Sun Edison disclosure practice

I have - on the grapevine - been sent a research report from Credit Sights on Sun Edison. "The title: Sun Edison and Terraform: Dual 10Q cut. Recourse?"

It is complete with the usual suggestion that there is debt at Sun Edison that is both (a) recourse to the parent company and (b) does not have sufficient and allocated cash left to settle it.

That is the central question with Sun Edison. Bears suggest that Sun Edison has parent company debt that they do not have the wherewithal to pay. The company has steadfastly denied this. They state all debt is either (a) non-recourse or (b) has well determined cash flows that will be used to pay it. Alas certain debts have shifted from the non-recourse to the recourse column.*

I confess I am concerned with the Credit Sights note. I own Sun Edison stock which I purchased in distress (about $9). This was after it lost two thirds of its value.

Proving my ability to pick stocks that halve it halved again.

The line in the Credit Sights report that concerns me most however is not assertions about recourse versus non-recourse. That is the bet I have taken.

My concern is this:

SUNE stopped returning our emails and phone calls over a month ago so we are unable to confirm this new recourse status with the company as the missing one letter footnote could just be a typo.

Sun Edison is a financial institution. It requires the trust of financial markets to do business.

Credit Sights is a highly reputable (if somewhat bearish) debt research shop.

Not returning their calls is simply unacceptable. The management of Sun Edison (as this blog has stated) have to start sounding like and behaving like the management of a mortgage REIT.

They are not doing so. Financial institutions do not ignore the people who analyse their debt.

So Mr Ahmad Chatila (CEO Sun Edison), how about you return Credit Sights' phone call?

Or, failing that, will the board of Sun Edison please fire the CEO now.





John Hempton
Disclosure: Long Sun Edison (unfortunately)

* One reclassified debt: a margin loan on Terraform stock was once classified as non-recourse and is now classified as recourse.

Sun Edison - some comments and a way forward

Bronte has taken a long position in Sun Edison. We did this after the first and indeed second stages of the collapse in that stock. The stock decline here is spectacular. First Solar and Solar City have had issues - but nothing like this.

Until about a week ago we were showing (small) profits on the position. Then it took yet another leg down. I know the cliche about trying to catch falling knives - but we think this is a quite good bet - and would be a better bet if the board took decisive action to fix immediate and pressing problems.

Background

Sun Edison develops huge and highly capital intensive solar and wind project where the power is largely pre-sold and where separate financing is developed for each project. These projects are then sold to [“dropped down to”] semi-captive yield companies sold to mostly to yield sensitive investors.

There are several issues. Big solar projects are massively capital intensive – think of utility scale power generation where you have to pay for the next 25 years of fuel upfront. The projects have huge debt but also reliable high margin cash flow.

Secondly there is a pretty obvious conflict of interest in the “yield co” drop-downs. We have successfully shorted a few companies where we think that overpriced assets were being sold to captive vehicles. In the end they these were good shorts - if you can't treat the investors in the drop-down vehicle fairly you will eventually wind up with fewer investors, less access to capital and less underlying profitability.

Thirdly, because of the related parties and the copious amounts of different types of debt these companies have complex and even scary accounts. At Bronte we are quite good at getting to the bottom of complex accounts. But we have a problem with these.

In a meaningful fashion Sun Edison is a “trust me” story.

Whatever, the problems Sun Edison and its yield cos have been smashed. Once fairly obscure solar developers have become a major topic of discussion on Wall Street.

It took us a while to understand why they have fallen so hard. The argument comes down to complex accounts, lots of debt and a peculiar acquisition of door to door marketing company(Vivint).

But there is also more than the usual amount of rumour and innuendo. On Twitter there are arguments we know to be wrong and arguments that are simple fear-mongering (calling Sun Edison “Sun Enron” is one such appeal). Sure the company is highly levered and complex but it is almost certain that the past deals have been good deals. Any solar farm deal you put in place 3-5 years ago has worked out. Both solar panel prices and interest rates are lower than you would have baked into your cash flow models. We would be enormously surprised if the past deals of Sun Edison did not work out.

Whether the future deals work out is however an open question. Low solar panel prices and low interest rates are not exactly a secret – and the funding cost for solar panel farms has risen with this panic. Bluntly we think unless the company repairs its relationship with capital markets it is unlikely to be able to generate good deals in the future and it will wind up in run-off.

There is a deeper problem with the way these companies [yield cos and their parents] see themselves and communicate with investors. That comes down to the fact that many have their roots in semiconductors where operating leverage is everything. You disclose your costs, your variable versus fixed, capacity expansion and so forth because if you make solar modules, wafers or chips that stuff matters a very great deal to your business. Investors use and demand that information because simply put, it matters and drives the profitability of the business.

A yield-co is a completely different business – it is a non-bank financial company.

Non-bank financials “blow up” for one of three reasons, (i) credit risk, (ii) duration mismatches and (iii) and unstable funding. If you want to assess TerraForm Power (Sun Edison’s yield co) you need to assess whether the credit risk on the projects (the counter-party) is okay, how the contract and funding is (eg floating/fixed etc) and all the ways in which project development funding is able
to roll into long-dated funding.

A friend put this to a yieldco and the management balked at providing that level of project detail. My friend's response: “well, are you Northern Rock?”

And that is the guts of the issue and the market fear. We have gone to considerable effort to convince ourselves Sun Edison is not Northern Rock with solar panels. We have talked to several people who have organised funding for these things and it seems okay to us. Specifically all construction finance automatically can be termed out as project finance (over the life of the project and linked to the project) when the construction is done.

If this is true the market fear for this company cannot cause insolvency. Given that the company is priced as if insolvency is likely this stock should produce a good return from here.

Alas we could be wrong here. We can’t see all the funding (the disclosure is complex) but the bits we have seen have this character. We checked through several sources and we don't think the company can have a “run on the bank”. The Northern Rock outcome is unlikely.

Now of course we have not seen and understood all of the finance deals. Only the ones we can find. But that is sufficient to know we are probably right. And that is the case for buying. The old projects are good and they should run off at an attractive clip.

The Vivint Acquisition

That said this company does not behave like a financial institution, they have been rash and callous in their treatment of capital markets. This is dumb. Capital (not solar equipment) is the main input in this business. And capital is cheaper if people trust you.

Moreover management did a really foolhardy acquisition and explained it badly.

Vivint (the target) is a door to door marketing scheme selling solar systems. Some suggest multi-level marketing scheme characteristics but I cannot find the contractual terms that indicate it is an MLM. [Contra: friends have done research on the numbers of complaints at State agencies concerning Vivint.]

Moreover the product it is selling door-to-door (financed solar systems) is not a bad deal for customers. Customers put the solar panels on their roof and their power bills go down. Whether the solar system is owned by the household or some corporate structure what is effectively going on is a loan to the householder where the householder will repay the loan by splitting the utility bill saving with the solar company. Things can go wrong in this deal – but those things are not very likely.

That said, there are good reasons why roof top solar is less attractive than utility scale solar farms. The main one is that rooftop solar gets under-priced use of the grid. The grid is essential here – unwanted solar is sold to the grid and the grid provides electricity when the sun doesn’t shine. My business partner was once a utility CEO. He has an instinctive skepticism of rooftop solar. He thinks – correctly – that people with rooftop solar underpay for grid services.

In Northern California this is becoming explicit. Pacific Gas and Electric is proposing changes which explicitly charge households with solar panels more to access the grid. Whilst we have no view on the size of the charge the direction is probably right. This will become a trend and make roof top solar less attractive in the future.

The Vivint acquisition - which looks strange - was poorly explained and was bundled with a few details that indicated that the margins on projects dropped down to the captive yeild-cos are declining caused a run on the stock. Moreover there were lots of hedge funds who had oversized positions in Sun Edison before the collapse. There clearly was a rush to the exits.

And in capital market terms those can be self-fulfilling. The equity and debt cost for Sun Edison has risen substantially and this seriously impedes the economics of the company. Its that strange thing about financials that lower prices for equity and debt reduce the future cash flows.

The current situation and the way forward

Sun Edison has lost about 80 percent of its value without the slightest hint from the management team that there is a problem. The credit default swaps have moved against them and it will be far more difficult to grow whilst the situation is like this.

There really is one issue here. Can they find and develop new solar plants and drop them down into project financed bankruptcy remote vehicles and (a) make a profit and (b) ensure the new owners of those vehicles make enough return to keep them coming back for the next vehicle? [At the moment there is a fairly strong private market for solar projects - people like large pension plans - but the same concern applies to them too. They got to trust you.]

If they can't develop and sell either growth stops dead or the company becomes a ponzi.

Alas with market distrust it becomes unlikely that future projects can meet the required return hurdles. The private market for completed projects will also have the same concerns about the management.

The best case here is that the company has become a melting ice-cube. It is worth something (I think a fair bit more than the current price) but every drip of cash that comes off in the end goes either for debt repayment or is returned to shareholders.

The whole project development team - the raison d'être of the company - ceases to have any use. They should all be fired. Yes - all of them. [If you work for Sun Edison it is your job too. And that will eventually include the board. Them are the stakes. If the current board doesn't do something about this it is eventually your job.]

There is an alternative - an alternative I think the company should take. They should pay their contrition to the market - and give the market what the market wants.

What the market wants here is a clear vision of financial control and responsibility. They want to know that Sun Edison is not Sun Enron.

Stocks don't just fall 80 percent in a vacuum. Someone has to be held responsible - and the board needs to ensure that happens to ensure Sun Edison has a future.

That person is the CEO.

Ahmad R. Chatila

Ahmad R. Chatila (Sun Edison's CEO) is a visionary. Indeed Mr Chatila is the reason for Sun Edison's success to date. I have heard managers describe him in glowing terms - amongst the best CEOs in America.

And I don't disagree.

Except that he should be fired. Pronto. Now.

Sun Edison - through the vision and drive of Mr Chatila has become a financial institution. One with a lot of run-off value. One which I think has improved the world a great deal.

Vision, drive and competence are usually great things for a CEO.

Not in this case.

I am an old fashioned kind of guy. I do not think visionaries should run financial institutions.

Visionaries running financial institutions end in disaster.

Mr Chatila has built an institution for which he is profoundly unsuitable to run. The market has made that abundantly clear.

Pay him out

I have mostly been unsympathetic to firing executives and leaving them with a big payout. Mr Chatila is an exception.

Mr Chatila has not done much that is wrong. He has created - from very little - a worthwhile, valid and large business. He has achieved much.

He has not done very much that is wrong except create a business which he personally is a woefully inadequate CEO for. For this he should be rewarded: as recognition of (a) what he has truly created and (b) for going quietly and constructively.

Calculate his payout, add thirty percent and fire him.

Who to appoint?

There is a core criteria on picking the new CEO.

They need to be boring and from a control culture. The idea CEO would be someone from (say) the risk management department of Goldman Sachs. What you want is a dull suit occupied by someone whose job it is to pull wings off butterflies. Someone whose job it is to ensure - and be seen to ensure - that bad projects are not funded.

The market wants someone who will get on an earnings call and talk about asset liability matching, FX risk mitigation and basically sounds like the CEO of a mortgage REIT, not a semiconductor visionary.

You want risk aversion above all other things.

And you want it for another reason. Mr Chatila has populated the senior ranks of Sun Edison with people like himself. Ambitious go-getters - people who get things done. It is notable that all of the ex Goldman hires at Sun Edison come from the banking and advisory side. They are deal people. Deal people do deals and are not happy if they are not doing deals.

The people Mr Chatila have hired have got things done. Alas if you are going to have people like this in a financial institution (and Goldman Sachs is full of such people) then you need a counter-balance. Someone who stops you doing silly things and has the intellectual horsepower to work out what is silly and what is not. There are plenty of such people around and if Sunedison can poach deal centric Goldmanites then perhaps it can pick up a few slighly more salty risk managers too.

There is an alternative of course. But that is harder. You could keep Mr Chatila. Have a visionary running your financial institution - but then you need to beef up the risk management culture of the place to an extraordinary degree. You need to sack the CFO, half the board need to resign (and be replaced by hard-headed financial types) and you need to remove about half the go-getters that Mr Chatila has installed.

Easy and difficult routes to dullness

This company has got to become dull and predictable and it has to get there fast. Anything short of dull and predictable will end badly.

There is a fast route to dull and predictable (the one I prefer). Start at the top. Sack Mr Chatila. Appoint someone who will embody the new (and boring) Sun Edison. And this guy is going to give the market the sort of information they need - that is

(a). Power purchase agreements and their counter-parties (the analog of credit risk for a non-bank financial institution),

(b). Contract terms for the above PPAs - eg fixed, floating, renewal terms and also for the debt for the projects (the analog of whether there are mismatches in funding), and

(c). The funding details (to ensure that there are not mismatches in the duration of funding).

There is the second route to dull and predictable. That is to leave Mr Chatila in place but sack half the people around him and replace them with people who will control his ambition. This is - in this case - a worthwhile option as Mr Chatila really is a visionary - someone who really has created value.

Whether you can keep the good parts of Mr Chatila (vision, drive) and also keep the market happy has yet to be seen. I have my doubts.

The third way to dull and predictable - and one which will be forced upon the company shortly if the board does not react sensibly is just to put this into a form of run-off. Fire everyone in project development. Just do it. My guess is that they have to start firing now - but a few is not going to do. In runoff they have to fire all the interesting people, leave a skeleton maintenance staff and send us (now suffering) shareholders lots of cash.

My guess is that the board will settle on the first option or Carl Icahn or some equivalently effective activist investor will buy a big stake and force the third option on them.





John

When do you average down?

The last post explained why I think a full valuation is not a necessary part of the investment process. A decent stock note is 15 pages on the business, one page on the management, one paragraph or even one sentence on valuation.

Valuation might normally be a set of questions along the lines of "what do I need to believe" to get/not get my money back.

But I would prefer a simple modification to this process. This is a modification we have not done well at Bronte (at least formally) and we should do better. And that is the question of averaging down.

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Warren Buffett is famously fond of "averaging down". If you liked it at $10 you should love it at $6. If it goes down "just buy more". And in the value investing canon you will not find that much objection to that view.

But 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 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 a 18 percent loss.

Do that on a few stocks and you can be down 50 percent. And in a bad market that 50 percent can be 80 percent.

And if you do not believe me this has a name: Bill Miller. Bill Miller assembled a startling record beating the S&P ever year for fifteen straight years and then blew it up.

Miller had a (false) reputation as one of the greatest value investors of all time: In reality he is one of the biggest stock market losers of all time and a model of how not to behave in markets.

How not to behave is be a false value investor, buying stocks on which you are wrong, and recklessly and repeatedly average down.

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At the other end traders who (correctly) think that people who average down die. The most famous exposition of this is a photo of Paul Tudor Jones - with a piece of paper glued to his wall stating that "losers average losers".

And yet Warren Buffett and a few of his acolytes have averaged down many times and successfully. And frankly sometimes I have averaged down to great success.

At least sometimes - the Bill Miller slogan is correct: "lowest average cost wins". Paul Tudor Jones may be a great trader - but he is not a patch on Warren Buffett.

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I would love it if I had an encyclopaedic knowledge of every mid-cap in Europe and could buy the odd startlingly good business when tiny and cheap. But the task is too large. The world is complicated and I can't cover everything.

But when I look at tasks that can be achieved by a four-analyst shop I have one very high on my list of things we can do and should do: We should get the average down decision right more often.

So I have thought about this a lot. (The implementation leaves a little to be desired.)

--

At a very big picture: averaging down when you are right is very sweet, averaging down when you are wrong is a disaster.

At the first pick the question then is "when are you wrong?", but this is a silly question. If you knew you were wrong you would never have bought the position in the first place.

So the question becomes is not "are you wrong". That is not going to add anything analytically.

Instead the question is "under what circumstances are you wrong" and "how would you tell"?

--

When you put it that way it becomes obvious that you must not average down (much) on highly levered business models. And looking at Buffett he is very good at that. He bought half a billion dollars worth of Irish Banks as they collapsed. They went approximately to zero. But he did not double down. He liked them down 90 percent, he did not like them more down 95 percent.

By contrast these are the stocks that Bill Miller blew up on: American International Group, Wachovia, Washington Mutual, Freddie Mac, Countrywide Financial and Citigroup. They were all levered business models.

By contrast you can probably safely average down on Coca Cola: indeed Buffett did. It is really hard to work out a realistic circumstance in which Coca Cola is a zero. And if it is still growing there is going to be a price at which you are right - so averaging down is going to go some way to obtaining an average cost near or below that price. 

Of course even Coca Cola is not entirely safe. You could imagine a world where the underlying problem was litigation - where some secret ingredient is found to be a carcinogen and where the company faces an uncertain future of lawsuits. It is not likely - and if it happens you are going to get at least some warning that this is a circumstance on which you could be wrong. Whatever, outside that circumstance on which you might be warned, Coca Cola is not a leveraged business model subject to bankruptcy and is almost entirely unlikely to halve four times in a row. You can average that one down.

Operationally levered business models

Not every business model is as as safe as Coca Cola. Indeed almost every business model is more dangerous than Coca Cola. A not financially levered mining stock can halve five or six times. If you have a mining company that mines coal at $40 per tonne, has no debt and the price is $60 a tonne it is going to be really profitable. But prices below $40 (highly possible) will take profits negative. Add in some environmental clean up and some closing costs and it is entirely possible that a stock loses 95 percent of its value. Averaging down when down 40%, some more when it halves, and then halves again and it will still lose two thirds of its value. The difference between averaging stuff like that down and doing what Bill Miller did is only one of degree.

It is still a disaster. And you will have proven Paul Tudor Jones adage: losers average losers.

Obsolescence

There is another iconic way that value investors lose money - and that is technical obsolescence. Kodak was made obsolescent and was a value stock all the way down to bankruptcy. The circumstances on which you might be wrong (digital photography going to 95 percent of the market) could have been stated pretty clearly in 1999.

You might thing it was worth owning Kodak as a "cigar butt stock" - plenty of cash flow and deal with the future later. There was a reasonable buy case for Kodak the whole way down. But technical obsolescence is always a way you should be wrong. When the threat is obsolescence you are not allowed to average down.

Bill Miller averaged Kodak down. Ugh.

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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.

We have a default at Bronte - and the default at Bronte is that we have a maximum percentage for a stock (typically say 9 percent but often as low as 3 percent depending on how we assess the risk of the stock) and as the fund manager I am allowed to spend that whenever I want but I am not allowed to overspend it. If we have a 6 percent position with a 9 percent loss limit and it halves I am allowed to add three percentage points more to the exposure. But that is it. Simon, being the risk manager, isn't particularly fussed if add the extra when the stock is down 30 percent of 50 percent, but I can't add it twice. If it is a position on which we agree we are allowed to risk 9 percent then I am allowed to risk 9 percent.

We will not fall for the value investor trap of losing 18 percent on a 7 percent position.

We have made a modification of this over time. And that is every six to nine months I get another percentage point to add. That is at Simon's discretion - but the idea is that the easiest way to find out whether you are wrong is to wait. After a year or two the underlying problem will usually become public. If time has not revealed new information then we are allowed to risk more.

But we can and should do better with ex-ante descriptions under the circumstances in which we are prepared to add and circumstances where we are not. The problem is that you can wind up in a mindset where you always where you want to add, where you think the world is against you and you are right and you will just be proven to be right.

Clear ex-ante descriptions of the issue (which require competent business analysis) might help with that problem.

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The bad case of averaging down

The iconic bad situation to average down is a levered business model involving fraud. It is surprisingly common because people who run highly levered business models have very strong incentives to lie or to cover it up when things turn to custard. I can think of two recent examples: Valeant and Sun Edison.

Much to my shame I added to my (small) position in Sun Edison as it fell. Ugh. But also this was a highly levered business model and thus by definition the sort of place where losers average losers. I should not have done it - and I won't in future.

But the highly levered business models apply fairly generally. When Bill Ackman rang Michael Pearson and asked if there was any fraud at Valeant he already had the wrong mindset. Then he added to a large holding in a company with over 30 billion dollars in junk-rated debt. Losers average losers.

Incidentally our six month rule (before you were allowed to add) would have saved Mr Ackman a lot of extra losses. Time has revealed plenty about Valeant. And it would have saved me at Sun Edison too.

--

Whilst I think that someone asking me (as per the last blog post) for a valuation on every stock is absurd, I think it is entirely reasonable for them to ask "under what circumstances would you average down". If you can't answer that you probably should not own the stock. I should insist on it with every long investment.






John

Comments on investment philosophy - part one of hopefully a few...

This is the first of several investment think pieces I have in my head dealing with investment philosophy, where markets are now and maybe even a stock or two... They are surprisingly hard to write so these posts might come slowly...

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When I was starting out in the investment game I read Warren Buffett's letters from inception, Ben Graham, Phil Fisher, anything I could on Charlie Munger and the rest of the standard investing canon. 

One thing that had a profound effect on me was Warren Buffett's twenty punch card. (Quoted here...)

Buffett has often said, "I could improve your ultimate financial welfare by giving you a ticket with only twenty slots in it so that you had twenty punches - representing all the investments that you got to make in a lifetime. And once you'd punched through the card, you couldn't make any more investments at all. Under those rules, you'd really think carefully about what you did, and you'd be forced to load up on what you'd really thought about. So you'd do so much better."

Buffett is right. That would be a really good way to run your private investments - you would, I think, be very rich by the time you were old. And indeed Charlie Munger has run his career close to that way (though I suspect he is closer to 100 investments by now...) 

Charlie Munger has quoted Blaise Pascal approvingly: "all of humanity's problems stem from man's inability to sit quietly in a room alone."

There are plenty of people out there who call themselves Buffett acolytes - and as far as I can see they are all phoneys. Every last one of them. 

Find any investor who models themselves off Warren Buffett and look at what they do.

And look at their investments against a twenty punch card test. 

They fail. They don't even come close. Several big-name so-called Buffett acolytes have made more than three to five large investments in the last three years and at prices that can't possibly meet the twenty punch card test. Most phoney Buffett acolytes have been turning stock over faster than that.

Warren Buffett's two juniors (Todd Combs and Ted Weschler) have turned over many stocks in the past few years too - and at prices that don't reconcile with any twenty-punch-card philosophy. They are phoneys too. Just a little less egregious than many other so-called Buffett acolytes.  

I used to profess myself a Buffett acolyte too. But somewhere along the line I realised I was a phoney too. I just wasn't close to that selective and when the situation was right I wasn't anywhere near willing enough to pull the trigger and go really large in a position. 

There are psychological feedback mechanisms that stop you meeting the twenty punch-card test. Firstly it is really hard to be that patient. I did not find a new stock that met that test this year. Or last year. Or the year before. Or the year before that. I found one in 2012. And prior to that I had not found a new one since the crisis (when there were many available most of which I missed). 

But I am incapable of sitting idle since 2012 (even though the local beach is very good) and so I do stuff. Inferior stuff. Stuff that may produce inferior results. 

And some of it (thankfully not much) did produce inferior results. [I was long Sun Edison for example.]

And when you are wrong like that it is scarring. It makes you less willing to pull the trigger in quantity when something does meet the twenty punch-card test. Indeed perhaps the main advantage of the twenty punch card test is the avoidance of mistakes so you can (both psychologically and from a risk-management perspective) take much bigger positions when they come along.

Phoney Buffett-style value-investing is dangerous

A twenty punch card investment portfolio is - by its nature - a concentrated investment portfolio. If I had run my portfolio like that I would have come out of the crisis with maybe six stocks, turfed one or two by now and added a single stock in 2012. 

The rest of the time I would have spent reading, talking to management of companies I was never going to invest in, and otherwise tried to work out how the world actually works. (And the world is always more complicated than you imagine so the work is endless even if the activity is muted.) 

Many so-called Buffett acolytes (phoneys, all of them) have imbibed that a concentrated portfolio is a good idea. And so they present as having five to twelve stock portfolios and are prepared to take 30 percent positions. 

But the stocks often don't meet the twenty punch-card test. And so these investors wind up with large positions in second rate investments. When one goes wrong it is deeply painful. When three go wrong simultaneously it is devastating. 

The lesson here is easily stated: "if you are going to fill your portfolio with crap, it better be diversified crap". 

Several of my favourite phoney Buffett acolytes have been posting catastrophic losses. It was due. The phoney Buffett acolytes still here are just waiting for their turn to have catastrophic losses. 

Real twenty-punch-card investing is impossible to sell to clients

Just imagine if I had run a twenty-punch-card style portfolio and sold it to clients. We would have made a bunch of decision in 2008 and 2009 and our numbers would have been stunning to 2012. (Our returns on our longs were very good in those years. Way ahead of market.)

We would have turfed one or two of these. (Some businesses just change, others go up seven fold and are just not worth holding.) 

I would have bought a single big position in 2012.  

And since about mid-way through 2013 my cash holdings would be going up and up. Partly from dividends, partly from asset sales. 

And I would be underperforming now. Quite badly, even though returns would be positive. Come to think of it, my longs mostly are underperforming now. So are the longs of many fund managers I admire.

But mostly I would have been just idle. So in the midst of underperformance a client might ask me what I did last year and I would say something like

a) I read 57 books

b) I read about 200 sets of financial accounts

c) I talked to about 70 management teams and 

d) I visited Italy, the UK, Germany, France, Japan, the USA and Canada 

but most importantly I did not buy a single share and I sold down a few positions I had.

And I underperformed an index fund.

That is kind of hard to justify. I don't have a clue how you would ever sell it to clients. I can't imagine any clients buying it.

And so to my knowledge there is absolutely nobody who is true to the formula and who really runs a concentrated 20 punch-card formula fund. 

They are all phoneys because (a) the truth is so difficult it hurts and (b) the clients can't handle the truth.

What I did when I realised I was a phoney Buffett acolyte

Somewhere along the line I realised that did not have the temperament to be a true 20 punch-card investor. So I did two things.

a). Rather than accumulate cash and just sit there for very long time periods (five to ten years) I tried to find shorts. The shorts have two benefits (i) they turn into cash when the market goes down and twenty-punch-card opportunities arise and (ii) they attempt to make some money on their own.

b) I run a portfolio that is more divesified than I desire. I desire to be 15 stocks in 15 industries and seven countries, though in reality my desire should be to be more concentrated than that. [I would/should be happy with five 20 percent positions as long as they all meet the 20 punch-card test.] Alas (justified) lack of conviction means my portfolio is about 45 long positions - many of which are for sale when a better idea comes along. In other words when I hold crap at least I diversify it.

This is not entirely satisfactory. I get some longs wrong and lose money on those. And the shorts can be difficult to make money on even when you are right. A stock that goes from 10 to zero might look like a great short but if it goes via 50 then you are likely to be forced to cover some on the way up and its unlikely you will ever recover your losses.

We have strategies to manage both those problems and the results have been and will remain satisfactory although they will not always glow. There can be sustained periods of dull performance. And whist this is not as hard to sell to clients (or yourself) as a true 20 punch-card portfolio after a couple of years dull performance can become exhausting. Clients who haven't lost any real money will leave - because there is always someone else who is making money - and the grass is always greener - and because clients see performance more than inherent risk in any portfolio - and low risk portfolios can be dull.

Portfolio managers I admire

I still admire Buffett's portfolio management more than I can say. He really is astonishingly good at what I have chosen to do for a living.

But I can't emulate Buffett and nor can anyone else I know. And if someone uses his name to describe their investment philosophy my (likely accurate) presumption is that they are a phoney.

There are other managers I admire. I still think Kerr Neilson at Platinum is a freak but it is awful hard to emulate him though in at least part of my portfolio I try. I worked for him for seven years and have some idea how he does it. [He is unbelievably good at cyclical stocks for instance - something Buffett professes no desire to do and which I lack some of the skills necessary to do.]

But almost every other portfolio manager I admire is a long-short manager who has come to an investing compromise like mine. They aspire to be world-class long investors but irregularly fill their portfolio with more diversified second-class stock picks. And they run short books.

And the short books hopefully make money on their own - but mostly make money at the right times - delivering their profits in down years like 2008, and stripping them of profits in super-strong markets.

The problem is that almost every one of these managers is having a dull patch at the moment. These are people I think are amongst the best in the world. And I think (without naming names) that they are having the dull patch the same way as I am. In particular it is devastatingly hard to find things that meet the 20 punch card test. [If you have one please email me. I am prepared to listen to almost anything.]

So instead they have been buying things which are "ownable" rather than "buyable". In other words things that are sort-of-okay in that if you owned them for a decade you would probably be happy enough but not thrilled with the result. And the results from doing this have - at least over the past year - been dull. [Exception: if you bought pure bond sensitives as an alternative to bonds you did really well - but alas I did not do that...]

And the good long-short managers have found it easy to find egregious crap to short. Stuff where the story has more resemblance to fantasy than reality. The typical tell is massive differences between "the story" and the GAAP accounts". 

Some of these fantasy stocks have blown up (Valeant, Concordia) but many are alive and well and when I describe them as fantasy stocks I just get back hostility. And as a rule long "ownable", short "fantasy" has not worked that well. Truth be told it has produced results that somewhere between 5% positive and 5% negative. It has been hard work to go nowhere. 

And there are fund managers who are doing better. Some of them have tricks I do not understand (I put David Tepper in this camp - I simply don't get how he does it and hence can't emulate it*). But the ones I do understand I don't like. Their chance of a plus 20 is clearly better than mine. And their chance of a minus 40 is alas even better than that, and that is something I find abhorrent even if the clients are seduced.

Its really hard out there. I don't think it is a time to be greedy, but low to negative yields make it a difficult time to be safe/fearful as well. 

John

*The Tepper trade that most impressed me this cycle was long the airlines. I had enough knowledge to know this cycle would be good if I put the pieces together. But I did not put the pieces together and my allergy to capital intensive competitive businesses overwhelmed common sense. Tepper made a great trade that almost any Buffett acolyte would have ignored.