Thoughts & Comments
Now That We've Survived Our Near-Death Experience . . .
. . . what we've learned

Thomas Brown  ( about me )
Posted 06/08/2009
bankstocks.com
tbrown@bankstocks.com

Notwithstanding the obligatory, not-so-fast-you-bulls headline on the front page of today’s Wall Street Journal (Land Mines Pockmark Road to Recovery), the last few weeks’ worth of economic news have provided convincing evidence that the financial crisis is finally healing and the worst of the recession is over. New unemployment claims are falling steadily. Consumer sentiment is on the rise. Monthly job losses are shrinking. It all points to an economic turnaround, perhaps as soon as the second half of this year. Landmines might indeed pockmark the road, but the road is clearly heading toward an economic recovery.

So this is as good a time as any for me to step back and reflect on how I screwed up so royally in the runup to greatest economic hurricane of our lifetimes, and what I’ve learned as a result of it all. 

First, a little background: From 2000 through 2006, as you may know, I had a lot of success, both financially and entrepreneurially, running a financial services-focused investment fund. I started it after 20 years of following the financial services industry. From 1998 to 2000, I covered financials for Julian Robertson at Tiger Management. Before that, I spent 15 years on the sell-side as a top-ranked bank analyst. I began my career at the old Kemper Financial in 1980.

From then until not too long ago, I was consistently able to help my clients earn strong returns and avoid the blowups that occur so regularly in the financial services business. My own investment style has been heavily value-oriented. I’ve tended to build highly concentrated portfolios, and have been most aggressive in adding to my positions in periods of declining markets and collapses in individual stocks as a result of rising investor anxiety. That approach worked well from the start of my career until the end of 2006. Then as the subprime crisis came to a head beginning in 2007, that same strategy very nearly put me out of business. By the middle of 2008, my portfolios were off by—well, I can’t tell you how much they were off for regulatory reasons (the S.E.C. has rules regarding performance disclosure), but let’s just say that Bill Miller and Ken Heebner aren’t the only value-oriented investors who experienced considerable, considerable pain during the credit crackup.  

My personal bottom came on July 15 of last year. Since then, we’ve outperformed very meaningfully, but still have yet to get back to where we were before the hurricane hit.

Which gets me back to my question: How could someone who invested so successfully for so long, over so many cycles, have gotten clobbered so badly by this latest bear market? Especially if you consider (irony of ironies!) that the epicenter of this decline is the very financial services industry that I’m supposed to be such an expert in? And a followup: In the aftermath of the crackup, how were we able to not only survive, but recover with a vengeance? 

Let’s take those one at a time. First, about the terrible investment performance. In hindsight, our disastrous returns in 2007 and 2008 came about for four reasons:

First, we were simply too optimistic about how the subprime mortgage business would shake out once the cycle finally turned down. We foresaw a subprime crackup but thought it would be similar to prior credit implosions. It was not.  We didn’t own any subprime lenders on the way up, and anticipated credit problems months before they finally occurred. We’d identified the best operators from the worst ahead of time, but then significantly underestimated the magnitude of the storm that followed. In the end, virtually the entire industry—the strong players as well as the weak—collapsed. For once, the people who expected it “to be different this time” were right. And we were wrong.  

But our losses on the expected recovery in subprime lending turned out to be relatively mild. (The positions we’d built were fairly small.) Which gets us to our second, and biggest, mistake: we underestimated the duration of the credit-market shutdown caused by the subprime collapse. It began in mid-2007 and is, well, still going on. This wasn’t the first time credit markets had become frozen, of course.  A similar episode had happened just in 2002. And do you remember 1998? In those cases, the paralysis lasted just a few weeks or months. We thought we were being opportunistic (“Be greedy when others are fearful . . . ”) as we added to our positions  in companies, such as First Marblehead and CompuCredit, that depended on the securitization market for their funding. But the markets stayed stuck for much longer than we imagined. The fundamentals of many of the companies we owned simply . . . stopped working. We were wrong to assume the credit markets would revive in time to save them.

Third, we did not anticipate that the financial crisis would become so severe that, by September 2008, it would disrupt the wider economy and send it into recession. (Nor, for that matter, did we expect that the recession would be accompanied by the second-worst bear market in the history of the stock market.)   

Finally, the leverage and high concentration that had worked so well for us before turned against us, and helped turn severe losses into harrowing ones.

By now, we’ve come through the worst of the crisis and have begun to decisively turn things around. “If it doesn’t kill you, it will make you stronger,” my pal Stephen Krug likes to say. If that’s so, we’re a lot stronger now than we were back at the start of 2007.   In particular, here are the lessons we’ve learned that figure to make us smarter, much more successful investors.  

Make sure your partners are aligned with your investment style from the beginning. For all our troubles over the past two and a half years, here’s one problem we didn’t have: significant investor redemptions. Other firms, who generated returns not nearly as bad as ours, saw their investors stampede out the door, and had to shut down as a result.

Not us. Our partners (bless them) understand our style and know, too, that we are well-positioned to recover their losses. Indeed, we’ve made steady progress along that line, already. If our partners didn’t believe in us and our style, we wouldn’t have survived.

Pick the right employees, then pay them well in good times and hope for the best. We were generous with our employees during the good years, and that has served us well during the bad. Not everyone is still around; some left voluntarily, others not. But despite the poor recent investment performance and associated subpar compensation, we’ve held on to the core group that’s enabled us to put in place the first part of a recovery.  You have to have the right people, regardless. But if you reward them well in good times, most will give you a break during the bad times, as long as they believe in the business model.

Friends are unbelievably helpful.  As the poor performance ground on, I was most surprised by how many friends and colleagues contacted me to offer support. Some of these individuals are recognized as great long-term investors; others are financial services executives I’ve known for years.  The common thread that connects them all is that they respect our work and want to help during this unusual period. It’s all been particularly surprising since I’ve become something of a lightning rod, and had no right to expect so many people to step forward when times got tough. I didn’t count on their offers of help, but am very gratified by it, and grateful, as well.

Be cognizant of the “black swan” event. I made the mistake of assuming that prior events always provide a good guide to what’s in store for the future. Wrong. This time around, things were different. The securitization market stayed locked for years, not weeks. A dozen or so major financial institutions—pillars of the system—collapsed. An entire subsector of the financial industry, subprime mortgage lending, essentially ceased to exist. The effect of it all was far-reaching and profound. I had assumed that such disruptions couldn’t happen. The scale of the disruption might have been highly unlikely—but it wasn’t impossible.

Despite the math, great investment recoveries are possible. The arithmetic of an investment recovery can be daunting. We all know, for instance, that if a fund falls by 50% it needs to double to get back to even. But in the real world, the chance of recovery isn’t as hopeless as the math might imply. We have found, for instance, that the very market disruptions that caused such painful losses in the first place have also created investment opportunities as compelling as anything one would hope to see in a lifetime. This a key reason (in my view) that we were able to generate attractive returns in a falling market for the better part of a year, before the bull market began in March.

Stay humble. This is a piece of advice I probably don’t need to pass along to anyone who’s been involved in the investment business over the past two years. Still, it’s come home to me in spades. The investment business has always been humbling, of course. But if the period of January, 2007 to July, 2008 has taught me nothing else, it’s taught me that disciplined self-doubt is a vital and necessary part of the investment process.  

We’ve learned a lot over the past two years. We’re still here and are, in my view, are stronger investors than ever.

What do you think? Let me know!


  Add your comment

 

 

Santo Posted On 6/8/2009 3:41:48 PM

I did double check the author name. Is this a ghost writer ? Congrats dude. You just earned a lot of respect from a few folks.

NY155 Posted On 6/8/2009 4:21:51 PM

Fantastic piece! I too hardly recognized the author!

Paul in KC Posted On 6/8/2009 4:30:50 PM

Tom; all investors should read this. You don't owe the world mea culpa but I appreciate you telling your tale of humility for all to learn from. Other posters; cmon; Tom Brown has always come across as a real and honest guy and a lot of money could have been made from reading this site! No complaints from me! Kudos Secondcurve Team!

Larry Fuller Posted On 6/8/2009 5:39:42 PM

Tom, Personally, I understand your experience totally. We are all hostages of our experience, if we have any experience, and then students of history. I blame myself for not understanding the extent to which the de-regulation of financial markets starting in the late years of the Clinton Administration would totally destroy the "normal functioning" of the greatest fiancial market system in the world. It happened. There are a lot of signs that the legislative and regulatory personnel in Washington, DC are responding to the situation. You always were and are still a great professional investor. Survival when there is a tectonic plate shift in the financial markets is all that counts. My first tectonic plate shifts experience was in the early 1970s and again in the 1980s. I did not anticipate this one. Best regards, Larry Fuller

Ben Hacker Posted On 6/8/2009 5:59:24 PM

Well said Tom. I wish you continued luck.

Thud_McGuffin Posted On 6/8/2009 8:27:32 PM

Nice one Tom but: “If it doesn’t kill you, it will make you stronger,” my pal Stephen Krug likes to say. Wasn't that Nietzche?

sprintlee Posted On 6/8/2009 10:59:29 PM

Hey Tom. As always, your frankness is appreciated. I am a small investor (7 figures) and thus had no real idea how your fund was doing for the past few years. I live in Texas (far from Wall Street) and don't really hear things about hedge funds and their successes and failures. I did suspect, though, that you probably had some trouble, given your concentrated position in FMD and appreciated your keeping up your postings on bankstocks.com during the difficult period. Your insight is something that I value and rely on. I count on you for the second-derivative analysis--when the rate of change is changing for the better. That is a level of analysis that most don't reach. FWIW, I think many, many people learned for the first time that black swan events are possible. That is a good thing, as you note. Keep up the good work.

cdn72 Posted On 6/9/2009 5:21:49 AM

I appreciate the honest accounting of your experience - there are many of us who there with you in lockstep.

stockmarketimplode.com Posted On 6/9/2009 7:16:52 AM

If you really believe this, ..the last few weeks’ worth of economic news have provided convincing evidence that the financial crisis is finally healing and the worst of the recession is over then you've learned nothing! This is not a recovery, or a road to one, it's just another bubble. It's like going into deeper debt to get out of the debt you are already in. haven't we seen this before? Tom WAKE UP!

Nick Posted On 6/9/2009 8:20:47 AM

Tom, I had a partner once who said that an accurate self perception, is a rare trait and one of the most reliable predictors of an individual's ability to thrive in good times and bad. The forthright candor matched with clarity of thought is why, 20 years later, I still value my Tom Brown connection. Thanks.

Nick Posted On 6/9/2009 9:34:46 AM

All kidding aside about who might have written this note, it should flat out be required reading for every investment professional. Pulls together all the major themes of the last two years into one accurate take. Bravo.

Sandy Berry Posted On 6/9/2009 9:47:52 AM

Tom, For a long time I have been a fan of you, your insights and your intellect. You interviewed me once when I was at Crestar and although apprehensive at the beginning, it was a meaningful experience - I learned from it. This article is insightful and enables the reader to analyze his/her own positions, mistakes and victories over the last two years. I am delighted that you are back on the path to success and I look forward to reading your articles for many years to come. I have been in and around financial services for 47 years and never thought I would live long enough to witness anything like these times. Hopefully the industry will learn (it has not killed it!) and be better for it. My belief is that those that are best at the basics will be the winners. All the best, Sandy Berry.

SR in Centerville Posted On 6/9/2009 10:01:35 AM

It is heartening to see Tom Brownc ome out and explain the good and the bad. I'll bet many a savvy investor has gone through the last 2-3 years in a similar fashion. Thanks for your keen insights and level headedness! Congrats on the fast comeback!

Don Newlin Posted On 6/9/2009 10:13:24 AM

Tom, Your candor and humility do you justice. I have yet to find anyone who saw the length and depth of the crisis. I do agree with the comment that with all the debt buildup, new programs and the train wrecks coming called social security and medicare that in two years or so we will begin to see some nasty inflation. I look forward to hearing your comments and suggestions as to what to do and where to put money in anticipation of it. I would not put it beyond this administration to inflate the economy to pay back all the debt. No wonder foreign holders are sweating over the dollar. Hang in there. You do fine work. DN

gary langbaum Posted On 6/9/2009 10:33:37 AM

A very insightful look at what you did right and wrong. As a past PM, I know how difficult it is to assess yourself but also how necessary it is in order to learn from your mistakes. As changes are taking place in the Boards and managements of some of the companies (C and BAC for example), you have long been critical of, I wonder if you are having new thoughts about them as companies and investments?

Ron Redfield Posted On 6/9/2009 10:43:54 AM

Excellent and honest reporting. Well done!!!

James Dailey Posted On 6/9/2009 11:58:24 AM

I give Tom kudos for publishing this piece - long over due in my opinion but better late than never. The one common thread I've noticed that tied many of the "value" investors (like Tom, Miller, Whitman etc) haven't grasped is the macro back drop. Whitman seems to have come around, but Tom's post leaves me questioning whether he has. It seems Tom has transitioned to believing that the past two years were just some unpredictable black swan event in the context of what is otherwise normalcy. What Tom seems to fail to grasp is that his entire career existed within the context of an ever growing credit bubble that has now popped. His entire sense of normalcy is likely dead and buried. The past two years were about a secular end to an era - not some cyclical correction of out sized proportion. I have yet to read a post from Tom about how he explains away the various debt metrics that remain near all time peaks like debt to household income etc. We are still early in the process of bringing those metrics back near historical norms, let alone considering the likelihood that they will overshoot on the downside, as secular trends are apt to do. I wish Tom luck and his partners the best. Being in the business, I know how terrible things are during periods of poor performance and self doubt. I'd simply urge Tom to think about the possibility that the past 2 years are just the beginning rather than some one off event.

David Posted On 6/9/2009 12:01:37 PM

Good writing.

gail Posted On 6/9/2009 12:24:01 PM

Nice to know other experienced investors feel the way I do. I like your style. MBIA has worked for me because I traded some on that spike and FHN is OK. I would enjoy your thoughts on worthy old ideas.

Donald Posted On 6/9/2009 1:14:00 PM

Tom, you made leveraged, concentrated investments in companies that are highly leveraged and correllated. At some point, it was likely -- not highly improbable -- that a leverage-on-leverage strategy would result in large losses, no matter how much you know about the sector. Sometimes as an investor, you're just wrong. Don't blame it on the Black Swan. Even the best investors are wrong a fairly high percentage of the time.

John - Baltimore Posted On 6/9/2009 1:49:35 PM

Your policy of, "If we change our mind about a company, we won’t necessarily post a story to say so. Please take the disclaimers we post on this site seriously. For instance, the paragraph at the top of the search page, that says that we may have changed our minds about the company in question since the original posting, really is true. The reason we don’t post updates is simple: we’re time constrained, and do not believe that providing follow-ups to past articles is the best use of a scarce resource. Even so, like all other investors, we change our minds about companies from time to time." IS ABSOLUTELY IRRESPONSIBLE AND SELF-SERVING. How you can possibly make the rationalization that you do not have an obligation to go on record that you have changed your opinion on a position is incomprehesible. I personally have taken positions in securities you have touted and was left holding nothing, while you had divested. Seems to be, at the very least, lacking morals, if not criminal.

JOE,CEx Posted On 6/9/2009 3:49:42 PM

Reading you article is almost like a mirror image of what i could write about myself except mine would be on a much smaller scale for many years i have consecrated on banks to hold and trade. Did very well but got hit like we all did. Been following you quite a while began when you supported one position that i didn't i was right from my view point but have always thought that you are one that speaks his mind on everything that matters to a investor like my self wheather i agree or not.

Stephen Corea Posted On 6/9/2009 6:05:33 PM

Unfortuantely every lender in America reads the Wall Street Journal every mornign before resuming their war on the economy. I buy Commercial Real Estate for a living and let me tell you the banks are determined to undermine all efforts to restore our economy to something approaching normal. They have their eyes firmly focused on the rear view mirror. The continued lack of liquidity will undermine all efforts to clear toxic assets from the economy and delay the recovery. Banks that do not lend need to be put out of their misery and soon.

KC Kid Posted On 6/9/2009 7:05:25 PM

Thanks Tom ----- your openness is very much appreciated and admired.------- This time around I bet Mr. Market has probably frustrated the highest percentage of investors and traders in history or at least for several decades. ------- Now, I hope that one of the things we’ve learned is that we must try to get rid of the pro-cyclical rules and regulations that stimulate and amplify the extremely harmful boom and bust cycles in our economy. ------ These seemingly ever more exaggerated cycles always tend to hurt the regular guy while rewarding clever and nimble traders. ------- The old timers are counting on smart (but humble) “ethics-first” bankers, economists, accountants and maybe even a few good control system design experts to streamline and stabilize the controls. ----- That would help our economic system act a little more like a finely-tuned automobile cruise control regulating to a stable speed over rolling highways! ------ Gee whiz guys; ------- We can get to the moon and we can control millions of very sophisticated ground, water, and in-flight processes with great stability and precision but we can't regulate our economy? ------ If really true it's a very sad statement about the “once upon a time” can-do technology leader of the world.

Mike Petee Posted On 6/9/2009 9:40:15 PM

This was great to read. I am a private investor, and see things the way you do. I particularly am interested in the financial sector, and its been easy to make money there, at least until now. Your web site has been helpful to me.

Mike Petee Posted On 6/9/2009 9:40:32 PM

This was great to read. I am a private investor, and see things the way you do. I particularly am interested in the financial sector, and its been easy to make money there, at least until now. Your web site has been helpful to me.

appreciatevalue Posted On 6/10/2009 12:43:19 AM

mark to mark market!! Nothing more needs to be said. It was the gas added to the sub prime fire that made many look like fools! By far one of the single biggest mistakes put forth in the name of fair disclosure. Disclose the damm marks but never ever require banks to mark to them. It's beyond stupid it's tragic as the damage has been done and many are our of work, without insurance, and hungry as a result. If not finally brought to an end in early March I am convinced it would have brought the world to its knee's. I'll go on TV and debate this with any clown wanting to take the other side. appreciatevalue@yahoo.com. Again m2m did not cause the problem it just made things a helluv alot worse!! As it would have any prior recession had that Godforsaken rule been in place!

bankman1 Posted On 6/10/2009 9:29:43 AM

appreciatevalue - so no MTM, eh? what would you suggest companies do? Hold their investments at cost? mark them to "fair" value? how would it be possible to compare companies to their peers when one marks to market, and one chooses to mark to fairy land values? are you also suggesting that the crisis would not have been as dramatic, had there been no MTM? I bet it woulda been worse, becasue leading up to the crisis, companies would have been even more generous with cap rates, valuations, etc - becasue they would never have to mark these investments!! your logic is flawed

bankman1 Posted On 6/10/2009 9:33:50 AM

stephen corea - thanks for putting us into this mess, mr. subprime guy. I just hope and pray that the banks wont ever lend to someone like you again. what a disaster you caused. and to blame it on the banks! what chutzpah. there is an open janitorial job at the local public school, if you are interested, email me your resume (union job too - you'll love it) eatcrapanddiemrsubprimeguy@yousuk.com

bankman1 Posted On 6/10/2009 9:36:19 AM

stephen corea - thanks for putting us into this mess, mr. subprime guy. I just hope and pray that the banks wont ever lend to someone like you again. what a disaster you caused. and to blame it on the banks! what chutzpah. there is an open janitorial job at the local public school, if you are interested, email me your resume (union job too - you'll love it) eatcrapanddiemrsubprimeguy@yousuk.com

KC Kid Posted On 6/10/2009 10:17:46 AM

appreciatevalue.......... I agree. ------- M2M is an indelible stain on the SEC and the otherwise honorable profession of accounting. ------ They clearly aren't trained in dynamic systems analysis but common sense would still have prevented most of the problem.

tompain Posted On 6/10/2009 3:08:14 PM

What possible use is the advice to "be cognizant" of the black swan event? If you know the "scale of disruption" is only "highly unlikely" rather than impossible (impossible? were you that much of a fool?), what do you do differently. There are many highly unlikely things that could happen tomorrow. Have you taken action to position your portfolio for them? Do tell.

kayjay Posted On 6/10/2009 11:15:35 PM

Great review and admire the self reflection. But one comment was missing and that is the business models of some of these sectors/companies were a sham and those (most all) who supposedly knew the industry never figured it out. I didnt, but I never represented myself as a financial industry expert. I did however, read FNM 10K several years ago could not make any sense of it. Totally opaque and gibberish. As cheap as it was I totally avoided. But many buyside and sell side analysts liked the cheapness and the consistant earnings growth and dug no deeper. I think self reflection will not be complete (and learning takeplace) until investors acknowledge, at least to themselves they did not dig deep enought to really understand these companies.

kayjay Posted On 6/10/2009 11:21:49 PM

Great review and admire the self reflection. But one comment was missing and that is the business models of some of these sectors/companies were a sham and those (most all) who supposedly knew the industry never figured it out. I didnt, but I never represented myself as a financial industry expert. I did however, read FNM 10K several years ago could not make any sense of it. Totally opaque and gibberish. As cheap as it was I totally avoided. But many buyside and sell side analysts liked the cheapness and the consistant earnings growth and dug no deeper. I think self reflection will not be complete (and learning takeplace) until investors acknowledge, at least to themselves, they did not dig deep enoughto really understand these companies.

Roberrt Rodriguez Posted On 6/28/2009 12:33:42 PM

Dear Tom, I do not know you but one of my associates passed your note on to me. I commend you for being honest and taking a critical self look at what mistakes were made during this entire process. After doing this self analysis, how will your investment procedures and checks change? What are the key take aways have you learned from this crisis that may be applied in the future? Remember, the next crisis will be different. I believe your last sentence in "Stay humble" is one that very few managers learn or take to heart. May your future in the investment business be both personally enriching and financially rewarding. Above all, maintain the highest levels of ethics and integrity. You are on the right road. Best regards, Bob Rodriguez CEO First Pacific Advisors, LLC

Larry Horan, PhD Posted On 7/7/2009 3:30:59 PM

Tom, congradulations on the turnaround! Larry Horan
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