I recently read an interview with Zeke Ashton who runs Centaur Capital Partners as well as a mutual fund for Whitney Tilson. Much of the interview focused on managing risk while investing in equities. Zeke has some credibility on the subject as the Centaur Value fund was down only 7% in 2008 vs the almost 40% decline in the S&P 500.
Zeke spoke on the subject of why so many prominent value investors got hammered in the 2008 market collapse despite investing using a strategy of buying with a significant margin of safety. Here are a couple of comments I found interesting:
“In the end, it appears to me that when faced with an extreme environment like 2008 and early 2009, there are really only two things that can save you: the luck or skill to see it coming and get out of the way, or a portfolio structure and risk management approach that is specifically designed to promote survival in a catastrophic scenario that you didn’t see coming. I feel very fortunate that we had a portfolio that was able to take some hits and survive to play another day.”
So what specifically had Centaur done to have their portfolio in a position to weather the worst of the storm ?
1) “The first was to introduce sector risk limits when we noticed that we were coming up with a lot of retail long ideas in late 2007 and early 2008 as that sector became hated and feared. And though not all retail businesses or retail stocks behave the same way, we felt that it would be wise to limit the overall retail basket to no more than 20% of the portfolio. I am convinced that had we not set a hard limit, we ultimately could have justified owning a lot more retailers than we did and would have been hurt far worse in the sell-off that followed. Having a limit meant that when we wanted to buy Target at $40, for example, we had to replace something in our portfolio that we thought it was better than, which for us meant selling Sears Holdings at $90. It’s not important whether Sears ended up falling more than Target; what is important is that none of our retail stocks did particularly well and the decision to limit our exposure to the group allowed us to keep our overall losses to a bearable level. In turn, that enabled us to hold on to our positions long enough to see some of them eventually recover in price.”
2) “The second example was our decision way back in 2005 to limit our portfolio-wide exposure to stocks with limited liquidity. If it’s hard to get into or out of a stock without moving the price, we simply go smaller on the position size at the individual idea level. In addition, we have limited the percentage of our fund that can be in low-liquidity stocks to no more than 30%. This was helpful to us in mid-2008 when we identified new risk factors emerging and were able to exit some of our less liquid ideas in a timely manner and without hurting ourselves in the process.”
Zeke also spoke about the Kelly formula and position sizing. Prior to the meltdown the Kelly formula was getting a lot of attention especially as managers such as Mark Sellers had earned outsized returns with incredibly concentrated portfolios.
“My understanding that Kelly assumes a series of bets with independent outcomes, and therefore fails to account for the correlation of positions inherent within a real life stock portfolio. There is an old saying in the financial markets that in times of extreme stress, the correlation of most investment assets gravitates to one, and I think we witnessed the closest thing possible to that in late 2008 and early 2009. All that said, my only point in mentioning the formula in my recent presentation was to voice my opinion that some people just got a little carried away with the ultra-concentration thing. The book and the Kelly Formula may have been a source of unintended encouragement in that regard.”
My favorite part of the interview was Zeke’s discussion of recourse versus non-recourse leverage as it relates to managing a portfolio.
“Basically, my view is that there are two flavors of leverage, and one is vastly superior to the other. One can take recourse leverage by going on margin to buy a stock, but the downside is that with enough leverage, even a moderate and temporary decline in the stock price can produce a very significant loss, and a significant decline can wipe you out. The other kind is non-recourse leverage, where you get the benefits of the leverage if the stock goes up, but at some point the losses become non-recourse to you in the event the stock declines significantly. The way to get non-recourse leverage relatively cheaply is through in-the-money call options (we favor long-term options going out at least 15 months).
As an example, in the summer of 2008, we decided that American Express looked cheap at a price of about $37. Rather than buy the stock, we bought a long-dated $30 call option, for which we paid about $9. This means that our effective purchase price for the stock was $39 rather than $37. The incremental $2 was about 5.4% of the stock price, and represented both the cost of the leverage and the cost of the loss protection if the stock were to drop below $30. We felt it was unlikely that we would need significant loss protection below $30 at the time. Luckily for us, we later sold Amex to buy something else that we thought was cheaper. Subsequently, the stock plummeted to under $10. Had we not sold it, we would have lost the entire premium we paid for our Amex position but it would have been a fraction of the loss we would have suffered had we bought the common stock and ridden it down. We would have been stopped out below $30, with any losses beyond that point having no recourse to us.
This brings me to the second part of the question, which is how we size positions when we use options. Basically, we size the idea in such a way that we economically control the same number of shares we otherwise would control if we just bought the stock. As an example, let’s say we wanted a given stock to be a 5% position. We would buy options on the exact number of shares that would otherwise comprise a 5% position if we bought the common. Now we have all the benefits of owning a 5% position if we are right, but we have limited the potential loss on the position to only a portion of that same 5% weighting if we are wrong.
At the portfolio level, we have a maximum long exposure of 125%, and we would consider our long exposure on the idea to be 5% whether we bought the common stock or we used the call options to control the identical number of shares. We don’t use options to increase our idea-level exposure, since that would simply offset the benefits of the non-recourse leverage by increasing the position size. But using options does in part allow us to consistently run a portfolio that has true economic exposure that is greater than 100% of our assets on the long side if we want to, funded in part by the leverage inherent in call options and in part by the float created by our short portfolio. And we can do so without being at the mercy of margin calls or worrying about suffering outsized losses. “
I believe that the best way to becoming a better investor is by learning from mistakes. Fortunately you don’t have to learn through your own mistakes, but can also learn from mistakes of others. As you read interviews with value investors such as Zeke it is pretty clear that as much of their strategy is focused on avoiding major mistakes as is focused on finding homerun investments. This message is repeated from Klarman (http://www.gurufocus.com/news.php?id=100894) to Pabrai (http://www.gurufocus.com/news.php?id=100097), both of whom preach versions of limiting the downside and letting the upside take care of itself.
