Risk management and sounding crazy

In early June Carson Block and his firm Muddy Waters research published a report which made outrageous sounding allegations against Sino Forest - then a highly respected Canadian listed Chinese forestry company that had borrowed well over $2 billion to develop and expand forestry operations in China.

The base allegation in the report was that most the forests did not exist and by implication the (more than) $2 billion borrowed was stolen. Presumably many more shares have been sold too taking the total theft well above $2 billion.

It was an outrageous jaw-dropping allegation and Carson made no attempt to soften the blow. His language was inflammatory because his message was inflammatory. When $2 billion is stolen by reputable people I can't see how you can say that without appearing inflammatory. Some people, understandably, refused to believe it.

In response I set about reading ten years of Sino Forest accounts and decided Ocham's Razor style that Carson being right was the only explanation that I could think of (and probably the only simple explanation) consistent with the facts. And I shorted some, and then shorted some more. The two main posts that outlined my thinking were here and here.

Still I am obsessed about discovering the ways my positions can be wrong (and my business partner is even more obsessed) and we followed the reports of everyone (and there were many) who doubted Mr Block's research.

Dundee Securities was the most prominent Sino-supporter labeling Muddy Water's research a "pile of crap". Somewhat more considered sounding (but also flat wrong just more reasonable sounding) was Metal Augmentor who found Carson "loose with the facts and somewhat breathless". On the naive-sounding side was Susan Mallin whose complaint was that she had "never seen a research report written in this manner". More prominent people were fooled too. I have heard Richard Chandler is not an idiot (but he seems to like losing money - I keep finding him invested in frauds and he does not answer my emails). He dropped $150 million on Sino Forest.

The analysis of these people was staggeringly weak and self-referential (I can't speak for Chandler because I never saw his analysis). They judged Sino Forest against data provided by Sino Forest or people associated with Sino Forest. This is an elementary mistake in assessing fraud. To find fraud you need to be able to judge against things you are fairly sure are not fraudulent.

Everything the Carson Block doubters said sounded reasonable. Certainly more reasonable than Carson Block sounded because Carson Block held the radical position. Sounding reasonable however was wrong.

I think what is going on here is a general problem. When someone says something - anything - that is so far from the consensus as to sound outrageous then they will be considered mad, and sometimes they will be considered mad even after they are proven right. This is iconic in the history of science from Galileo (who observed the moons revolving around Jupiter and the crescent shapes of Venus and deduced much from those) to the more minor genius of Émilie du Châtelet (who thought, contrary to Newton, that energy in a moving body was proportional to velocity squared). Galileo was imprisoned. Émilie was excused because she was a woman and from there sprung her eccentricities. Her status was as Voltaire's mistress, not as a great scientist.

The mad genius is iconic in finance too.

I have heard people say - even now - that Carson was sloppy and breathless in his allegations. He was not. He was right. Dismissing him as sloppy and breathless is in itself sloppy and breathless. Indeed siding with conventional sounding language, conventional sounding reason lost you a lot of money in the Sino Forest case. It was better to side with Carson - the seeming madman.

This happens again and again and again. If you have very non-conventional views - even if they are well supported - even if they are right - if you spell them out plainly you will be thought of as a madman because your views sound outrageous.

But a hedge fund manager has it easier than the scientist. The scientist would be ostracized for the views. A hedge fund manager just makes lots of money. If you are right and nobody believes you then there is a chance to make mega-spondulick$. Indeed by far the strongest opportunities for making really good returns come from doing something original. I shudder to think how much Carson and his backers made on Sino Forest but I think we could safely measure it in lifetimes of average earnings.

There is however a problem with this: a portfolio manager who sounds mad may indeed be mad. Even if they are not mad the market may be wrong longer than they can be solvent. Which brings me to the schizoid character of a really good money manager or money manager team. It is highly rational but it appears like controlled insanity. You need the slightly crazy idea-driven maniac who is prepared to think outside the box and you need someone to button them down, to make them appear reasonable and to act reasonable.

Sometimes the two people are in the same body (I know a few of these people and some are not pleasant people because they are so strangely strung). In Bronte's case they are in different bodies with my business partner appearing much more socially, intellectually and even politically conservative than me. We are an odd-couple rather than an odd person.

All this leads me to wondering about Warren Buffett - the greatest fund manager of them all. He is an unusual individual with strange personal predilections. But he sounds so rational. And he is amazingly self-controlled. Indeed his ability to sit on billions of dollars excess cash for years and years at a time waiting for the time to pounce is legendary and extraordinarily hard to duplicate. Buffett says that temperament is more important than brains in investing and I think this is what he means. But it is often Buffett against the world. Buffett is thought of as a has-been by many people. It doesn't matter whether he was avoiding tech stocks in 1998, 1999 and 2000. It does not matter whether he was buying Bank of America now. He is - of course - just mad.

The madness is an important part of how Buffett made all that money. But the self control is - I think - more important.

When we meet clients I do all the talking. Some people have even wondered why I am with Simon (my business partner). We fundamentally have nothing in common. But there is a reason... he is the best control mechanism I have ever found. It took me a long time (and some losses) to realize I even needed one - he has the temperament. But if the career of Warren Buffett is a guide (and I think it is) then to make money over very long periods you need an ability to think right outside the box and a lot of self-control. The self-control is what most people think of as the risk management.

I don't know how you judge the yin-and-yang of this - and I don't know how you pick the individuals or the teams that have it. But when you see two guys who present themselves as partners but one is voluble and one is quiet then make your assessments of the quiet one. Our record at Bronte is fabulous: if it stays fabulous (and I think it will) then it will be control of Simon rather than idea generation of me that keeps it that way.


John

PS. I often run my blog posts through Simon. This one is in praise of the mad-guy (Carson) and the sane-guy (Simon). I think they should just see it when it pops up.

PPS. The best fund managers hire the misfits who work hard, don't belong in suits and often put them in suits to make them seem more reasonable. (We skip the suits.) This famous letter to a job-applicant by Dan Loeb is a gem.

PPPS. John Paulson is a mad genius. His problems at the moment are as much as anything a function of risk control. His positions were too large and when he was wrong (and everyone is wrong sometimes) his wind-down was horrible. He should hire Simon but I am not going to let him!


J