Today, Michael Burry is best known for his role in the financial crisis, as immortalized in the film, The Big Short. But before he made a name for himself shorting the global mortgage market, he made millions for himself and his investors at Scion Capital where he used a value strategy.
These are the most exciting years of his life, and luckily we have plenty of literature detailing some of his best trades and investment style.
Reading through some of his early letters to investors, I've come across some interesting takeaways on risk. The following was written by Burry in one of his letters to investors in the early 2000s. As the dot-com bubble burst, Burry was busy searching for bargains amid the refuse:
"During this time, the Fund was comfortably positive. The main accomplishment of the Fund, in my opinion, was not grossing 8.24% in two months but rather avoiding such debilitating devaluations as affected the indices and many widely held stocks during that month. While I cannot proclaim that my stock-picking ability is responsible for the gain – the size and most probably the direction of that gain is almost surely a random short-term fluctuation in our favor - I can with some confidence assert that my strategy is entirely designed to avoid and otherwise minimize the price risk in individual securities...It is a tenet of my investment style that, on the subject of common stock investment, maximizing the upside means first and foremost minimizing the downside. The deleterious effect of permanent capital loss on portfolio returns cannot be overstated."
The letter went on to explain how difficult it is to recover from even a small loss, and why it is sensible to concentrate on limiting the downside at all costs.
"Some basic math elucidates this point. When planning for a double, every dollar in excess cost amounts to two dollars in excess gain required. Every dollar saved amounts to the same two dollars in excess gain already realized. And it goes without saying that a 33.3% loss requires a 50% gain just to attain breakeven. On the flip side, 33.3% saved on the buy price makes a 50% gain back to the price of first consideration. On a percentage basis - and it is on this basis that we must evaluate each and every decision - lost dollars are simply harder to replace than gained dollars are to lose."
This was not the last time Burry covered the topic of risk analysis in his letters. During 2002, in one of his letters to investors, Burry wrote, "Although an outsider might think the goal of prevailing modern investment practice to be one of mediocrity, there, in fact, remains much more competition to achieve gains in the market than there is competition to record losses."
He went on to say that inaccurate security analysis, coupled with the general misunderstanding of how to measure risk in a portfolio "dooms most institutional portfolios to mediocre performance." Also, he declared that the reason most institutional investors are doomed to mediocre performance is that traditional risk management activities are "centered on minimizing volatility in various forms."
Burry argued that instead of focusing on volatility, "The correct view remains that risk is minimized not through the alchemy of volatility calculus but rather through respectful business evaluation." He also said that successful business evaluation requires investors to understand the "boundaries" of "one's fund of knowledge." Without understanding the limits to your circle of competence, you expose yourself to the risk of losses:
"Venturing cash-first into unfamiliar territory nearly always results in either losses appropriate for the bonehead move or successes borne of dumb luck. Be assured that neither do I employ dumb luck as an input into my investment process nor do I count on its sudden appearance by my side. Risk management need not be more complicated than this."
Here is the link to the rest of the letters.
Disclosure: The author owns no share mentioned.
