Forgetting your mistakes is a terrible error if you are trying to improve your cognition. – Charlie Munger
The last five months have been rough on Whitney Tilson and Glenn Tongue of T2 Partners. Two of their biggest longs, Microsoft (MSFT) and Berkshire Hathaway (BRK.A), have failed to stay in line with the recent run up by the S&P 500 (long both, so I’ve watched in amazement as well). On the flip side, their short book has continued to take a beating, with St. Joe’s (JOE) and Netflix (NFLX) rising 25.4% and 21.8%, respectively over the past month. Combined, these factors have led to a decline of 4.3% for the fund over the past 5 months, compared to a 23.5% gain in the S&P 500 over the same period.
For investors in their fund, this is little more than a blip on the screen; Mr. Tilson and Mr. Tongue have beaten the benchmark index by more than 7% per annum over the past 12 years (annualized), and continue to have success with other opportunistic investments (such as BP, which based on an average entry of around $30/share has been good for more than a 50% return in 7 months). However, the recent struggles, especially with the short book, provide investors with an interesting case study of what went wrong; at times like these, it is important to stand back and learn from the struggles of well known value investors in order to avoid similar missteps in the future (if they can do it, I could easily too).
In T2 Partners January Letter, they discuss the short book in depth; here is what they had to say:
“From 2003 through 2007, our typical portfolio positioning was 80-100% long and roughly 20% short. In early 2008, when we became convinced that the housing market would collapse, we tripled our short book to around 60%, with an emphasis on highly leveraged housing, real estate, and financial companies that were most exposed to the subprime bubble. Needless to say, this worked out spectacularly well – so well, in fact, that we became accustomed to running a short book in the 50-70% range and – we’re embarrassed to admit – we pushed to the back of our minds two facts that have always been true: 1) shorting is a terrible business (as we highlighted in our book), and 2) we’re much better long investors than short investors. Said another way, long investing is a massively better business than shorting, plus our experience, skill set and temperament is much better suited to it. We will not forget this again.”
This point is well warranted, and is backed by the long run success of equity investments. When shorting, you are fighting against the long term upward trend, have a compounding issue when the trade moves against you, and pay the highest tax rate on your successes. These factors don’t say “don’t short”, but go along with T2’s point: keep it relatively small (unless it goes along with an extreme market valuation/bubble), and stick with companies that fit the short thesis; which brings us to the next point…
“Over time we’ve been quite successful shorting fads, frauds, promotions, declining businesses, and bad balance sheets. Where we have had much less success, however, especially in recent months, is shorting good businesses that are growing rapidly, even when their valuations appear extreme. Such open-ended situations, regardless of valuation, are very dangerous, so going forward we will avoid them entirely unless we have a high degree of conviction about a specific, near-term catalyst.”
The description in the second sentence is the epitome of the NFLX trade, which T2 has caught so much heat for (and lost a fair amount of money on). Their short thesis (here) still holds today, just like it did when they initiated it at under $100/share. Unfortunately, the valuation went to 40x, then 50x, then 60x, and now 70x; couple that with a great leader in Reed Hastings and a company that has continued to deliver good enough results for investors, and you are looking at a short position that has moved 242% in the wrong direction over the past year. The near term catalyst is closer today than it was 12-18 months ago, but is still fuzzy; on top of that, NFLX has spent that time building a stronger brand image, bundling with devices like XBOX 360, and strengthening mental connection to streaming movies in the minds of consumers.
Lululemon Athletica (LULU), another T2 short position, fits under this same description. The company makes yoga apparel for a niche audience, and is seeing increased competition from names like Nike (NKE), Adidas, and Under Armour (UA). Despite these headwinds (and a struggling consumer/economy might I add), LULU currently trades for 55x earnings; just to reiterate, that’s a company that made $58M in yearend January 31, 2010 and currently has a market cap in excess of $5 billion (after a 150% run up over the past 12 months). While this is crazy to a value investor (T2 included), nothing will change with the valuation until they miss and take a dive, which could be a ways out based on plenty of opportunities to build off such a small base. Both of these businesses fit the good business/growth description; and both have cost T2 a good amount of money.
In summary, be careful when making valuation shorts. Despite the illogical basis for many of the longs in these types of investments, that doesn’t necessarily mean to jump in as a short; without an identifiable near term catalyst (preferably those that fit within Jim Chanos’ four broad categories of short candidates: booms that go bust, especially when debt financed; technological obsolescence; bad accounting; consumer fads), it is probably best to avoid the situation for the time being. In the words of John Keynes, “The market can stay irrational longer than you can stay solvent”.
The last five months have been rough on Whitney Tilson and Glenn Tongue of T2 Partners. Two of their biggest longs, Microsoft (MSFT) and Berkshire Hathaway (BRK.A), have failed to stay in line with the recent run up by the S&P 500 (long both, so I’ve watched in amazement as well). On the flip side, their short book has continued to take a beating, with St. Joe’s (JOE) and Netflix (NFLX) rising 25.4% and 21.8%, respectively over the past month. Combined, these factors have led to a decline of 4.3% for the fund over the past 5 months, compared to a 23.5% gain in the S&P 500 over the same period.
For investors in their fund, this is little more than a blip on the screen; Mr. Tilson and Mr. Tongue have beaten the benchmark index by more than 7% per annum over the past 12 years (annualized), and continue to have success with other opportunistic investments (such as BP, which based on an average entry of around $30/share has been good for more than a 50% return in 7 months). However, the recent struggles, especially with the short book, provide investors with an interesting case study of what went wrong; at times like these, it is important to stand back and learn from the struggles of well known value investors in order to avoid similar missteps in the future (if they can do it, I could easily too).
In T2 Partners January Letter, they discuss the short book in depth; here is what they had to say:
“From 2003 through 2007, our typical portfolio positioning was 80-100% long and roughly 20% short. In early 2008, when we became convinced that the housing market would collapse, we tripled our short book to around 60%, with an emphasis on highly leveraged housing, real estate, and financial companies that were most exposed to the subprime bubble. Needless to say, this worked out spectacularly well – so well, in fact, that we became accustomed to running a short book in the 50-70% range and – we’re embarrassed to admit – we pushed to the back of our minds two facts that have always been true: 1) shorting is a terrible business (as we highlighted in our book), and 2) we’re much better long investors than short investors. Said another way, long investing is a massively better business than shorting, plus our experience, skill set and temperament is much better suited to it. We will not forget this again.”
This point is well warranted, and is backed by the long run success of equity investments. When shorting, you are fighting against the long term upward trend, have a compounding issue when the trade moves against you, and pay the highest tax rate on your successes. These factors don’t say “don’t short”, but go along with T2’s point: keep it relatively small (unless it goes along with an extreme market valuation/bubble), and stick with companies that fit the short thesis; which brings us to the next point…
“Over time we’ve been quite successful shorting fads, frauds, promotions, declining businesses, and bad balance sheets. Where we have had much less success, however, especially in recent months, is shorting good businesses that are growing rapidly, even when their valuations appear extreme. Such open-ended situations, regardless of valuation, are very dangerous, so going forward we will avoid them entirely unless we have a high degree of conviction about a specific, near-term catalyst.”
The description in the second sentence is the epitome of the NFLX trade, which T2 has caught so much heat for (and lost a fair amount of money on). Their short thesis (here) still holds today, just like it did when they initiated it at under $100/share. Unfortunately, the valuation went to 40x, then 50x, then 60x, and now 70x; couple that with a great leader in Reed Hastings and a company that has continued to deliver good enough results for investors, and you are looking at a short position that has moved 242% in the wrong direction over the past year. The near term catalyst is closer today than it was 12-18 months ago, but is still fuzzy; on top of that, NFLX has spent that time building a stronger brand image, bundling with devices like XBOX 360, and strengthening mental connection to streaming movies in the minds of consumers.
Lululemon Athletica (LULU), another T2 short position, fits under this same description. The company makes yoga apparel for a niche audience, and is seeing increased competition from names like Nike (NKE), Adidas, and Under Armour (UA). Despite these headwinds (and a struggling consumer/economy might I add), LULU currently trades for 55x earnings; just to reiterate, that’s a company that made $58M in yearend January 31, 2010 and currently has a market cap in excess of $5 billion (after a 150% run up over the past 12 months). While this is crazy to a value investor (T2 included), nothing will change with the valuation until they miss and take a dive, which could be a ways out based on plenty of opportunities to build off such a small base. Both of these businesses fit the good business/growth description; and both have cost T2 a good amount of money.
In summary, be careful when making valuation shorts. Despite the illogical basis for many of the longs in these types of investments, that doesn’t necessarily mean to jump in as a short; without an identifiable near term catalyst (preferably those that fit within Jim Chanos’ four broad categories of short candidates: booms that go bust, especially when debt financed; technological obsolescence; bad accounting; consumer fads), it is probably best to avoid the situation for the time being. In the words of John Keynes, “The market can stay irrational longer than you can stay solvent”.
