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Market Musings - March 25, 2019

We continue our blog series: Market Musings, Volume 3, Edition 2, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present UPDATED: Whitney Tilson Vindicated (Sort Of).

Everybody loves to mock Whitney Tilson. Or, at least, used to love mocking him prior to the demise of his hedge fund Kase Capital (fka T2 Partners). Witness, for example, the following snark-infested Tilson-related news items from recent years:

Regarding the last Tilson snark item, bashing him for underperforming the S&P for the 2004-2011 period, it is interesting to take a refreshed look at Tilson's YE 2011 portfolio and partner letter after the passage of 7+ years. First, take the partner letter (link here):

Tilson notes that 2011 was a "dreadful year", during which T2 underperformed the S&P by a whopping 27%. Yes, that is truly dreadful, inexcusable really. Tilson goes on in the letter to state that his grade for the year is still TBD, however, because it was too soon to tell whether he was wrong about his stock picks or right but early:

Tilson invokes the famous Ben Graham dictum that the market is here to serve, not instruct you, that it is imperative to ignore the "noise" of the market when assessing one's stock holdings, and that he continued to believe in the long-term prospects of his portfolio:

Note particularly the statement that "the real money is made betting against the herd when it's wrong".

Now with the passage of over seven years we can judge whether Tilson was correct or not regarding his YE 2011 holdings. First, below we show the top 12 holdings in T2's portfolio as of December 31, 2011 (source here) [both BRK-B and NFLX are listed twice because T2 owned common shares plus call options (and these were listed separately in the 13-F filing); for the sake of our analysis we've assumed that all call options were converted to the underlying common shares as of 12/31/2011]:

Overall, the portfolio was worth $325 million (again, assuming T2 had enough funds to convert all call options to common shares; note that the actual portfolio was only valued at $296 million in the 13-F, so T2 would have needed at least $29 million of cash to convert all of the options to common stock). The top 12 positions comprised about 65% of the total portfolio.

Below we present how this portfolio would have looked had Tilson simply gone on an extended vacation for the past 7+ years, completely ignored the stock market and not made a single change to the portfolio from December 31, 2011 to today (again, we present the top 12 holdings, some of which are listed twice for the reasons described above):

Overall, the portfolio would have increased in value from $325 million to $1.167 billion today. In addition, $31.6 million of dividends would have been received. This means that the YE 2011 T2 Portfolio would have generated a total return of 269% including dividends, versus 146% including dividends for the S&P 500, from December 31, 2011 to the present. And this despite the fact that Tilson's second largest holding in 2011, J.C. Penney (JCP), would actually have fallen 96% since then. The much-maligned Tilson--if he had simply stood pat following his disastrous 2011--would have outperformed the S&P by a total of 123% over the past 7.25 years and would now be running well over $1 billion! (Note: This assumes no redemptions from or flows into the fund since 12/31/11.) With respect to annual returns, the T2 portfolio CAGR would have been 19.7% while the S&P CAGR would have been 13.2%, meaning T2's alpha would have been ~650 basis points per year.

What's amazing about Tilson's portfolio is that a single stock, which was a 4.3% position as of YE 2011, i.e., Netflix (NFLX), would have been responsible for $509 million of the $874 million total portfolio gains, or 58% of ALL GAINS for the entire portfolio during the past 7 years and 3 months, and would today be responsible for over 45% of the portfolio value today. Without that one insane growth stock, Tilson's portfolio would actually have underperformed the S&P slightly. Amazingly, Tilson had previously been short NFLX before reversing course and going long (see the short thesis here and the about-face long thesis here).

Of course, we have omitted any analysis of T2's short book, which is described in the 2011 T2 letter as follows:

Some of these would have worked out well (ITT Educational filed for bankruptcy in 2011), however others would have blown up in Tilson's face (GMCR and CRM, for example). But this would have been the result of running a short book far too early in a nascent bull market (Tilson's decision to run a short book just two years following the greatest financial crisis since 1929-1932 is questionable at best).

What to make of all of the foregoing?

Well, first we can confirm that Ben Graham was correct--the market is here to serve us, not instruct us. The pessimism surrounding many of Tilson's YE 2011 holdings was unwarranted, given the subsequent massive share price appreciation of many of these issues. So it pays to stick to one's guns if one has a firm conviction about an investment thesis, regardless of what the market may think at any given time. Paradoxically, however, one must retain enough flexibility and humility to be willing to admit mistakes. The one decision that would have made all of the difference between being a hero and being a zero for Tilson since 2011 would have been the key choice to drop the NFLX short and instead go long.

Second, buy and hold works. Generally speaking, letting your winners run (NFLX and IRDM) and avoiding putting more money into hopeless cases (JCP) is the best long-term strategy to outperform the market. This lets your best ideas grow until they reach a size that dominates your portfolio, while your worst ideas shrink into obscurity (it doesn't matter whether JCP falls another 50% tomorrow, because even though it represented 7% of the portfolio as of YE2011, it now represents just 1/25th of 1% of the overall portfolio).

Third, avoid short selling. Every minute spent focusing on short candidates or short theses is a minute not spent trying to find the next 35-bagger (NFLX), which can make or break your performance over time. Moreover, when you short, you are betting against the house (stocks go up over time), and the house normally wins. Ironically, Tilson has expounded at length on the dangers of short selling (see here, for example), but in our view by far the worst aspect of shorting goes unmentioned in his list (namely, that it needlessly distracts you from your primary goal of finding multi-baggers). Therefore, holding cash or bonds is the best hedge against a market decline, as these can be harvested quickly to put into new long positions just as easily as shorts.

Of course, Tilson only came to put on his NFLX long position after first examining it as a short, so one might argue that shorting in this case "worked". However, shorting NFLX in late 2010 was clearly an error, no matter what the eventual outcome of Tilson's NFLX long investment. Thus, one should logically conclude that it is perfectly fine to *examine* a short thesis, but only to determine whether to go long (if the short thesis is flawed) or not (if the short thesis is convincing). Some of the very best investments can be found when a flawed short thesis temporarily crushes the stock of a promising long (see, e.g., Herbalife (HLF) in late 2012 [see here] or Chemours (CC) in mid-2016 [see here]).


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