T2 Partners January Letter - Eating Some Humble Pie On Short Selling Mistakes
February 1, 2010
Dear Partner,
Our fund declined 2.8% in January vs. gains of 2.4% for the S&P 500, 2.9% for the Dow and 1.8% for the Nasdaq.
Our long book actually beat the market in January largely due to Grupo Prisa (the A shares rose 34.0% and the B shares rose 16.4%), but we gave back all of these gains and then some thanks to significant losses on the short side, led by St. Joe (up 25.4%) and Netflix (21.8%) (both discussed below).
Our Recent Performance
Over the last five months, our fund has declined by 4.3% net, which, in isolation, isn’t a terrible number. For perspective, since inception just over 12 years ago we’ve had 16 months worse than this – and let’s not even talk about October 2008 through February 2009. Now that was painful!
But given that the S&P 500 has surged 23.5% over the last five months, this has been, by far, our worst relative performance in our history. While we are focused, first and foremost, on absolute returns and preserving capital, missing such a big move is very disappointing and led us to carefully evaluate what went wrong so we can identify our mistakes and fix them.
Repositioning Our Short Book
As we’ve discussed in prior letters, our underperformance is due almost entirely to our short book, so we’ve been thinking hard about it, both in terms of stock selection and also how we size it. We’ve come to the following conclusions:
Stock selection
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.
Sizing our short book
A far bigger mistake we made was maintaining a large short book even after the crisis had passed. Allow us to explain why this occurred by starting with some background: 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.
What we are best at – and what has accounted for our long-term outperformance – is the ability to identify cheap stocks and special situations such as the four that drove our returns in 2010: General Growth Properties (in bankruptcy), Berkshire Hathaway (a safe blue chip with the catalyst of being added to the S&P 500), Liberty Acquisition Corp. (illiquid warrants, betting on a merger going through), and BP (horrible headlines and bankruptcy fears).
To be clear, our conclusion isn’t to abandon short selling altogether. Done very carefully and selectively, in limited size, we are confident that our short book can provide both hedging and positive returns. But at most times we will have a short book in the 25-40% range.
Keep in mind that if the market tumbles and stocks are cheap across the board, as they were in early 2009, we’ll likely have a smaller short book. Conversely (and far more likely, in our opinion), if the market or certain sectors become very overvalued and we become convinced that the fundamentals are about to fall apart, we won’t hesitate to increase our short book substantially, as we did in early 2009.
Over the past dozen years, there have been two periods in which it was an exceptionally good time to short stocks. The rest of the time, however, even the best short sellers found it difficult to make money. While we have no ability to predict short-term market gyrations, we have proven adept at identifying enormous, obvious bubbles: for both the internet and housing/credit bubbles, we publicly identified them as bubbles before they burst and took steps to protect our portfolio. Equally importantly, in the aftermath, we publicly identified when stocks had become cheap and profited from the rebound.
While our outlook today is cautious, for reasons we outlined in our annual letter, we do not think that we are currently on the brink of a major market and economic decline. Rather, we think the most likely scenario is that the U.S. economy will muddle through and slowly get better over the next few years. If so, it will likely not be a good time for short selling and hence we have reduced our short exposure.
In summary, we are redoubling our focus on what we do best – buying cheap stocks – and are deemphasizing short selling – both in terms of time and capital. Still, we are always keeping a close eye out for the occasional big bubble that might give us the opportunity to make a lot of money on the short side.
Microsoft
We have recently been adding to Microsoft and Berkshire Hathaway, which are now our two largest positions. Microsoft reported blowout earnings last week, far exceeding analysts’ estimates, as revenues, operating income, and earnings per share rose 15%, 20% and 28%, respectively. The balance sheet is Fort Knox, with net cash exceeding $31.5 billion ($3.68/share), and the company bought back $5.1 billion of stock during the quarter, at which rate Microsoft will retire about 8% of its shares annually. Finally, the stock, at $24.05 net of cash, trades at a mere 10.1x trailing EPS and 9.3x consensus analysts’ EPS estimates for the next 12 months (which we think are much too low).
Despite all of this, the stock fell after Microsoft announced earnings, due no doubt to the consensus view that Microsoft is a fading giant, doomed to a future of lower market share, sales, margins and profits. It is of course possible to concoct such a scenario – people have been doing it for well over a decade – but there is no current evidence to support it. Microsoft’s market share in its key business areas is stable or rising, and sales, margins and profits are growing nicely.
We think there is robust growth in the store for Microsoft, as numerous areas of its business are booming. Most notably, while the company has now sold over 300 million Windows 7 licenses, the operating system is running on only slightly more than 20% of the world’s internet-connected PCs, so there is huge embedded growth here.
Berkshire Hathaway
We recently updated our Berkshire Hathaway slide deck and have posted it at www.tilsonfunds.com/BRK.pdf. We have increased our estimate of intrinsic value to $160,000 per A share, more than 30% above today’s price, due to the enormous surge in profits from Berkshire’s operating businesses, driven by a recovering economy and the acquisition of Burlington Northern. This, plus the roughly $6 billion in stock gains in Q4 and reversal of mark-to-market derivatives losses from earlier quarters will, we believe, result in an exceptionally strong Q4 earnings report later this month.
St. Joe Company
In light of St. Joe’s big move up, we have revisited our analysis of the company and we still believe that it’s 3-4x overvalued. St. Joe is most emphatically not an open-ended growth situation (though the stock has been acting like it recently). To the contrary, the company is burning cash and time is working against it.
To give you an idea of how disconnected from reality its shares are, when the company disclosed in early January that the SEC “is conducting an informal inquiry into St. Joe’s policies and practices concerning impairment of investment in real estate assets,” the stock, after falling at first, finished the day up (and rose an additional 17.7% over the rest of the month).
If you wish to learn more about the company and the bearish case for the stock, we suggest that you read and listen to David Einhorn’s 139-slide presentation which he presented at the Value Investing Congress on October 13th. It’s an exceptional piece of analysis, and our short thesis mirrors his.
Netflix
Since we first wrote to you in December about our Netflix short position, we have received quite a bit of new information including results from our survey, input from investors, and the company’s recent earnings release. We are still digesting this information, which has both bullish and bearish implications, and will write to you about our conclusions in the near future.
February 1, 2010
Dear Partner,
Our fund declined 2.8% in January vs. gains of 2.4% for the S&P 500, 2.9% for the Dow and 1.8% for the Nasdaq.
Our long book actually beat the market in January largely due to Grupo Prisa (the A shares rose 34.0% and the B shares rose 16.4%), but we gave back all of these gains and then some thanks to significant losses on the short side, led by St. Joe (up 25.4%) and Netflix (21.8%) (both discussed below).
Our Recent Performance
Over the last five months, our fund has declined by 4.3% net, which, in isolation, isn’t a terrible number. For perspective, since inception just over 12 years ago we’ve had 16 months worse than this – and let’s not even talk about October 2008 through February 2009. Now that was painful!
But given that the S&P 500 has surged 23.5% over the last five months, this has been, by far, our worst relative performance in our history. While we are focused, first and foremost, on absolute returns and preserving capital, missing such a big move is very disappointing and led us to carefully evaluate what went wrong so we can identify our mistakes and fix them.
Repositioning Our Short Book
As we’ve discussed in prior letters, our underperformance is due almost entirely to our short book, so we’ve been thinking hard about it, both in terms of stock selection and also how we size it. We’ve come to the following conclusions:
Stock selection
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.
Sizing our short book
A far bigger mistake we made was maintaining a large short book even after the crisis had passed. Allow us to explain why this occurred by starting with some background: 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.
What we are best at – and what has accounted for our long-term outperformance – is the ability to identify cheap stocks and special situations such as the four that drove our returns in 2010: General Growth Properties (in bankruptcy), Berkshire Hathaway (a safe blue chip with the catalyst of being added to the S&P 500), Liberty Acquisition Corp. (illiquid warrants, betting on a merger going through), and BP (horrible headlines and bankruptcy fears).
To be clear, our conclusion isn’t to abandon short selling altogether. Done very carefully and selectively, in limited size, we are confident that our short book can provide both hedging and positive returns. But at most times we will have a short book in the 25-40% range.
Keep in mind that if the market tumbles and stocks are cheap across the board, as they were in early 2009, we’ll likely have a smaller short book. Conversely (and far more likely, in our opinion), if the market or certain sectors become very overvalued and we become convinced that the fundamentals are about to fall apart, we won’t hesitate to increase our short book substantially, as we did in early 2009.
Over the past dozen years, there have been two periods in which it was an exceptionally good time to short stocks. The rest of the time, however, even the best short sellers found it difficult to make money. While we have no ability to predict short-term market gyrations, we have proven adept at identifying enormous, obvious bubbles: for both the internet and housing/credit bubbles, we publicly identified them as bubbles before they burst and took steps to protect our portfolio. Equally importantly, in the aftermath, we publicly identified when stocks had become cheap and profited from the rebound.
While our outlook today is cautious, for reasons we outlined in our annual letter, we do not think that we are currently on the brink of a major market and economic decline. Rather, we think the most likely scenario is that the U.S. economy will muddle through and slowly get better over the next few years. If so, it will likely not be a good time for short selling and hence we have reduced our short exposure.
In summary, we are redoubling our focus on what we do best – buying cheap stocks – and are deemphasizing short selling – both in terms of time and capital. Still, we are always keeping a close eye out for the occasional big bubble that might give us the opportunity to make a lot of money on the short side.
Microsoft
We have recently been adding to Microsoft and Berkshire Hathaway, which are now our two largest positions. Microsoft reported blowout earnings last week, far exceeding analysts’ estimates, as revenues, operating income, and earnings per share rose 15%, 20% and 28%, respectively. The balance sheet is Fort Knox, with net cash exceeding $31.5 billion ($3.68/share), and the company bought back $5.1 billion of stock during the quarter, at which rate Microsoft will retire about 8% of its shares annually. Finally, the stock, at $24.05 net of cash, trades at a mere 10.1x trailing EPS and 9.3x consensus analysts’ EPS estimates for the next 12 months (which we think are much too low).
Despite all of this, the stock fell after Microsoft announced earnings, due no doubt to the consensus view that Microsoft is a fading giant, doomed to a future of lower market share, sales, margins and profits. It is of course possible to concoct such a scenario – people have been doing it for well over a decade – but there is no current evidence to support it. Microsoft’s market share in its key business areas is stable or rising, and sales, margins and profits are growing nicely.
We think there is robust growth in the store for Microsoft, as numerous areas of its business are booming. Most notably, while the company has now sold over 300 million Windows 7 licenses, the operating system is running on only slightly more than 20% of the world’s internet-connected PCs, so there is huge embedded growth here.
Berkshire Hathaway
We recently updated our Berkshire Hathaway slide deck and have posted it at www.tilsonfunds.com/BRK.pdf. We have increased our estimate of intrinsic value to $160,000 per A share, more than 30% above today’s price, due to the enormous surge in profits from Berkshire’s operating businesses, driven by a recovering economy and the acquisition of Burlington Northern. This, plus the roughly $6 billion in stock gains in Q4 and reversal of mark-to-market derivatives losses from earlier quarters will, we believe, result in an exceptionally strong Q4 earnings report later this month.
St. Joe Company
In light of St. Joe’s big move up, we have revisited our analysis of the company and we still believe that it’s 3-4x overvalued. St. Joe is most emphatically not an open-ended growth situation (though the stock has been acting like it recently). To the contrary, the company is burning cash and time is working against it.
To give you an idea of how disconnected from reality its shares are, when the company disclosed in early January that the SEC “is conducting an informal inquiry into St. Joe’s policies and practices concerning impairment of investment in real estate assets,” the stock, after falling at first, finished the day up (and rose an additional 17.7% over the rest of the month).
If you wish to learn more about the company and the bearish case for the stock, we suggest that you read and listen to David Einhorn’s 139-slide presentation which he presented at the Value Investing Congress on October 13th. It’s an exceptional piece of analysis, and our short thesis mirrors his.
Netflix
Since we first wrote to you in December about our Netflix short position, we have received quite a bit of new information including results from our survey, input from investors, and the company’s recent earnings release. We are still digesting this information, which has both bullish and bearish implications, and will write to you about our conclusions in the near future.
