It's hard for many people to look at hedge funds' successes without a touch of envy, and often impossible to behold their messes without schadenfreude. Forbes estimates that 46 of the world's billionaires made their money in hedge funds. Yet it's not at all difficult to recount episodes where specific hedge funds lost billions, and hedge-fund closings are routine.
The late, great dean of value investing, Benjamin Graham, said: "The investor's chief problem — and even his worst enemy — is likely to be himself."
"There is no perfect strategy, and there is no mistake-free investor," said Justin Carbonneau, partner at Validea Capital Management, which runs an ETF — the Validea Market Legends ETF (VALX) — that is based on investing models of market icons.
Here are a few recent bets made by market masters that haven't paid off for them but offer some teachable moments for all investors.
— By Tim Mullaney, special to CNBC.com
Posted 8 April 2016
The multibillion loss Bill Ackman's Pershing Square Capital has taken on shares of Valeant Pharmaceuticals, which has plunged to $36 from $241 a share since September, has garnered plenty of headlines. (As of last June 30, Pershing owned 19.5 million shares of Valeant. It now owns 30.7 million and also owns derivative positions in Valeant.)
CEO Michael Pearson, who ran the putatively Quebec-based company from New Jersey, was ousted on March 19. Ackman, 49, joined Valeant's board in a bid to salvage the biggest loss in the history of his fund.
Carbonneau said that the big Valeant bets like Ackman's show that investors failed to make sure that a "margin of safety" existed and to have a disciplined sell criteria. "Prior to VRX's crash, it was trading at a very high multiple, and when that's the case, you're really betting that the firm will produce exceptional results. Any shortfall in earnings or other problems and the stock can get hammered, since it's priced for perfection." He added, "Ackman's mistake was focusing on potential rather than proven results."
Another legendary investor caught up in the Valeant free fall was the money manager Ruane, Cunniff & Goldfarb, which runs the now $5.5 billion Sequoia Fund (SEQUX). It's a cautionary tale for all investors who think only the hedgies bet really big. The Sequoia Fund is one of the famed mutual funds available to average investors.
Sequoia achieved success by a focused approach — 70 percent of its assets in its top 10 holdings. Sequoia management said in its 2015 annual report that its "credibility as investors" had been damaged by the Valeant bet. In a more recent letter, in which it announced the retirement of longtime CEO Robert Goldfarb, the fund wrote, "While we have beaten the market over the past decade, through the end of 2015, our investment in Valeant has diminished a record that we have built over two generations."
Valeant and its backers said it was a "risk-free" drug company version of Berkshire Hathaway, but New Yorker financial writer James Surowiecki noted, "The attempt to evade risk turned out to be the riskiest strategy of all."
A hedge fund investor, Centerbridge Partners, may call a default on Valeant, citing the company's inability to file its annual report on time, according to a Wall Street Journal report on Tuesday, April 12.
Icahn has made some great trades lately. One example: the billions he made on Netflix when investors soured on the company. The Netflix trade was notable for the fact that Icahn got out with a big gain, even though the stock has continued higher. What had been his biggest recent holding, Apple, is one Icahn told CNBC on April 28 he'd finally cashed in, making in the range of $2 billion.
It could take Icahn a lot longer to generate value from some other big bets in the energy sector. Icahn has blown a good chunk of his $20 billion fortune on shares of Chesapeake Energy, one of the most aggressive drillers for shale oil and gas and a company that got hit hard when oil prices began their historic plunge in 2014.
The good news for Icahn: His 73 million shares of Chesapeake represented only 1 percent of his portfolio as of Dec. 31, according to WhaleWisdom, a service that watches giant investors. The bad: Energy represented 16 percent of Icahn's portfolio even after a tough 2015 for energy stocks. His companies' losses on Chesapeake, Cheniere Energy and refining company CVR Energy each totaled $1 billion or more.
David Einhorn built a billionaire fortune largely on big short-selling bets against financials. but, like Icahn, has stubbed his toe on energy bets. His Greenlight Capital has been buying Consol Energy, now at $11, since it was in the $30s. Consol is the lowest-cost coal producer in Appalachia and also has natural gas interests. His bet is that Consol will be the last coal producer standing, ready to supply a big chunk of the 25 percent of U.S. electricity that will come from coal after global-warming rules are implemented. (Coal, once 60 percent of electricity, will supply 30 percent this year, according to the Energy Information Administration, and 2016 will be the first year that natural gas surpasses coal generation annually).
Year-to-date, Consol is up 46 percent, though still down 60 percent in the past year. Consol and Einhorn may get there, but it will be a tough ride. Ask Carl Icahn.
In 2015, three stock positions cost Einhorn as much as three percent of capital in a calendar year — the first time that ever happened: Consol Energy, Micron Technology and SunEdison, which may file for bankruptcy, according to many recent press reports. An old investing adage advises to be happy if you miss out on the final 20 percent of gains in a stock that has already done well. Greenlight told investors that maybe it should have monetized gains in these stocks when they were higher.
"We run a concentrated portfolio. Our philosophy is to invest the most capital in ideas where we have the most conviction. Unfortunately, a good process does not prevent mistakes, nor does it guarantee good outcomes, especially on a short-term basis," Greenlight wrote.
The Oracle of Omaha is usually a peerless picker of classic American blue-chip stocks — except this time.
Berkshire Hathaway began assembling what's now a $11.9 billion position in IBM in 2011, at average prices of about $170 a share, he said on CNBC last year. IBM's now at $147, up about $10 this year. As hedge fund boners go, this isn't the biggest. But this is Buffett we're talking about.
"It seems like he violated one of his own rules with IBM, which is that you should invest within your core competency," Carbonneau said.
In a sense, the core competency problem was why Buffett chose IBM and not Apple, Facebook or Google to make his tech bet in. He wanted the least "techie" of the tech bets. But in the recent bull market run, it's been the high-growth tech firms that have been most richly rewarded.
Carbonneau said a good lesson from Buffett's bet on IBM is that when an investor goes outside a sweet spot, take it slowly. "In retrospect it seems that his mistake was not necessarily going outside of his core competency, but doing so in such a big move," he said. "When you are venturing into unfamiliar waters, you probably want to dip your toe first rather than diving in headfirst."
For the record, Buffett continues to show faith in IBM, unlike another recent dog pick of his, Tesco, which he bailed on after performance shortfalls were followed by an accounting scandal. Buffett said his mistakes in the Tesco case were simple: first, he, and no one else, got the facts wrong, and then, he "thumb-sucked" for too long before selling.
Traders can mess up by picking the wrong company or by diagnosing trends wrong. When they do both, it's a doozy.
Billionaire hedge fund manager Lampert, who founded ESL Investments, has lost billions on his position in Sears Holdings, which has dropped to $15 a share from $175 since 2007 (Lampert joined the board in 2005 and became Sears' CEO and chairman in 2013). That's an eerie note to Ackman, now on the Valeant board, about how long it might take to turn around a failed bet.
One premise of Lampert's investment was that Sears' real estate holdings, including anchor-store positions at shopping malls, would be valuable even if the core retail franchise suffered. But retail has been unkind to department stores in general, making those spaces less coveted. Declining revenue, big losses and the spin-off of the unsuccessful Lands End acquisition are all negatives. Sears is closing about 50 stores this year in a bid to stop declines in same-store revenues.
Lampert controls 53 percent of Sears, according to its 2015 proxy statement, and another famed investor, Fairholme Capital honcho Bruce Berkowitz, owns about a quarter of the company, joining the board in March 2016 after first investing in 2005. He still believes in the company's real estate, too. But skeptics abound: "Someone's going to be left holding the bags, and those bags are not going to be worth much," a distressed-debt investor told TheStreet.com in March.
Another cautionary tale for mutual fund investors, especially those stretching for income in a low-rate world, as well as any investor taking comfort in "legendary" names in the fund market. Third Avenue Management's chairman is widely respected value investor Martin Whitman, and the firm has been long known for its flagship $1.3 billion Third Avenue Value Fund (TVFVX). Whitman made his name during the heyday of active mutual fund managers by beating the market picking value stocks.
But last December, it was the $800 million Third Avenue Focused Credit Fund that became the largest of at least three funds to fail in the teeth of the drop in the junk bond market, stemming from the collapse in oil prices. Stripped to essentials, Third Avenue, a mutual fund rather than a hedge fund, tried to goose its returns by loading up on the junkiest junk: Even before it began to implode, it had nearly 20 percent of its holdings in the lowest-rated, most illiquid debt securities.
As investors got more worried about energy last year, the spread between junk bond yields that concentrated in the energy business and investment-grade government debt got ever wider as the price of junk fell. That sparked investor redemptions that Third Avenue ultimately couldn't meet. "Third Avenue Focused Credit was a collection of the worst pieces of garbage under one roof that I have ever seen," CNBC's Jim Cramer said after the collapse.
Third Avenue is currently in the process of returning capital to shareholders "in as timely a manner as possible," according to a shareholder letter. For the record, the majority of its assets are in other mutual funds.
While the hedge fund industry in its modern form is only about 30 years old, there has never been a shortage of investing blunders to review courtesy of the brightest, brashest minds stalking the market. And the recent stumbles sure don't compare to the really big ones, like John Meriwether and Long-Term Capital Management in 1998.
But being on the wrong side of big trades, even smaller ones, is one reason the average hedge fund has trailed the S&P 500 each of the last four years. Meanwhile, Warren Buffett's famous bet that the broader market would beat a collection of the best hedge funds over 10 years is now eight years old, with the market way ahead.
The allure of the big score keeps people talking about hedge funds: Giant fortunes can be built when a previously obscure firm is right just once. "All of these picks highlight a broader issue that is evident but often glossed over when people talk about investment gurus," Carbonneau said. "There are far too many moving parts in the stock market for anyone to figure it all out. ... Good investing is about finding a good strategy and sticking to it through the inevitable ups and downs of the market."
Carbonneau said that even Graham, who is a legend and essentially created value investing from scratch, had an imperfect model. His approach was brilliant in assessing valuation at a particular moment in time, but it overlooked the quality of the company, which can open the door for some value traps. Buffett built on Graham's imperfect approach by adding in quality metrics such as return on equity and capital and retained earnings, and someday (if not already) someone will improve on Buffett's imperfect approach, too, Carbonneau said.