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!