"I'm Here To Tell You I Was A Pig"

Conviction, Humility, and Value Traps

In 2015, Stan Druckenmiller delivered a speech to members of The Lost Tree Club. The legendary investor was introduced by Sam Reeves, who noted Druckenmiller’s illustrious investment career (he closed his fund in 2010, returning $12 billion to outside investors):

“$1,000 invested 30 years ago in the S&P 500 compounded at a little over 11.3% per annum, something like that. Your $1,000 would be $27,000 before taxes today, with 25 up years and five down years. Warren Buffett, over the past 30 years, compounded at just under 20% per annum. $1,000 invested 30 years ago would be worth $177,000 today, with 24 up years and six down years, of which three of the six down years were more than 20%. Our speaker tonight, if you invested $1,000 with him 30 years ago, it would be worth $2.6 million before taxes; and after taxes, because people say hedge funds are not tax efficient, it would be $300,000 [roughly 21% p.a.] – and in 30 years, no losing years.”

Clearly, that’s an astounding record over a long period of time. That leads us to the overarching theme of his speech, which is also the focus of today’s article: how did Druckenmiller deliver such impressive results over the course of his career, and what can we learn from him?

Druckenmiller touched on a number of factors that played a role in his success, including an obsession with the subject matter (“I had an incredible passion for the business”) and great mentors. But the primary point of differentiation between Druckenmiller and the average market participant, at least from his perspective, comes down to a willingness to capitalize on justified conviction in a big way (knowing when it’s time to bet the house and acting accordingly):

“The first thing I heard in this business was bulls make money, bears make money, and pigs get slaughtered. I’m here to tell you I was a pig. And I strongly believe the only way to make superior long-term returns in our business is by being a pig.”

The old adage refers to the idea that when pigs eat too much (get greedy), they ultimately pay the price (get slaughtered). The antithesis of being a pig is broad diversification, which is a logical approach for a passive investor. But diversification, as a key tenant of one’s investment philosophy, strikes me as somewhat misguided for the active investor. If the rationale for being active is the prospect of better than average returns over the long run, this demands an honest conversation: in a competitive arena like capital markets, how will you come out ahead of the average participant? Druckenmiller’s answer is to have the patience to wait for big opportunities – but more importantly, when they come across the plate, to also have the willingness to swing aggressively:

“If you look at all the great investors, and they’re as different as Warren Buffett, Carl Icahn, and Ken Langone, they tend to make very, very concentrated bets. They see something, they bet it, and they bet the ranch. And that’s the way my philosophy evolved… there may be only one or two times a year that you see something that really, really excites you… The mistake 98% of money managers and individuals make is they feel like they’ve got to be playing in a bunch of stuff. If you really see it, put all your eggs in one basket and watch that basket very carefully.”

Druckenmiller explained how he truly learned to embrace this philosophy while working with George Soros:

“When I read ‘The Alchemy of Finance’, I understood very quickly that he was already employing an advanced version of the philosophy I was developing in my fund… I was as proficient as he was, maybe more so, in predicting trends. That’s not what I learned from George Soros. I learned something incredibly valuable, and that is when you see it, bet big… I had a higher batting average, but Soros had a much higher slugging percentage… In his personal account, working 10% of the time, he beat Duquesne and Quantum while I was managing the money… He just had more guts. He was betting more money with my ideas than I was [presumably meant as a percentage of portfolio assets, not in dollars].”

And then Druckenmiller shared a notable example from his time with Soros:

“Nothing explains our relationship and what I’ve learned from him more than the British pound… In August 1992, there was $7 billion in Quantum. I put $1.5 billion short the British pound… I wake up one morning and the head of the Bundesbank… basically said ‘the British pound is crap and we don’t want to be united with this currency’. I thought, well, this is my opportunity… I go in and I said, ‘George, I’m going to sell $5.5 billion worth of British pounds tonight. Here’s why I’m doing it, and that means we’ll have 100% of the fund in this one trade.’

I think he’s about to blow away my thesis, and he says, ‘That is the most ridiculous money management I’ve ever heard. What you described is an incredible one-way bet. We should have 200% of our net worth in this trade, not 100%. Do you know how often something like this comes around? Like once every 20 years.’ We didn’t get the whole $15 billion on, but we got enough that I’m sure some people in this room have read about it in the financial press.”

(Soros: “We must have been the biggest single factor in the market in the days before the E.R.M. fell apart. Our total position by Black Wednesday had to be worth almost $10 billion.")

Before going any further, I should clarify that I’m not intimately familiar with the investment philosophy that Druckenmiller employed during his years at Pittsburgh National Bank, Duquesne, or Quantum; my sense is that his approach (macro investor, high turnover, etc.) differs quite a bit from my own investment philosophy. That said, I think it would be foolish to disregard the perspective of someone who has delivered such stellar results over the course of three decades. Another way to frame that would be to say that long-term, fundamental investors, like myself, suffer from our own biases and would be well served to learn from others who have successfully played the game by employing different strategies.

For example, later in his speech, Druckenmiller said the following:

“I’ve thought a lot of things when I was managing money with great, great conviction, and a lot of times I was wrong. When you’re betting the ranch and the circumstances change, you have to change – and that’s how I’ve always managed my money.”

That’s one example where concentrated, long-term investors like myself are disadvantaged: by the nature of only making 100, 50, or maybe even 20 meaningful bets over the course of an investment lifetime, the cost / impact of a mistake will naturally be outsized relative to someone who makes hundreds or thousands of bets over the course of their career. That fact indicates that I should be even more focused on those situations where the circumstances change and ultimately lead to meaningful underperformance (i.e., value traps).

And that’s one area where I think we can learn from Druckenmiller: there’s something in his ability to simultaneously balance overwhelming conviction in his assessment of a situation along with a willingness to admit (or at least seriously consider) that he’s the one who’s wrong when faced with the wisdom of crowds. It’s a flexible mindset that I greatly admire.

It reminds me of something that Seth Klarman wrote in his year-end 1996 investor letter:

“We regard investing as an arrogant act; an investor who buys is effectively saying that he or she knows more than the seller and the same or more than other prospective buyers. We counter this necessary arrogance (for indeed, a good investor must pull confidently on the trigger) with an offsetting dose of humility, always asking whether we have an apparent advantage over other market participants in any potential investment.”

Striking that balance between arrogance and humility, while difficult in practice, is key to long-term investment success (particularly for someone running a concentrated portfolio). The humility to respect Mr. Market’s opinion, which is probably heretical to the way that some investors view the world, is something that I place more weight on than I did previously; importantly, I think it’s an approach that increases one’s likelihood of having a high slugging percentage (the number that matters) by reducing the emphasis on one’s batting average.

What I think we can learn from someone like Druckenmiller is that there are times where Mr. Market does a good job “telling” you circumstances have changed. That said, there’s a very fine line between arrogance (completely disregarding Mr. Market’s opinion) and pure humility (rolling over the minute Mr. Market suggests that you’re wrong). Without a way to apply it to our process, it’s nothing more than fortune cookie advice. How can we make this idea useful?

First, we have to accept that it’s an art, not a science. I think part of it is the muscle memory (experience) an investor accumulate over the course of years and decades in the market.

But I also believe there are steps we can take to “learn faster”, to ensure that we’re imparting some logical and thoughtful consistency throughout the lifecycle of an investment. For example, memorializing (writing down) your long-term investment thesis is an important part of the process. It’s a road map that can serve as a helpful guide on future decision-making. I also find it helpful to include both qualitative and quantitative aspects as part of this discussion.

Here’s an example: the Dollar Tree (DLTR) thesis that I laid out in June boiled down to a fair price on a high-quality business (the Dollar Tree banner), with upside from a turnaround at Family Dollar (as you know, I don’t own DLTR, so this is a theoretical example). Notably, there are some KPI’s that give us historic context for whether or not each banner is living up to reasonable investor expectations (two-year stacked comps, the margin profile, etc.).

Over time, our reaction to subsequent business results and stock price changes should be framed within that context. For example, while the supply chain issues that DLTR is currently facing are clearly a major headwind to 2021e EPS (and likely 2022e EPS as well), I personally do not place too much weight on that factor. That is based on the belief that these headwinds are temporary and are unlikely to have a material / sustained impact on per share intrinsic value.

On the other hand, the degradation of DLTR banner comps (and to a lesser extent margins) is a real concern in my mind. It strikes at the core of my investment thesis. Even over a period as short as a few quarters, that’s something we need to take notice of, particularly if we struggle to provide a good explanation (and to the extent you can, that may be where opportunity lies).

This is an area where I think I’ve evolved as an investor: while I probably would’ve been a buyer in this type of situation five years ago (10%+ drawdown after earnings to a valuation that strikes me as reasonable), that isn’t the course of action I’ve decided to take today. I’ve become less willing to initiate or double down on an investment simply because the price is more attractive; when the circumstances change, you should force yourself to recognize – and appropriately adjust to – that new reality. Increasingly, I find myself asking that question in terms of the business results, as opposed to starting with the valuation (change in the stock price relative to my estimate of the change in intrinsic value).

Again, this is more art than science. This comment from Bill Nygren of the Oakmark Funds does a good job summarizing why I’ve adjusted my approach in these situations:

“As a value investor, discipline and patience are prerequisites for success. However, taking them too far and becoming stubborn can be a fatal flaw… Sometimes, the company’s fundamentals disappoint, and our estimate of intrinsic value falls short of our original expectations - but many times when this happens, the stock price drops to a greater extent than our value has changed, and it’s quite tempting to declare that the stock is cheaper than ever and, thus, an even better idea than it was initially. This, however, is precisely the setup that we’ve found leads to a value trap.”

Averaging Down

In 2017, John Hempton of Bronte Capital Management asked an important question: “When Do You Average Down?”

“Averaging down has been the destroyer of many a value investor. Indeed, averaging down is the iconic way in which value investors destroy themselves (and their clients). After all, if you loved something at $40 and you were wrong, you might love it more at $25 and you are almost as likely to be wrong, and like it more still at $12 and could equally be wrong. And before you know it you have doubled down three times, turning a 7 percent position into an 18 percent loss.”

For a long-term, concentrated investor (like myself), this is the crux of the discussion. It’s something that Hempton has spent a lot of time thinking about as well. Ultimately, he believes that land mines fall into three main buckets: (1) financial leverage, (2) operational leverage, and (3) obsolescence.

Hempton’s solution for avoiding value traps, which is a slight tweak to what I proposed earlier (clearly memorializing your ex ante investment thesis), is worth considering:

“If I could improve our formal stock notes in any way I would like an ex-ante description of what circumstances we are allowed to average down a particular stock, and how much.”

I think this is the perfect compromise: the flexibility to act very aggressively when the situation warrants it, but also some guardrails to avoid sub-optimal, price driven decisions (most notably after a portfolio holding reports lackluster results and the stock price declines precipitously).

Conclusion

The rubber meets the road in terms of finding a practical solution, which is ultimately a question of position sizing (add, hold, or sell). For example, should we implement a cap on position weights based on business quality, or is it solely a question of risk-adjusted IRR’s? There isn’t a single “correct” answer, but even addressing that question is part of finding your solution (an approach that aligns with the risks you’re willing to bear). Personally, I’ve come to believe that the business quality filter must come first. At the very least, I would demand a very high bar in terms of expected rates of return to even consider compromising on that prerequisite (it’s rarely black or white).

I feel that this is a bit light on the specifics for now, but it’s a framework that I think can add value to the investment process. It’s something that I intend to work on, and talk about more, in the years ahead.

NOTE - This is not investment advice. Do your own due diligence. I make no representation, warranty or undertaking, express or implied, as to the accuracy, reliability, completeness, or reasonableness of the information contained in this report. Any assumptions, opinions and estimates expressed in this report constitute my judgment as of the date thereof and is subject to change without notice. Any projections contained in the report are based on a number of assumptions as to market conditions. There is no guarantee that projected outcomes will be achieved. The TSOH Investment Research Service is not acting as your financial advisor or in any fiduciary capacity.