Value Investor Insight - Tilson Funds

BEHIND THE NUMBERS: Hedgingavoid selling too soon – and why we don’tregret losing money on the hedging so far:We think McDonald’s [MCD, $35.78] iseasily worth $40 per share, based on a16x multiple of the $2.50 per share offree cash flow we think the company canearn in the not-too-distant future. Whenthe stock hit $32 in late 2004 – havingrisen steadily from a low of around $12in March 2003, when we last purchased it– it was, in our opinion, the proverbial80-cent dollar.In the past we might have sold andlocked in our gains, but this would havetriggered big taxes and, more importantly,denied us the healthy long-term compoundingwe expect from this stock overmany years to come. Instead we boughtlong-dated puts on the S&P 500, whichwe felt were very attractively priced, witha notional value proportional to ourholdings in McDonald’s. In this way, wecould hedge our McDonald’s positionagainst the possibility of a substantialmarket decline, yet still benefit from theupside of an undervalued stock that webelieved was highly likely to outperformthe S&P 500 over time.So what has happened? The S&P 500has risen, volatility has fallen and timehas elapsed, all of which have caused theS&P 500 put position to decline.Multiply this across a number of positionsand it’s easy to see how this strategylost us a lot of money.Is hedging 80-cent dollars – when theHEDGING AS INSURANCE:The fact our home didn’t burndown doesn’t mean we’re upsetwe lost 100% of our “investment”in home insurance.cost of hedging is at or near all-time lows– the wrong strategy? We don’t believeso. Buying insurance always looks wrongin hindsight when the event you insuredagainst doesn’t happen. But the fact thatour home didn’t burn down last yeardoesn’t mean we’re upset that we lost100% of our “investment” in our homeinsurancepolicy – and it doesn’t keep usfrom renewing our policy.Capital preservation is far moreimportant to us than keeping up with theS&P 500 over short time periods. We dobelieve, however, that we erred somewhatin how we sized our “insurance” policies– in essence, we took a good idea andoverdid it. All of our index put positionstended to move together, so we effectivelyhad more insurance than we needed. Thisserved us well during the down months of2005, but cost us for the year as a whole.In addition, our buying of at-the-moneyputs was, in hindsight, a mistake. We’renot trying to hedge against modest 5-10% declines, but against a much largercorrection, so we’ve recently been buying10% out-of-the-money puts. Finally, ourmacro concerns lessened our confidencein our long stock positions more thanthey should have. We’re still hedging our80-cent dollars, but at what we now thinkare more appropriate levels. VIIFunds managed by Whitney Tilson andGlenn Tongue own puts on the S&P 500, Russell2000 and MBIA, and are short Fairfax Financial,Farmer Mac, MBIA, OmniVision, Palm, Inc.,Planar Systems and Research In Motion.Profit in L.A.at the 2006 Value Investing Congress West!We are assembling another high-powered group ofbrilliant, successful investors who will teach theirinvestment philosophies and techniques, as well as sharetheir very best, actionable investment ideas including:• Whitney Tilson, Value Investor Insight• John Rogers, Ariel Capital• Dan Loeb, Third Point• Jeff Ubben, ValueAct Capital• J. Carlo Cannell, Cannell Capital• Bill Miller, Legg Mason• Mitch Julis, Canyon Capital Advisors• Steve Romick, First Pacific Advisors• Tom Brown, Second Curve Capital• Mohnish Pabrai, Pabrai FundsNO PANELS! Each session is taught by one of our experts – in-depth –and includes time for your questions. In addition, our experts willexplain their best and most current investment ideas in detail.Optimally scheduled between the Berkshire Hathaway andWesco annual meetings so we can all easily attend Wescotogether and learn from the incomparable Charlie Munger!Limited Attendance – Avoid Disappointment!The Congress is limited to the first 480 paid registrantson a first-come, first-served basis.REGISTER TODAY!VALUE INVESTOR INSIGHT READERSSAVE UP TO AN EXTRA $150!REGISTER ONLINE AT:http://www.valueinvestingcongress.comYour discount code is VICVIIA1January 31, 2006www.valueinvestorinsight.comValue Investor Insight 19