing schemes collapse and increased government regulation (of whatever form), and the shorts were vulnerable to continuing profitability and squeeze pressure from both opportunistic investors and the company. The shorts also lacked both proof of fraud and a precedent of real government intervention. Of course anything can be an attractive at the right price but HLF was (hardly) ever there.

Herbalife is a case of weak shorts and weak longs. Everyone, both sides, are choosing to play a hard game, when the reality is I don’t have to. I think making things harder than they have to be is probably one more the most pervasive errors in investing. We, me, people, spend a lot of time, do a lot of research and as a result feel like we need to have a conclusion to show for it. So we make wagers that we don’t have to because we feel like we deserve to have an opinion based on all the work we’ve done.

People talk a lot about being unemotional about investments but not nearly as much about remaining unemotional about our investment candidates. Likewise, people often say investing is hard, but sometimes it’s the not investing that’s difficult. Stepping away from something you’ve put your time and energy into is hard. There is a huge psychological barrier against it.  To combat this tendency I’m going to start making a list of all the things I’ve learned while researching the stock. Then I’m going to look at that list and say to myself, even if I don’t invest now, these are all the new things I know that can help me with future investments. That way I’ll be able to feel like I haven’t wasted my time, and more importantly, stop myself from wasting my money.

JCP – Know Your Business

JC Penny was a situation where I didn’t understand the business well enough. My thesis was that with Ron Johnson out and Mike Ullman in, the company had enough cash and assets to get it through the turn around 2.0 without diluting current equity holders.  I believed I had done my research, I read financial statements, created an elaborate financial model of the capital structure and checked to see how others opinions compared with my own. I ended up being wrong about the capital structure, and the company had to raise equity because their business (suppliers) demanded it. This mistake was a result of not sufficiently understanding the stock and/or business. It was a small comfort to see that Kyle Bass and Hayman Capital were in the same boat I was. Sometimes even smart people with better access to experts get things wrong.

MUSA  – Using Leverage With Catalysts

“Bulls and Bears make money, but Pigs get slaughtered.” – Anonymous

“Experience is what you get when you didn’t get what you wanted.”  – Howard Marks

MUSA which has been previously profiled on this site was a recent spinoff trading at a significant discount to its peers. In addition, it had ethanol assets worth more than their carrying value that it was going to dispose of, and windfall income from the sale of RIN credits. My thesis was that the first earnings call would bring the Wall St’s attention and lead to the stock trading higher. Since I thought knew the timing of an event which would be the catalyst for a higher valuation, I decided to use options to increase my leverage. Lo and behold the stock did climb nearly ~20% to $45 in the run-up to and following the first earnings release. And of course, instead of congratulating myself on the windfall I had just made I decided to try and avoid paying taxes in 2013, and see if the stock could get to my price target of $51 per share. Now I did sell some options but not nearly enough and soon after J.P. Morgan put a price target of $45 on the stock, and a slight sell-off crushed the stock back down to ~40 per share turning my formerly spectacular profit into an abysmal loss.

I may have been wrong to buy those options in the first place. Spinoffs can take a long time to develop a following. Joel Greenblatt says you should give the market 2-3 years to correct a mis-pricing.  Assuming I was correct to have the position in the first place, I should have sold much more of it as we moved away from the “catalyst event” in question. Another lesson I’ve learned is that while options are great when they work for you, when you own illiquid options in a stock you believe in it is extremely painful to start caring about daily price fluctuations.

So two take always; one, only use options (or lots of leverage) when you are sure about a catalyst event, and two, once that catalysts delivers the juice you were hoping for, start selling down the position, cover your ass – don’t wait.

 The Wages of Sin – Pandora, Tesla, TTS, Et al.

“We don’t short stocks because we don’t like trading misery for money.” – Charlie Munger

2013 taught me that shorting stocks is very hard.  I think the most important lesson was to never short a company whose product you would actually use or want. I don’t care how overvalued, unless there is fraud, it’s probably not going to be a strong short. Whatever your conditions for being long a stock they should be doubly stringent for going short, and the position size greatly reduced because of the negative convexity shorts exhibit.

Timing is another important element of short selling that I can improve upon. As a small investor, it is fairly easy for me to get in and out of positions, and because shorting is so difficult (especially in a bull market), I think it would be wise to use that to my advantage.  This goes especially for weaker shorts where I believe I’ve identified a catalyst/trigger event. Using technical factors to try and position oneself into an event could very much help limit losses associated with a rising market or single name. Of course if the stock were pure scum with no discernable trigger you probably don’t want to play games jobbing around the position. But with more “event driven” short opportunities, I think this kind of positioning game could help performance. On the other hand, I’m sure it would also be a lot of work to implement.

In Sum

All in all, 2013 was a great year, and I can’t complain but I can try to improve.

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Aug 5, 2013

J.C. Penny – Don’t Call it a Comeback!

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Introduction What follows is a short pros and cons breakout of my thinking about J.C. Penny (JCP). Normally, I would focus more on price and value, however due to the more or less binary nature of the situation, I think this form of consideration is actually more relevant (at least for the equity). A warning, […]

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