After Julian Robertson closed his famous Tiger Fund in 2000, he began providing seed money to a handful of “Tiger Cubs” – hedge funds run by protégés. Many of the Cubs have become famous, prominent funds in their own right, but the other day, a friend sent through a news story about one Tiger Cub – Tiger Veda Management – that had closed its doors.
News like this – the failure of a famous investor – usually brings a wave of schadenfreude in the investment community, but reading through the story, I realized there were some good learning points to be gleaned as well. These learning points involve portfolio management and idea generation.
The article mentions that Tiger Veda had a large proportion of its assets in cash due to what the manager perceived as a dearth of good investment ideas. Anyone who invests recognizes the attractiveness of staying in cash. If you’re not invested, you can’t be wrong. If the market falls, you look like a genius.
Unfortunately, the longer one stays in cash, the greater the tendency is to stay in cash, especially in a rising market. This has to do with behavioral biases we discuss in IOI 102 – “Anchoring” and the topsy-turvy perception of risk described by “Prospect Theory.”
One way of steering away from the rocky shore of holding too much cash is to invest in the index when one doesn’t have a better investment idea. In IOI 101, we frame the choice of discount rates for our cash flow models to the expected return of the next best alternative – the next best alternative is most always just an investment in the index – so allocating unused capital to an index investment makes sense from that perspective.
Some proportion of this index allocation can be protected with put contracts – index options are my preferred hedging vehicle for reasons I discuss in IOI 101 – which you can think of as “potential cash.” If the market falls, any profits on the puts can be realized, converted to cash, and used to make a good investment at a more attractive price.
Another thing that struck me about the article was, of the stocks held by the manager, most of them were “typical” value stocks. While value investors like to think of themselves as practical, insightful people willing to buck the trend, many times I see a herd of value investors crowding into the same dozen or so names.
Herding (another behavioral bias) is common in the institutional investment world, just as it is among individual investors. Working for a prominent value investing hedge fund manager years ago, I was struck by the fact that he would spend more time combing 13-F filings (the SEC documents showing what companies institutional investors owned stakes in) than in 10-K filings (SEC documents containing companies’ financial statements). Put simply, he was more concerned about what hedge fund competitors were doing than how potential investment targets were performing. There are structural reasons for institutional herding that we discuss in IOI 102, and we show how individuals can use these structural factors to their advantage.
Another reason for crowded value trades is that the vast number of investors are looking at stocks in the same way – by analyzing the financial ratios of a company and how those ratios appear vis-à-vis firms in the same industry. “XYZ is trading at only point-seven times sales – that’s got to be a good investment!” is the kind of thing you often hear
As I discuss in IOI 102, ratio analysis is a shorthand way of looking at stocks that serve the needs of a very small class of institutional investors particularly well. However, this short-hand method is, more often than not, overused and misused, by individual and other institutional investors alike.
At the end of the day, IOI believes that the best way to invest is to understand:
- The key valuation drivers of a company
- How to conceive of a company’s cash flow growth in the future
- How to know when you are right or wrong about your assumptions about a company’s value creation potential.
Doing so requires some knowledge and practice, but in the long run is more efficient and less risky than relying on rules of thumb and the “common wisdom” of other investors.