With Whitney Tilson, Former Hedge Fund Manager, Long-term Berkshire Shareholder, Author, and Educator
Whitney Tilson is well-known in the investment world. He founded numerous investment partnerships, mutual funds, and other enterprises. His book, More Mortgage Meltdown: 6 Ways to Profit in These Bad Times, was published in May 2009 and made a lot of sense after the mortgage meltdown.
He’s also one of the authors of Poor Charlie’s Almanac, the definitive book on Berkshire Hathaway Vice President, Charlie Munger.
On Being An Expert In The Field Of Investing
Whitney Tilson believes that being an expert in the field of investing isn’t the same as being an expert in other fields. He views investing as a craft, analogous to being a first-rate teacher, doctor, or fighter pilot.
One becomes highly skilled at a craft by learning the basics and by being an apprentice under a great teacher for a number of years. The same is true of investing. Warren Buffet became a great investor by learning at the feet of Ben Graham.
Worsening Returns Prompted Introspection
Tilson learned his investing lessons the hard way. Over 20 years of investing, his returns got worse over time, which confounded him. He realized, then, that he had gotten overconfident, which hurt his returns.
He also started shorting stocks, which turned out to be brutally painful over the last ten years of the long bull market. Additionally, Tilson thought stocks were overvalued and sat on a lot of cash through this long bull market.
Tilson says he got too smart for his britches and paid a big price for it.
Extreme Brilliance Can Be Investor’s Liability
Tilson adds that most good investors have high IQs, but they aren’t out-of-this-world brilliant.
In order to be a good investor, you need to understand finance and accounting and be comfortable with math and numbers. You also need to understand business strategy, marketing, and competitive analysis, and process large amounts of information.
Stick With What You Know
Investors should stick with what they know and understand, as Warren Buffett famously does. They also must have the humility to know what is beyond their scope of understanding.
Know where you have an edge and where you don’t. Then, very rationally and humbly, pick investments where you have an edge and steer clear of where you don’t have an edge.
The Puzzling Lure Of Hedge Funds
Steve notes that despite a history of poor performance and high fees, hedge funds still lure customers with their promise of excess returns. High fees take a bite out of returns and predispose hedge funds to underperform the market. This is why Whitney Tilson decided to close his hedge funds a year ago.
As a conservative value investor in a bull market, he kept waiting for the market to become attractive and lost out on the upside. The way to win at investing is to keep up with the market during good times and avoid losses during down periods.
But there aren’t very many funds that are able to do that.
No 20% Pullback
A 20% pullback typically defines the end of a bull market. While the market has declined over the past 10 years, it hasn’t dropped by 20%. Hedge funds often outperform the market during crashes and down markets, but they haven’t had that opportunity over the past 10 years.
Another reason hedge funds underperform is that they look for opportunities outside of the ten biggest stocks that tend to drive major indices.
Short Lesson From Lehman
Whitney Tilson shares a big mistake he made with Lehman. He shorted 68,000 shares and had huge paper gains. But when Lehman went bankrupt, its shares stopped trading. Tilson was unable to buy back 68,000 Lehman shares and close out his position. To maintain his short, Tilson has had to park $170,000 with his broker.
His advice to short-sellers: You aren’t off the hook if the company goes bankrupt, so take your gains and run before shares stop trading.
Disclosure: The opinions expressed are those of the interviewee and not necessarily United Capital. Interviewee is not a representative of United Capital. Investing involves risk and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. Content provided is intended for informational purposes only, is not a recommendation to buy or sell any securities, and should not be considered tax, legal, investment advice. Please contact your tax, legal, financial professional with questions about your specific needs and circumstances. The information contained herein was obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by United Capital.
Steve Pomeranz: Whitney Tilson is well-known in the investment world. He founded and ran numerous investment partnerships and mutual funds and other enterprises. He has authored investment books like More Mortgage Meltdown: 6 Ways to Profit in These Bad Times, and this was published in May 2009 when something like that made a lot of sense.
And he’s also one of the authors of Poor Charlie’s Almanac, the definitive book on Berkshire Hathaway Vice-President Charlie Munger. Whitney Tilson, welcome back to the show.
Whitney Tilson: My pleasure, thanks for having me.
Steve Pomeranz: I want to ask you some questions about a topic you addressed recently which has intrigued me.
It has to do with the idea that being an expert in the field of investing isn’t the same as being an expert in other fields, can you expand on this?
Whitney Tilson: Sure, well, I view investing as a craft and it’s something that I analogize to being a first-class teacher, doctor, fighter pilot.
How does someone get skilled at a very high-level craft or skill? And the answer is you go to school and you develop the basics and the foundation. But then it’s sort of an apprenticeship business; someone becomes a great teacher generally by being an assistant teacher to a great teacher for a number of years.
Someone learns to become a good surgeon by being an assistant for many years in the operating room. And the same is true of investing. The right way to learn to become a great investor is to do what Warren Buffet did, learning at the feet of Ben Graham. It’s how I learned, learning at the feet of Buffett and Munger.
I’ve been to the last 21 consecutive Berkshire Hathaway annual meetings. What I talked about that led to your question in a recent article that I wrote, however, is that my experience over 20 years or so of professional investing was that my returns actually got worse over time. And that was very confounding, very humbling, very frustrating for me.
And that is what you would have to expect. You would expect given that I know, that I really didn’t know very much about what I was doing 20 years ago. I was sort of a late 90s bull market genius when I got into the investing field. Why did this happen?
And it was very puzzling to me. And I think the answer is, is unlike other things, someone who’s been a brain surgeon for 10 or 15 or 20 years, doesn’t all of a sudden start sort of freelancing and going and doing ankle surgery. Or they don’t get too smart.
They just do what they’ve always been doing better. And where I got into trouble was I got too smart. As I got more experienced, had a lot of success picking stocks, and that’s what I’ve always been good at, I started to stray over time. And there are so many ways you can get in trouble in investing.
So I started to trade the portfolio more. I started to own more than five or ten stocks. I started to own 20 or 30 or 40 stocks. I started to short stocks. So instead of just buying stocks that I thought would go up, I made bets on stocks that I thought would go down.
And that’s been brutally painful over the last ten years of this long bull market. So I started to have an opinion on the general evaluation level of the market. And the market’s fairly richly valued these days. So I was sitting on a lot of cash during this long bull market.
So basically, as I got more experienced, unlike other professions where I don’t think there’s as much temptation to get too smart for your own breaches, I got too smart for my own breaches and I paid a big price for it.
Steve Pomeranz: So that brings up a couple of ideas that you made me think about.
First of all, this idea that you don’t really need a high IQ to necessarily be a great investor. As a matter of fact, I think what you’re kind of saying is that an active mind can actually work against you because there are so many compelling stories and ideas out there that you think you understand and then you kind of grab after them.
Whereas someone who does a tedious task over and over and over again learns that very well, becomes extremely effective. But in effect, you really wouldn’t look at a person like that necessarily as having an active mind because what keeps them so focused for so many years when they could easily go astray.
You think IQ has something to do with this?
Whitney Tilson: Well, there are a number of different variables at work. I will say that the best investors I’ve encountered in my career all have high IQs. But I would not say they are the absolute highest IQ people I’ve ever met.
I think, I forget, if the average IQ is somewhere around 100, the highest IQs in the world are around 200. Pretty much everyone I know who’s good at this is, let’s say, in the 130 or 140 range for sure.
Steve Pomeranz: Sure.
Whitney Tilson: But there’s no difference between 130 and 160.
In order to be a good investor, you need to have an understanding of a wide range of topics related to, obviously, finance. Then being able to being very comfortable with math and numbers. But also understanding strategy and how businesses work and marketing and competition. And understanding certain rules and regulations, being able to process very large amounts of information.
So having a fairly high IQ is important, but I think what the other part of your question now gets to, you need to have a high IQ which generally goes along with a high degree of self-confidence. But you also need a fair amount of humility.
Steve Pomeranz: Yeah.
Whitney Tilson: You need to not get try to be too smart. You need to pick your spots and you need to be able to say like Warren Buffett often says—he once said at the Berkshire meeting long ago. He said, look, maybe somebody is making a lot of money trading cocoa beans and he’s like, I don’t care. I don’t know anything about cocoa beans. And he’s one of the world’s smartest richest men. And he has the humility to say, I don’t know anything about cocoa beans and it doesn’t bother me one iota that somebody else is out there making a lot of money trading cocoa beans.
Steve Pomeranz: Right.
Whitney Tilson: So knowing where you have an edge and where you don’t. And when you’re the sucker at the poker table and when you got an advantage at the poker table. And only being willing to invest in areas where you have very rationally and very humbly evaluated the situation and picking your spots when you have an edge.
And just staying completely away from everything else where you don’t have an edge.
Steve Pomeranz: So there’s an emotional quality, a behavioral quality, to this intelligence that you also have to have. I think being humble is a part of that, but it’s also understanding your limitations. And having the ability to be patient, very patient to take your own counsel even when you know you’re right but things at present aren’t going right for you.
So it brings up this idea that if the longer you do something in the investment world, if you become too smart, it could lead to the law of diminishing returns, literally. And yet there are so many hedge funds still operating that to an individual’s mind offer the promise of excess returns, returns greater than the average return of the stock market, which would be represented, let’s say, by the S&P 500 and which is simple investment in the S&P can give you the average return on all of those 500 stocks. What is working against hedge funds, they’ve been out of favor for so long and yet people still seem to be attracted by the idea that nobody really wants to be average.
Whitney Tilson: Yes, well, hedge funds are now such a large asset class that it’s almost mathematical that they will under-perform by the amount of their fees. And hedge funds tend to charge very high fees. At least 1% off and 2% management fees but then even bigger, 20% of the profits typically.
And so also hedge funds are designed to out-perform the market during down markets because they hold cash and they have a short book, hence the word hedging. And in almost a ten-year bull market, not surprisingly, hedge funds have trailed because of their investment strategy and then on top of that mathematically they’re trailing by the amount of their very hefty fees.
So hedge funds over the last ten years have offered the worst of both worlds, poor performance and high fees. And so, naturally, it’s quite an out of favor asset class and it’s one of the reasons why I decided to close my hedge funds a year ago. I was suffering from these exact problems.
And I was practicing what I thought was conservative value investing, looking for cheap stocks and waiting for the market to become more attractive. And the market never did become more attractive. So I was just sitting there on a bunch of cash which obviously wasn’t generating any returns. My short book was hurting my returns.
Steve Pomeranz: Yeah.
Whitney Tilson: And the frustrating part is, is I owned a bunch of good stocks on the long side, and I’ve always been good at that over almost 20 years. And it was everything else that was just getting me into trouble. So there are people out there who are able to deliver good returns to keep up with the market during good times but they avoid the losses during the down periods.
And that’s what the big institutions look for and that’s what people are willing to pay the big fees for. But there aren’t very many funds that are able to do that.
Steve Pomeranz: Well, ten years of a bull market, I mean it really hasn’t, when you look back you could say it’s been a long bull market, but it has been interrupted by numerous very difficult downturns.
And yet, I don’t really think that the hedge funds prove themselves. Does it take a crash-type market for hedge funds to show their value?
Whitney Tilson: Well, generally, if you look there have been little hiccups, 10% here. What there hasn’t been is a 20% decline over the last ten years or so.
Which is what is typically defined, whoever decides these things, sort of decides that’s the end of the bull market when you have a 20% drawback. But hedge funds, generally, my understanding is, have out-performed during those little downturns, but they’ve only lasted for a couple of months. So over a one year period, the last year that the market, the S&P 500 had a down year was 2008, that’s how long it’s been.
So that means hedge funds are trying to keep up now, where it’s almost ten consecutive years of positive returns. So there really hasn’t been any kind of sustains downturn where hedge funds can outperform.
Steve Pomeranz: Looking at the average returns of the S&P 500, when you look under the hood, the movement of the S&P 500 is really driven by almost a handful of stocks.
If you own the darlings of the day which would be Netflix and Google and Amazon and sometimes-
Whitney Tilson: Apple and Microsoft-.
Steve Pomeranz: I was going to say sometimes Facebook.
Whitney Tilson: Facebook, those are the biggies.
Steve Pomeranz: [LAUGH] Maybe not so much Facebook right now. But right, those are the biggies.
If you didn’t own those, your rates of return are going to be disappointing.
Whitney Tilson: Yes.
Steve Pomeranz: How does an investor…
Whitney Tilson: And that’s another reason why hedge funds specifically, but also active managers, in general, have been underperforming the index because they tend to be looking for opportunities outside of the ten biggest stocks which tend to drive the major indices.
So when you’re in a sustained period like this where those mega-cap stocks have really been doing well, all active managers have tended to trail for that reason as well.
Steve Pomeranz: Yeah, it’s always something. There’s always some reason that things can go wrong. I want to change gears here because there was an interesting article about an experience that you had that I don’t think people really have ever thought about before.
You just spoke a minute ago about this idea of being able to short stocks which is really a bet that a stock price will decline. And what you’re basically doing is you’re selling shares that you don’t own. The brokerage firm that you’re holding your money at gets the shares from somebody else and delivers those shares to the buyer.
And then you’ve got this open position that if the stock price goes down, you can then come in and buy it back or buy it out and you can earn the difference between the amount that you sold it for and the purchase that you bought it for. Now back in ‘08, you shorted Lehman Brothers right at the right time as well.
You made a lot of money. And yet there’s still $170,000 sitting at Goldman Sachs that you can’t get back. What’s going on there?
Whitney Tilson: Yeah, it’s a very unusual problem and it really caught me by surprise when I was closing my funds a year ago. I, as you mentioned, shorted Lehman Brothers seeing that the company was likely to encounter real financial distress, and the stock would get clobbered.
And in fact, I borrowed the shares, I sold them and collected the cash. Then the shares went to zero. And that cash was then mine, that was my profit because the stock went to zero, then the company went bankrupt. I had shorted, I had borrowed and then sold.
I shorted 68,000 shares of Lehman. And now, once a short position works, or if it doesn’t work, for whatever reason, if you want to exit the position, unlike if you own a stock, and if the stock goes up, you sell it and you make a profit. In this case, the stock went down, what is required is I needed to go back out into the market, buy the 68,000 shares in the marketplace and then deliver them to my broker, my prime broker Goldman Sachs who had provided me with what’s called the borrow. The 68,000 shares that I had borrowed to initiate the short position. So you basically, in order to unwind and exit the short position, you just have to buy back the shares and deliver them back to your prime broker.
Steve Pomeranz: Mm-hm.
Whitney Tilson: Well, I didn’t do that because this company went bankrupt and the shares stopped trading. So I assumed that there was no need for me to return the shares and what I discovered ten years later is that it’s a little bit convoluted, but the Goldman shares are not actually completely cancelled until the bankruptcy is finalized and that’s probably another two years.
Believe it or not, ten years after Lehman went bankrupt, all sorts of lawyers and other folks are still working on recovering assets and delivering it to the bond holders. So there’s not going to be anything for the equity holders, but I discovered much to my surprise and dismay that I still had an obligation to deliver the 68,000 shares that I had shorted of Lehman ten years earlier, that I could not close out the position.
And the standard in the industry is, even for a stock that doesn’t really exist anymore or trades refraction of a penny, I wasn’t able to buy it back because it doesn’t trade anymore. And so I’m required to hold $2.50 a share just in case this stock somehow comes back to life.
And so that’s $170,000 that I have, that I personally have now, have to keep at Goldman until the Lehman bankruptcy is complete. So it’s sort of a long and convoluted story, but the message to your listeners is that if you ever do engage in any shorting of any stocks, even if you have the most successful short ever, the company goes bankrupt, the stock goes to zero, you still must go buy the shares.
Generally, at that point, they’re trading on the pink sheets and bankruptcy, and you need to deliver them back to your broker and close out the position. You cannot just assume that because the company went bankrupt that you’re off the hook for buying them back and delivering them back to your prime broker.
In my case, I discovered was not the case and, as a result, I’m going to get my $170,000 back, but it sort of stinks that it’s tied up right now for another couple years.
Steve Pomeranz: Well, a lesson learned about assuming things and not, I guess, doing what you would normally do, which was just go out and buy the stock back.
Whitney Tilson: Yes, I wanted to delay paying the taxes honestly.
Steve Pomeranz: That’s what it was. [LAUGH]
Whitney Tilson: But I got too cute.
Steve Pomeranz: Yeah, my guest, Whitney Tilson, you can see why I’ve asked him to join me on the show, an interesting guy. You can Google him and see all the things that he is up and round doing.
And also his opinions and thoughts when he visits the Berkshire Hathaway annual meeting out in Omaha in May. If you have a question about what we just discussed, go to stevepomeranz.com. While you’re there, sign up for our weekly update and we will send you a weekly notice with all of the segments that we do on the show including this one.
Whitney, thanks so much for joining us.
Whitney Tilson: My pleasure, thanks for having me.