~ Oliver Cromwell, to the General Assembly of Kirk
It’s interesting when traders (and investors) blow up. Sometimes you can see it coming, based on telltale actions or statements.
For instance, I remember reading Vic Niederhoffer’s “Education of a Speculator” in the mid-1990s and telling multiple friends and colleagues: “This guy is definitely going to blow up.”
In various spots, Niederhoffer bragged about his near-death experiences — wearing them as a weird badge of pride — including a story in which George Soros tells him point blank: “Get out… You’re in over your head!”
Soros was right. Niederhoffer’s bragged about almost-blow-ups later became actual blow-ups – more than one, for more than one trading fund – in a multi-year sweep of self-fulfilling prophecy. (A habit of selling naked option premium played a role too.)
Another well-telegraphed example is Bill Miller of the Legg Mason funds. At one point Miller was a mutual fund superstar, famous for having beaten the S&P 15 years in a row. His reputation was built on long side contrarianism — taking positions at odds with the general consensus.
But Miller was also terminally arrogant. He considered himself a student of poker, latticework, and multidisciplinary study — and was even a supporter of the Santa Fe Institute — yet proceeded to completely ignore every risk control lesson these pursuits had to offer.
When convinced he was right, the chance of being wrong never crossed Miller’s mind. On being asked how long he would keep adding to a position going against him, the reply was: “Until there is no longer a price quote.”
You can’t invent that kind of hubris… which helps explain why Miller loaded his funds with black-box financial positions, then plunged headlong into the abyss.
And then, of course, you have the Long Term Capital Management guys. As the old joke goes, LTCM had not one, but TWO Nobel laureates. With one they might have had a chance… with two they were doomed from the start.
Smart traders and investors take a keen interest in blow-ups for a simple reason: They don’t want to blow up themselves.
Witnessing and dissecting other blow-ups, then, is akin to careful drivers analyzing a fatal car accident. The question is, “Could that have been me in some unforeseen circumstance? What could I have done differently to ensure my survival?”
In trading and investing, excellent risk control requires walking a fine line between confidence and paranoia.
On the one hand, you take confidence in knowing that you never flirt with blow-up risk, ever… and that your risk-mitigating processes and protocols are so strong you never touch the borderline.
On the other hand, you never want to become so confident as to think “that can’t happen to me no matter what”… because a sense of permanent vigilance is one of the things that guarantees survival in the first place.
If you lose that sense of vigilance – a sort of healthy paranoia of the Andy Grove variety – it can be problematic.
This discussion comes about in relation to the Herbalife spectacle. In case you haven’t been following it, Herbalife (HLF) is a publically traded multi-level-marketing company with a slightly dodgy business model.
As a business, HLF is cash-rich. The questions revolve around whether Herbalife actually makes money from its products, or merely milks its “distributors” – i.e. get new recruits to buy product, find more recruits ad infinitum – which would make the company a pyramid scheme.
Bill Ackman, an extremely high profile hedge fund manager, publically announced a massive Herbalife short in December.
In essence Ackman declared himself “all in” – shorting more than a billion dollars worth of shares – and pounded the table for the company as a “zero” (in the assumption the SEC would take Ackman’s side, though Herbalife has been around since 1980, and shut the company down).
Herbalife shares plummeted on Ackman’s high profile presentation – a full on media event – then later reversed as other hedgies pushed back.
Robert Chapman, of Chapman Capital, put out an extensive piece titled “Herbalife: Why I Made It a 35% Position After the Bill Ackman Bear Raid.” And Dan Loeb of Third Point Advisors, another hedge fund heavyweight, announced an 8% longside stake.
Here are some background articles for the timeline:
- Ackman Outlines Bet Against Herbalife (Dealbook Dec 20th)
- Ackman isn’t just short Herbalife – He IS the short (Barron’s Dec 21st)
- Herbalife: Why I Made It a 35% Position (Chapman Capital Jan 1st)
- Activist Investor Dan Loeb takes 8% Stake in Herbalife (CNBC Jan 9th)
(Full disclosure: We took a small long-side trading position in HLF this week.)
Some of the best work on the Herbalife story has been done by John Hempton of Bronte Capital (who took a long HLF position shortly after the Ackman news).
In a piece titled “Notes on visiting an Herbalife nutrition club in Queens,” Hempton comes to this devastating conclusion:
Herbalife is a company which combines a lot of good (think the life-saved diabetic above) with some pretty ugly features.
But this is not really a story about Herbalife - Herbalife will survive globally. Like all multi-level marketing schemes it will have its ups and downs. There will be all sorts of problems (such as tax compliance throughout the scheme, cash handling, perhaps even using Herbalife accounts to launder money).
What this has (deservedly) become is the story about how Bill Ackman can be so wrong. He spent (by his own admission) a year and a half analysing this company and his thesis can be falsified by visiting a few clubs in his home city. Bill Ackman’s thesis is the most easily falsified bear-thesis I have seen from a major hedge fund ever.
You have to wonder how this happened. So I am going to tell you:
Bill Ackman a Harvard educated (magna cum laude) billionaire New York hedge fund manager bet over a billion dollars on a short position (imperilling his fund and his reputation) without checking the facts.
And he did not check the facts because he was so rigid with a misplaced silver spoon that he could not stoop to sit on a subway for thirty minutes and talk with poor people for ninety minutes.
Let’s take a minute to discuss the mechanics of short selling here.
Many investors are afraid to sell short, pointing to the potential for unlimited capital loss. In most cases this fear is overblown and a canard, because it is just as likely for stocks to fall sharply as rise sharply – think “accounting scandal” as the flipside of “corporate buyout” – and it is possible to manage one’s shorts with a high degree of risk control. (Those same investors who “fear” going short often show little fear of getting hurt by oversized long positions with no risk point.)
To sell short responsibly, one can do things like 1) make sure your position is small relative to total assets; 2) make sure your position is small relative to share float; 3) make sure to use stop losses and only short liquid names; or even 4) use options to define your risk of loss 100%.
Ackman, however, did none of these things.
Instead he eagerly made himself the poster-boy of short seller blow-up risk:
- He took a huge position relative to his $10B fund (more than a billion dollars’ worth)
- He took a huge position relative to the stock float (roughly 20% of HLF shares)
- He made it impossible to employ a stop loss (far too big and public a holding)
- He basically dared the world to squeeze him (which may now happen)
Yours truly was a wet-behind-the-ears commodity broker in 1998. Some early market memories thus formed around the Long Term Capital Management (LTCM) unraveling.
One wild aspect of that LTCM unwind was the bottle-rocket price action in the Japanese yen.
Basically, all of Wall Street knew LTCM was massively short yen… and all of Wall Street also knew LTCM would have to unwind those yen positions (buy them back) at any cost. The result was a bloodbath (for trapped yen shorts) as USDJPY went vertical, in a moonshot reminiscent of the energizer bunny — it just kept going, and going, and going…
Time will tell, but the same thing could happen to Ackman with Herbalife.
If the Chapman / Loeb base case is correct, a reassessment of HLF fundamentals, combined with the potential for HLF share buybacks and knowledge that a great white whale (Ackman) is vulnerable, could lead to a historical recounting of Colonel Vanderbilt’s merciless squeeze of Daniel Drew, complete with the phrase: “He who sells what isn’t his’n / Must buy it back or go to pris’n.”
It’s fascinating, really.
Why would any super-successful money manager (or businessperson of any kind) willingly put their neck in a noose? Messiah complex? Compulsive need for attention? Megalomania? As with Niederhoffer and Miller, the warning signs went back a long way (years and years)…
Ackman is a billionaire, with a track record of great success. Now he is risking it all on a reverse asymmetric bet. If he wins, he gets another boost to his ego. If he loses, potentially everything he has built goes up in flames.
In a recent review of “Antifragile,” we discussed the importance of optionality – finding situations that offer large upside with limited and defined downside.
One can build a career, and a life, from basic optionality principles. With Herbalife Ackman managed to do the EXACT OPPOSITE… taking the mother of all “concave” positions (limited upside, non-trivial potential for absolute disaster) for reasons that are hard to fathom.
So what are some lessons from the Herbalife spectacle – useful takeaways regardless of how things play out?
Here are a couple:
BE WARY OF ARROGANCE.
This should go without saying, but in hiring managers to run their money, investors fail to heed the basic lesson over and over again. When seeking a financial professional, you want confidence born of excellence and an ability to do the job. But confidence and arrogance are not the same thing.
Guys who are so arrogant they act as if they can walk on water (ahem, Ackman, cough) are prime candidates for blow-up risk, because their supreme smugness eventually gets the best of them (or fuels the situation that invites disaster in the first place).
For examples of confidence with humility (rather than arrogance), keep reading…
PUT PROCESS OVER OUTCOME.
The enduring lesson of LTCM is that understanding process is every bit as important, if not far more important, than pure track record.
This is because bad habits, hidden hubris, and gross deficiencies of risk control can lay in wait for years before blowing up in investors’ faces.
Worse still, a bad process – rife with hubris – can contribute to the illusion of reliable profitability in the first place, before the fullness of time calls forth catastrophe.
DON’T PICK GNAT SHIT OUT OF PEPPER.
Never has the expression felt more appropriate. As Hempton points out, Ackman spent more than a year and a half researching the Herbalife short thesis (by his own admission), and yet missed major disconfirming factors right under his nose.
The clear lesson here is that knowledge, especially fundamental knowledge of a trade or investment, has absolute limits. You can never get all the puzzle pieces — and even if you could, there’s no guarantee you will weigh all the variables correctly (one might dominate the others), or anticipate the X factor that derails your thesis.
As we wrote of Ackman on a message board last year (well before Herbalife unfolded):
That kind of granular activity makes sense for, say, private equity, where you are actually diving into the guts of a company, restructuring it and rebuilding it from the inside out — or for distressed debt investing, where the visibility is seriously opaque and it takes real forensics to get a true sense of risk levels — but from the stock-picking perspective as to which investment valuations will rise or fall, it’s the racehorse handicapper fallacy writ large: The false idea that if 10 variables are helpful, 60 variables are even better etc — or in Ackman’s case 600 variables. If he were a handicapper he would be sticking a periscope up the horse’s ass and taking bacterial cultures, then writing a 10,000 word thesis on the petri dish findings... For all his digging, Ackman is congenitally optimistic, to a potentially dangerous degree, and has happily admitted as much. Overkill on the micro side does not cancel out disregard of the macro side, though many seem to think it does, mainly because it can take a long time to see who’s swimming naked.
EMPHASIZE RISK CONTROL, MISTAKES, AND SURVIVAL.
Paul Tudor Jones: “…at the end of the day, the most important thing is how good you are at risk control. Ninety percent of any great trader is going to be the risk control.”
Michael Steinhardt: “One of the advantages of trading the way I do — being a long-term investor, short-term trader, individual stock selector, market timer, sector analyst — is that I have made so many decisions and mistakes that it has made me wise beyond my years as an investor.”
Ray Dalio: “Anyone who has been involved in the markets knows that you can never be absolutely confident. There is never a trade that you know you are right on. If you approach trading that way, then you will always be looking at where you mght be wrong. You don’t have a false confidence. You value what you don’t know.”
And last but not least, Howard Marks: “Sun Tzu said if you sit by the river long enough, you’ll see the bodies of your enemies float by. The key is “long enough.” If you live long enough, you have to be the survivor… if you look at distressed debt where we started in 1988, I could tell you who our number one competitor was in every year through 1995 and not one is a main competitor today. And it’s not because of what we did; all we did is perform consistently. They crapped out. It sounds simplistic to say, but the first requirement for success is survival…”
There’s a reason those guys are all legends…