Wednesday, 2 March 2016

The Big Short

I recently caught the film in the cinema. I’d read the book a few years ago but none the less the film was both entertaining and thought provoking. As one would expect from a film about financial markets it had a lot of relevance to investing.

Firstly what a great trade it was. The main characters in the film spotted an asset that was priced as if its components were uncorrelated (as they always had been in the past) and realised that they were in fact highly correlated. The best thing was that the trade had a very high pay out. By buying Credit Default Swaps on Mortgage Backed Securities Derivatives they were paying an insurance premium and getting the principle in return if they were correct. These sort of opportunities don’t come around very often but when they do they are highly lucrative.

The film showed really well why value investing is hard. Buying or selling something because its market price varies significantly from a conservative estimate of true value sounds great but the only reason that you get mis-pricing is because very few people agree with this assessment. It can be psychologically hard to go against the consensus opinion with your own money. The film showed that when you do it with other peoples’ money there’s always a chance they will call you up, shout at you and then threaten to sue you.

Short selling is hard. When you take a short position you are essentially betting that something will fail. This often has real world consequences like people losing their house or jobs. I think this is one of the reasons that a lot of short selling focuses on frauds. Yes a fraud is usually a zero which is the best return you can hope for as a short seller. But I think there may be something deeper too. By exposing fraud it is quite clear that justice is being done whereas it is less clear cut with a business that is merely overvalued or fails due to management incompetence. That said I do believe that for good businesses to succeed, some bad business need to be starved of capital and fail. I personally have never had a moral issue shorting a company. But as the character Ben Rickert points out in the film, when they do fail sober reflection is probably a more fitting reaction than triumphalism.

Despite being a great trade I do think the film showed all the participants making mistakes.  Mike Burry in particular was too early putting his trade on in 2005. This is always a difficult part of investing, particularly for those of us of a ‘Value’ bent so I’m not sure really what he could have done to prevent being early. Where I think he did go wrong was with position sizing. He thought that his history of past returns was enough for his investors to stick with him through all short or medium term under-performance as long as he was right in the end. He suffered from the illusion of permanent capital and in the end had to gate his fund to get the permanent capital he needed to see the trade through. I reckon a lot of value investors who took large positions in specific stocks and underperformed in 2015/2016 may find that they were suffering from the illusion of permanent capital. We all sometimes underestimate how long it will take for a particular investment thesis to play out and we would be wise to treat each investment like a DIY project. Think how long it should take, then double it…and double it again.

I think the final mistake that most of them made was underestimating the counterparty risk in the trade. The character Mark Baum’s hedge fund was part of Morgan Stanley so had exposure to the financial crisis despite his short position. All the others had bought their CDS from investment banks so would have been potentially valueless had the investment banks failed while they still held them. If they truly saw the scale of the coming financial crisis they should have had CDS on each counterparty and maybe even a long government bond position to protect themselves further.
And as always in investing luck played a part. Several of the characters found the trade because someone else introduced them to it. And the founders of Cornwall capital were able to access CDS because of a former neighbour.

The secret of finding the next Big Short? Be open to new ideas, bet on value, look for asymmetric returns, focus on position size, consider counterparty risk up front and practice humility when it pays off.

No comments:

Post a Comment