Value Investor Insight - Tilson Funds

BEHIND THE NUMBERS: Hedging IIWhitney and Glenn offer a key argumentfor making bearish bets: hedging.Specifically, they see such bets as “insurance”against their portfolio of “80-centdollars,” and take comfort in the analogythat “The fact our home didn’t burndown doesn’t mean we’re upset that welost 100% of our ‘investment’ in homeinsurance.”But any insurance only makes sense ata given cost, which I’d argue is too highwhen it comes to short-selling. Greatshort-sellers like Michael Steinhardt andEdward “Rusty” Rose have made significantprofits over the course of theircareers from shorting, but from my interactionswith each, it was always clear thattheir motives in shorting were not as“insurance,” but as a vehicle to createhigh absolute profits in every single position,in up markets or down.Are put options a better alternativethan shorting for making bearish bets?They do take away the risk of unlimitedloss and aren’t susceptible to shortsqueezes, but they suffer from two additionalmajor flaws. First, other than duringthe Internet bubble, I’ve found thatthe most overvalued and hyped stocks aresmall- or mid-caps, for which puts usuallyaren’t available or are extremely expensive.Second, puts require that you beright not only on the fundamentals, butalso on timing. Payday may arrive, butyour options may already have expired.So if making bearish bets is the costlygame I think it is, how should valueinvestors address issues of risk management,preservation of capital and periodsof underperformance? I like Icahn’sdescription of his risk-managementapproach as “fundamentally driven bythe underlying value of the companyrather than prevailing market conditions.”In other words, nothing beats gettingthe value proposition right on astock-by-stock basis as your best protectionfrom permanent capital loss. I amstill looking for and finding 50-cent dollarsand would argue that the 80-cent dollaroffers both inadequate downside protectionas well as insufficient upsidepotential. I also insist on growth as a keycomponent of the investment thesis –value accreting over time furtherenhances the risk-reward equation.Don’t worry about short-term swingsin performance. Contrary to modernportfolio theory – and as legendary valueinvestors such as Buffett and JoelGreenblatt have well articulated – portfoliovolatility and risk are not remotelysynonymous. Tweedy, Browne’s ChrisBrowne studied the long-term performanceof seven of the greatest valueinvestors in history and found that theyunder-performed market averagesbetween 28% and 40% of the time –sometimes accompanied by hair-raisingasset drawdowns – while still trouncingthe averages over long periods. My unsolicitedadvice: Embrace volatility – you’llmake more money in the long run.There will, of course, be many marketswoons to come and short selling mayhelp mitigate losses during the toughesttimes. But for my and my investors’money, the structural disadvantages ofshorting make it too un-businesslike topursue. VIIJoe Feshbach runs Joe Feshbach Partners,which invests primarily in companies facingsome type of crisis – from accounting scandalsto government investigations.Look here for insight and ideasfrom the best investors.Subscribe now and receive a full year ofValue Investor Insight – includingweekly e-mail bonus content andaccess to all back issues – for only $349.That’s less than $30 per month!Subscribe Online »Mail-in Form »Fax-in Form »Want to learn more?Please visit www.valueinvestorinsight.comOr call toll-free:866-988-9060February 28, 2006www.valueinvestorinsight.comValue Investor Insight 21