I want to call attention to something that I think is a really important lesson for investors and, to a lesser extent, traders. The first quarter of this year was an absolute risk-on extravaganza for US stocks. Not only did raw beta (the S&P 500) give you a 12% howyadoing, some of the most horrid and risky stocks were able to deliver more than double that return (Bank of America, anyone? Netflix! etc).
And if you were running a pedal-to-the-metal book of holdings in that atmosphere – and picked a few of the standouts while concentrating in them heavily, you had one hell of a quarter. No one exemplified this concept better than hedge fund manager Whitney Tilson of T2 Partners.
This was from his March investor letter (as relayed by Business Insider):
Our fund rose 10.6% in March vs. gains of 3.3% for the S&P 500, 2.1% for the Dow and 4.3% for the Nasdaq. Year to date, during the best first quarter for the S&P 500 and Dow since 1998, and the best for the Nasdaq since 1991, our fund also had its best first quarter, jumping 23.6% vs. 12.6% for the S&P 500, 8.8% for the Dow and 18.9% for the Nasdaq.
26% in Q1 is outstanding no matter which way you slice it. Tilson had a tough 2011 but came into the beginning of the year very strong. But for investors looking at this quarterly performance, the stated return should NEVER be the focal point – it should always be a question of “how was this return produced.” Now we know the answer – it was produced by taking aggressively-sized positions in a collection of volatile, out-of-favor “value” names in the context of a junk rally, a from-worst-to-first meltup that saw last year’s losers benefit from a cessation of year-end
I like Whitney, always have. He is more forthcoming than almost any other hedge fund manager I can think of, admits his losses and is never shy about laying out his investment theses in public forums, essentially availing himself to the critiques of a million armchair portfolio managers around the world. I give him credit for that and I respect the amount of homework he does on each of his ideas.
But we have to talk about the consequences of not knowing the “how” and only paying attention to a portfolio’s stated return in a given period. Here’s how Whitney fared in May with his strategy and stockpicking (via ValueWalk):
Our fund fell 13.6% in May vs. -6.0% for the S&P 500, -5.9% for the Dow and -7.1% for the Nasdaq. Year to date, our fund is up 8.5% vs. 5.2% for the S&P 500, 2.6% for the Dow and 8.9% for the Nasdaq.
On the long side, other than our two largest positions, Berkshire Hathaway (-1.6%) and Iridium warrants (-2.8%), everything else got clobbered: Pep Boys (-37.8%), J.C. Penney (-27.3%), Dell (-24.7%), Sears Canada (-23.2%), JPMorgan Chase & Co.(NYSE:JPM) (-22.9%), Netflix (-20.8%), Barnes & Noble (-20.8%), Citigroup (-19.8%), Grupo Prisa (B shares) (-19.3%),Goldman Sachs Group, Inc. (NYSE:GS) (-16.9%), American International Group, Inc.(NYSE:AIG) (-14.3%), Resource America (-12.9%), SanDisk (-11.6%), and Howard Hughes (-10.8%)
Our short book declined substantially more than the market (though not nearly enough to offset the losses on the long side), led by Green Mountain Coffee Roasters, which announced dreadful earnings and fell 51.6%. Other winners included First Solar (-31.7%), Nokia (-26.8%), Salesforce.com (-11.0%), Tesla (-11.0%), and St. Joe (-10.4%), partially offset by Interoil (+9.9%).
It was an ugly month – our second-worst ever – but for perspective, our fund gave back slightly more than the 12.3% gain of the previous two months. We’re still having a decent year, with a healthy, market-beating gain. In fact, this is the fourth-best start to a year in our fund’s 14-year history.
Now for a hedge fund manager, this is perfectly acceptable, big risk alongside the prospects of even bigger rewards. Volatility being just a distraction and risk management being virtually non-existent here (how else can you explain having positions down almost 40%?).
But is this an acceptable strategy for you? Is this level of volatility worthwhile?
The next time you are told of an eye-popping track record or rate of return, roll your tongue back up into your mouth and ask the following question:
“But how were those returns produced?”
Most strategies aren’t successful in all market climates and very few outliers are repeatable in the investment management world (ask the folks who piled into Paulson’s hedge fund in 2010).
Live by the sword, die by the sword. Tilson is a swordsman.