Tilson & Pabrai: A Change In Strategy Or Just Finetuning Tactics?

One of the toughest aspects of successful investing is maintaining discipline in the face of adversity. Every investment strategy will have periods of underperformance. Those unable to hold to their strategies in down periods risk compounding their woes.

In my estimation, value investors have a harder task in this respect than do growth or momentum investors. Growth investors have their views confirmed by company earnings and guidance while momentum players use technical indicators and market pricing as validation.

In contrast, value investing is contrarian by nature; bad company developments and horrible price action are often invitations for investing capital. The value investor is reliant on what Warren Buffett calls “the courage of your convictions.” This begets that most famous of value mottos, “The massive drop in the share price doesn’t bother me — I’m a long-term investor.”

Which brings us to a Financial Times article by Whitney Tilson titled “Lessons To Be Learnt From Losses.” Tilson’s piece illustrates the slippery slope between self-confidence and denial, conviction and stubbornness.

Tilson is, among other things, a hedge fund manager whose views on the housing/mortgage markets have been spot on. Despite being early and right on the carnage in the financial sector, Tilson didn’t fully anticipate the collateral damage this carnage would inflict on the rest of the economy. As a result, his long picks fared poorly.  Tilson’s lesson? In his case, an overly strict definition of “bottoms-up” investing and inadequate consideration of macro factors in his stock-picking.

Tilson also mentions the case of Mohnish Pabrai (see my review of his book, The Dhandho Investor). Pabrai’s losing streak is going on a few years now. Coincidentally, he announced a change to his investment strategy, basically switching from “focus investing” (holding a concentrated portfolio of a handful of positions) to a diversified portfolio with more stocks and less concentration in holdings. Anyone who has read Pabrai’s book will recognize this change as a complete retreat from the chapter in his book titled “Dhandho 301: Few Bets, Big Bets, Infrequent Bets.” His new motto could be summed up as “Lots of Small, Frequent Bets.”

Where is the line between improving yourself and admitting defeat with a change of course? In the case of Pabrai and Tilson, it’s impossible to say. Each of us can only make that distinction for ourselves. Perhaps the most important investing tenet can be summed up as “investor, know thyself.”

For what it’s worth, I generally agree with both Tilson’s and Pabrai’s new insights. In fact, I previously discussed both Pabrai’s performance/outlook and macro views in value investing in this June 2008 post.

I’ve always felt that value investors have misunderstood the bottoms-up vs. macro question — after all, how can an investor accurately assess a company’s future prospects without a good handle on the industry and economy that company operates in? No company exists in a void.

As for Pabrai’s fascination with the Kelly Formula, which uses expected value (EV) to dictate how big a position to take in a stock, perhaps a key point is overlooked: assessing EV may be straightforward in terms of hypotheticals or card games but in stocks, both the expected return and the probabilities are guess-timated by the investor. As Ben Graham would point out, the more assumptions built into your decision-making process, the more likely a mistake will be made.

The current bear market will present investors with many opportunities for self-introspection. Perhaps the true lesson from Tilson and Pabrai is that there are no set rules for investing. Rather, investors should consider a guidelines-type approach and assess each situation in its own right. It’s never different this time except the one time it is.

Seth Klarman, in his seminal Margin of Safety book, implied that investors did not need “a book about investing, but a book about thinking about investing.” Somewhere in that cryptic quote lies one of the keys to investing success.

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