We Study Billionaires - The Investor’s Podcast Network - TIP579: Big Mistakes by Michael Batnick

Starting point is 00:00:00 You're listening to TIP. One of the best ways to become a better investor is by learning from our own mistakes. The next best way is probably to learn from the mistakes of others. Not only is it less painful to do so, but it's also less expensive. So I picked up Michael Batnik's book called Big Mistakes, the best investors and their worst investment mistakes. Michael Battenick is a director of research at Ritthold's Wealth Management, and he wrote this incredible book here that I've really enjoyed, so I think the listeners are really going to enjoy this episode as well as I share my takeaways from reading through it. The book dives

Starting point is 00:00:34 into the stories of Benjamin Graham, Jesse Livermore, Mark Twain, long-term capital management, Bill Ackman, Stanley Drunken Miller, among others. And it dives into their biggest mistakes that cost many of them billions of dollars. If you enjoy this episode, then I'd encourage you to also pick up Batnik's book called Big Mistakes, which we will include a link in the show notes for those who are interested. This was a really fun one to read and record, as the stories in it are interesting, as you'll find out here shortly. With that, let's get right to it. You are listening to The Investors Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Making money in the stock market

Starting point is 00:01:28 is an incredibly difficult task. If you don't believe me, consider that many of the world's greatest investors have made investment decisions that have costed them billions of dollars. Even Even the best investors have experienced an equal part of failure for every ounce of their success. Buffett and Munger knew that Walmart was a great business, but they didn't end up buying it. And Stanley Drunken Miller had decades of incredible success as an investor, and he still got suckered into buying tech stocks near the peak of the dot-com bubble. If there's one certainty when it comes to being an active investor, is that eventually, we're going to make multiple major mistakes.

Starting point is 00:02:05 And Batnick explains that once you think you have it all figured out, the most of the most of the market will humble you once more. Psychologically, dealing with these failures can be incredibly difficult, as the mistakes are oftentimes self-inflicted, and it makes it difficult to deal with these mistakes in an objective manner. The book Big Mistakes has 16 chapters covering the biggest mistakes from all these great investors, and I wanted to start with Chapter 1, which focuses on Benjamin Graham. If anyone is going to be forever remembered in the history books of investing giants, Benjamin Graham is certainly going to be one of those people. Batnik writes that Ben Graham is to investing what the right brothers are to flight.

Starting point is 00:02:42 And just as their names will be forever linked to the airplane, so will Graham's to finance, end quote. Then later he writes, the most important lesson that investors should take from the person who taught us the difference between value and price is that value investing is not a panacea. Cheap can get cheaper, rich can get richer. Margins of safety can be miscalculated and value can fail to materialize, end quote. I love how Batnik also pointed out how much how much different today's economy is relative to when Graham was investing. Since he was interested in these cigar butt-type companies, he looked for companies with these hard assets that could be relatively easily valued. You know, you look at property, plant, equipment, raw materials, inventory,

Starting point is 00:03:24 but today the world's most valuable companies have immense amounts of intangible assets, things that you can't touch, see, or feel. To give an example of just how difficult investing can be nowadays. Considered this example that Batnik writes about Walmart and Amazon. Over a five-year period, Walmart earned $75 billion in profits, and that was on $2.4 trillion in revenue. During that same period, Amazon earned just $3.5 billion in profits, and that was on $490 billion in revenue. And then you look at their margins. Walmart had a margin of 3.1 percent, and then Amazon's margin was 0.7%. So Walmart earned well over 10 times the amount of profits, and their margins were much better. But over that time period, Walmart lost $3.6 billion from its market cap, and then

Starting point is 00:04:17 Amazon gained $350 billion in their market cap. So it's no wonder so many people thought that Amazon was richly valued for so many years. The world was just in a process of changing drastically right before our eyes. Anyways, back to Benjamin Graham's story that I wanted to tell here. Despite being on the Mount Rushmore of investing grades, he made major investment mistakes that went even against his own teachings. Graham started an investment partnership in 1923, and it was in the midst of the roaring 20s. He performed exceptionally well until the market eventually hit its peak in 1929, and then at the end of 1929, Graham's fund was down 20%, and he thought that the worst of the bear market was over.

Starting point is 00:05:00 He went all in and he even started to use leverage to try and juice his returns. The trouble was many of these stocks that he owned, they looked really cheap, but they ended up getting even cheaper and the worst of the stock market crash was not over. The Dow Jones collapsed and Graham had his worst year ever losing 50%. From 1929 through 1932, Graham lost 70%. Just to get back to even, his portfolio would have to rise by over three times or 230%. To give you a sense of just how cheap the markets got during that time, Graham wrote the following in 1932 in a Forbes article. There are literally dozens of companies which have quoted value

Starting point is 00:05:40 of less than their cash in the bank. This means that a great number of businesses are quoted at liquidating value, meaning that these businesses are worth more dead than alive. From peak to trough in the Great Depression, the Dow Jones lost 89%, end quote. So $10,000 that was invested at the top would have dropped to just $1,100, which is why a generation of investors would never touch stocks again after that experience that would scar them forever. This is a reminder that just because you believe a stock is incredibly cheap, it doesn't mean that it can't get a bit more or maybe even a lot more cheaper. The market can stay irrational for much longer than you can stay solvent.

Starting point is 00:06:20 What it was that made Ben Graham such a great investor was his ability to accurately assess value and then invest based on the premise that eventually the price and the value will converge towards each other. When asked why this happens, he stated, this is one of the mysteries of our business, and it is a mystery to me as well as everybody else. We know from that experience that eventually the market catches up with value. It realizes it one way or another. Batnik then writes that it's critically important to be aware of value, but it's more important

Starting point is 00:06:50 to not be a slave to it. Graham taught us that there are no ironclad laws in finance and that cheap, can get cheaper." Relative to the other chapters here in the book, Graham's mistake really isn't as apparent as the others. He of course suffered an immense drawdown for a few years, but so did practically every other stock investor at that time. So there really wasn't much he could do to avoid it other than just being in cash or investing

Starting point is 00:07:14 in companies that happen to do well during a depression-like scenario. Of course, using leverage was a really big mistake in my opinion. And the concept of avoiding leverage is something I think our audience is generally pretty familiar with. The next chapter here covers one of the more brutal stories of investing history, which was that of Jesse Livermore. People love to use these sayings or rules of thumb when it comes to investing, whether it be like, buy when there's blood in the streets or nobody went broke taking a profit.

Starting point is 00:07:42 There's always a deeper level of complexity when it comes to investing, and we should never take these simple, really hard rules too seriously. Batnik writes, no investor is more emblematic of the dangers of human being. than Jesse Livermore, who made and lost several fortunes, and each time came away with beautifully elegant analysis, end quote. Livermore first got experience in the world of finance at the age of 14 as a bored boy in the year 1877. By age 17, he had traded his way to $1,200 in bankroll, and he got the taste of trading success very, very early. After a few years of trading in Boston, he was practically the only person who could consistently make money

Starting point is 00:08:25 So the trading firm just wouldn't let him come back, so he was forced to move to New York and then start trading there. By age 23, he had accumulated $50,000 and during his trading, he ended up losing it all in just a few hours because of all the leverage that he used. By age 28, he had bounced back and then he accumulated a bankroll of $100,000. And then he had this one big trade shorting Union Pacific stock, which would turn $250,000 into $6 million rather quickly. At this point in his life, he was just addicted to trading in the market, and he was continually

Starting point is 00:09:00 searching for his next big win. Because of this really big addiction, he yet again nearly lost all of his fortune. He was just whipsying back and forth. And it just reminds me of sitting at a blackjack table and you're continually putting the chips in on the table and you have no willingness to preserve your stack or walk away with big profits. In 1907, just before his 30th birthday, he had yet another. another big win, which took his net worth to $3 million, and then it was just two years later

Starting point is 00:09:27 in 1909 that he got wiped out completely again. When Livermore was 38, he was over $1 million in the hole, and he was forced to declare bankruptcy. Then once the stock market recovered, so did Livermore once more. He was making more money than ever during the Roaring 20s. Batnik writes, by the fall of 1929, Livermore built up his biggest short position ever. There was a $450 million short position spread across 100 stocks, and he was about to receive one of the biggest paydays of his entire life. From October 25th through November 13th, the Dow Jones crashed 32%.

Starting point is 00:10:04 In those 11 days, the Dow fell 5% seven times. Livermore then covered all of his shorts and he was worth $100 million, which is equivalent to $1.4 billion today after you adjust for inflation. He was one of the richest people in the world, and this would be the height of his powers." Remember earlier how I said the Dow had fallen 89% in the Great Depression? Well, when it finally recovered, Livermore was short the market. Once Livermore realized this mistake, he had gone long at the top during a debt-cat bounce, and that was when stocks started to fall again.

Starting point is 00:10:40 And already by 1933, everything he had made during that run-up through 29 and then that huge amount of money he made during the crash, all that money he made was totally wiped out. So he was short when the market ripped and long when the market crashed. Apparently much of Livermore's early trading tactics eventually became outlawed and he had a really difficult time trading profitably like he did earlier in his career. By 1939, he had had enough and he ended up taking his own life and he passed away with a net worth of roughly negative $300,000, despite being worth $1,000. million a decade prior. Clearly, Livermore lacked proper risk management. If you continually

Starting point is 00:11:23 put yourself in a position to have a small chance of losing everything, then eventually your bad luck is going to come. Always ask yourself when you're investing, what is the downside of this investment? And what does the worst case scenario look like? No matter how small your chance of the downside, it must be considered. Now I wanted to jump to chapter four on John Maryweather, which teaches us the lesson of a genius's limits. This chapter harps on the dangers of your own intelligence, and how much of investing success not only comes from making intelligent decisions, but also being disciplined in your investing process. One of the biases we have as investors is that the vast majority of us believe that we are above-average investors

Starting point is 00:12:04 with above-average intellect. But by definition, only 50% of us can actually be above-average. To illustrate this bias of overestimating ourselves, there was a study done that found that 94% of professors rated themselves as above their peer group average. And it's likely you'd see similar results if you asked most traders and most investors. One of the things that makes investing so hard is that there are so many smart people involved. Battenek estimated that 90% of trading volume is done by institutions, which are attracting these very smart people and they're all competing against each other to some degree. Another issue is that when it comes to investing, it's practically impossible to distinguish between skill and luck when we have a successful or unsuccessful investment. A skilled investor may have a bad year purely due to bad luck, and an unskilled investor may have a

Starting point is 00:12:57 great year purely due to luck. This is where John Meriwether comes into this story. Maryweather founded long-term capital management in 1994 after two decades of investing success at Solomon Brothers. Maryweather pulled together all these super smart people, and it's the smartest people he could find from these top business schools, and they joined forces with him with the goal of outsmarting the market. It was reported that while Maryweather was doing this trading at Solomon Brothers, he had

Starting point is 00:13:25 been paid $89 million, while the CEO was only paid $3.5 million. In starting long-term capital management, which is quite a funny name given where this story ends, he attracted some of the smartest people in finance that were clearly much, smarter than what the majority of firms were pulling in for their talent. And this attracted some of the biggest investors as well, and they ranked in $1.25 billion in AUM, and they became the largest hedge fund to open at that point in time. In the years that followed, they achieved exceptional returns. They earned 20% in the first 10 months, 43% in 1995, and 41% in 1996.

Starting point is 00:14:05 Their success continued uninterrupted as they managed to quadruple their capital without having a single losing quarter. But eventually, the good times would cease to roll on. Their arbitrage trading strategies started to become pretty well known, and once they started to put on a trade, they would see the opportunity gap start to close. Also, since they managed so much money, it was really difficult to move the needle because there were a finite number of opportunities to invest in. They ended up returning $2.7 billion to their investors to help alleviate that problem, but

Starting point is 00:14:36 they didn't take down their position sizes at that time. So they had up their leverage essentially from 18 to 1 to 28 to 1. In fact, at one point, they had $1.5 trillion in open positions, and they were levered 100 to 1, which as Livermore taught us, is a recipe for disaster. Batnik writes, this leverage would lead to one of the largest disappearing acts of wealth the world has ever seen. In May 1998, as the spreads between U.S. and international bonds widened, more than their models anticipated, long-term capital management lost 6.7%. Their worst monthly

Starting point is 00:15:16 decline up until that point. In June, the fund fell another 10%, and they were staring down the barrel of a 14% decline for the first half of the year. Russia was at the epicenter of long-term's downward spiral, and in August 1998, as oil fell by one-third and Russian stocks were down by 75% for the year, short-term interest rates skyrocketed, and then the wheels fell off for Marywell and his colleagues. All the brains in the world couldn't save them from what was coming, end quote. So very quickly, the whole thing came crashing down. By the end of 1998, the fund was down 52% year-to-date. Day after day, they were losing hundreds of millions of dollars before the Federal Reserve Bank of New York would do a $3.6 billion takeover. Long-term capital management

Starting point is 00:16:04 was four times bigger than the next largest hedge fund, and the world hadn't seen any collapse like They had $3.6 billion of capital, of which 40% was theirs, and in five weeks, it was all gone. The takeaway here is that the hedge fund manager's biggest mistake was putting too much weight on their complex models. In their models, they have a view of how much they could lose in the worst case scenario, but sometimes the unthinkable can happen, that your models aren't taking into account, and that led to the downfall of long-term capital management. Batonick closes this chapter with,

Starting point is 00:16:39 the lesson Usmir mortals can learn from this seminal blowup is obvious. Intelligence combined with overconfidence is a dangerous recipe when it comes to markets. Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord, and every conversation you have is with people who are actually shaping the future. That's what the Oslo Freedom Forum is.

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Starting point is 00:21:01 Jumping to chapter six, this chapter teaches us a lesson of staying within your circle of competence through the story of Michael Steinhart. But before getting to Steinhart, Batonick gives the great example of Buffett staying within his circle of competence during the tech bubble. While tech was going through the roof and shares of Berkshire were down 50%, Buffett stayed true to himself. He would continue purchasing companies he could understand at a price that he deemed sensible. In July of 1999, Buffett spoke at a conference filled with those in the tech industry, which

Starting point is 00:21:33 were newly minted millionaires. Buffett stuck to his guns of being skeptical of these valuations that didn't make any sense to him. Meanwhile, over the previous 12 months, Berkshire had lost 12% of its value, while the NASDAQ rose 74%, Yahoo gained 350% and Qualcomm gained over 400%. Batnik writes, one of the keys to successfully managing your money is to accept, like Buffett did, that there will be times when your style is out of favor or when your portfolio hits a rough patch.

Starting point is 00:22:04 It's when you start reaching for opportunities that you can do serious damage to your financial well-being. Michael Steinhart and his investors learned this lesson in 1994, end quote. Steinhart was one of the early pioneers in the hedge fund industry. In 1967, he launched one of his own funds. And from 1967 through 1995, he earned an average return of 24.5% annually. One dollar invested with Steinhart all the way through would have turned into $481. Had that dollar been invested in the S&P 500, it would be worth just 19.

Starting point is 00:22:39 Of course, any investor that does this well is going to go through some rough patches as well. And that makes it incredibly difficult to stay invested through those tough periods, such as during the market crash in 1987, which Steinhart's fund got a number. But Steinhart's critical mistake came during the 1990s when the popularity of hedge funds exploded. Because of the spectacular investors such as Steinhart, hedge funds started to gain a ton of attention, credibility, status, and every quote-unquote sophisticated investor wanted to invest with them. Easy money was available for the taking, so Steinhart launched his fourth fund

Starting point is 00:23:15 in 1993, and he had assets under management just shy of $5 billion. This was 200 times. the amount of money he had started out with after adjusting for inflation, but his biggest issue was that his specialty was in small and mid-cap stocks. And this was a field that was becoming more and more difficult to really move the needle on, given that he was managing just so much capital. And given his tremendous success to date, he felt confident venturing into these other areas of the market. And he ended up seeing opportunities in emerging markets, which Batnik described as not just a few miles outside his circle of competence, but akin to traveling to the moon, it was so far out of his expertise. Batnik shares a quote from Charlie Munger

Starting point is 00:23:58 that if you play games where other people have the aptitudes and you don't, you're going to lose. And Steinhart was playing a game that was destined for failure through these obscure trades such as swaps and directional bets on the debts in Europe, Australia, and Japan. Also, he had built solid relationships with these brokers here in the U.S., and that gave him an edge because he was able to get in and out of positions rather quickly, but this edge was lost when he explored overseas. Batnik writes, trouble arrived on February 4, 1994, when the Federal Reserve raised interest rates by one quarter of 1%.

Starting point is 00:24:32 U.S. bonds fell, but not nearly as much as European bonds. The bond market meltdown left a whole the size of Europe in Steinhardt's portfolio. He lost $800 million in just four days after the rate hikes. Putting too much money into something you don't fully understand is a good way to lose a lot of money. But what's more damaging than losing money is the psychological scar tissue that remains after the money vanishes. His decision to exit his circle of competence sealed his fate. The episode from 1994 left Steinhart mentally drained. Those feelings cannot be shrugged off any longer.

Starting point is 00:25:08 In his words, 1987 had shaken me. 1994 had been devastating. It had taken a part of me that could not be retrieved. Steinhard and his clients, the ones who had stayed with him anyway, enjoyed a nice comeback in 1995 as they gained 26% and recouped much of the losses from the previous year. On the back of this rebound, he decided to retire for good at 54 years old, end quote. So, Steinhart, despite having this remarkable career, was permanently scarred by this of getting burned badly by venturing outside of his circle of competence.

Starting point is 00:25:43 He was suckered in by what looked like an opportunity, and it's a reminder for us that there will almost always be a sector or be a part of the market that looks really tempting to jump in on. There's almost always something that you don't own in your portfolio, but you wish you owned it because it's outpacing everything else. Oftentimes when you feel tempted to hop on a trend, it's too late to get on, and you're better off just staying with your current approach. And before you venture into something new, be sure you aren't just doing it purely because of FOMO and that you have a solid understanding of the risks of what you're getting into.

Starting point is 00:26:15 It reminds me of that saying for investors that invest internationally that when you invest outside of your domestic country, you're trading the known risks for the unknown risks. And it points to the fact that nationally we tend to know our domestic market a lot better than other markets. So it can feel somewhat comforting to go out and invest in other countries because it appears to be safer from an outsider's perspective. I wanted to jump in here to Chapter 8. This is the chapter that covers Warren Buffett.

Starting point is 00:26:42 It's titled Beware of Overconfidence. At the beginning of this chapter, Batnik talks about the Endowment Effect. The Endowment Effect explains how when investors purchase a stock, they tend to value the holding more than when they previously owned it. Psychologically, there's something that happens when you purchase a stock where you tend to value it more, even though the company itself didn't change at all upon. on you purchasing it. It's similar to how if you placed a bet on a sports team, say it's playing in the Super Bowl, then you feel good about the decision after you place the bet. You feel much

Starting point is 00:27:14 more confident just because you place a bet on a particular team. Batnik writes, when something belongs to us, objective thinking flies out the window. This also ties directly into overconfidence, which is also a trait that is hardwired into us. For much of Buffett's career, he really did keep his emotions in check pretty well. When he'd have a really good year, he would tell his investors to not be surprised if a bad year were to come in the near future, and that exceptional results like what he delivered should not be expected year in and year out. But of course, not every one of Buffett's purchases would be a big winner. His costliest mistake of his career was in 1993 with the purchase of Dexter's shoes for $433 million. The mistake was not only costly because

Starting point is 00:27:59 the business would eventually go to zero, but because he was so confident in their long-term prospects that he agreed to purchase this company through the issuance of shares of Berkshire Hathaway. The 25,200 shares he paid in 1993 would be worth $13.8 billion in 2020. In 1991, Berkshire purchased a company called H.H. Brown. This was a leading North American manufacturer of work shoes and boots, so when he saw the opportunity to buy Dexter, he made sure he did not miss this opportunity. Buffett told New York Times that, quote, Dexter Shoe is exactly the type of business

Starting point is 00:28:37 Berkshire Hathaway admires. It has a long, profitable history, enduring franchise, and superb management. In his 1993 annual letter, Buffett wrote, it is one of the best managed companies Charlie and I have seen in our business lifetimes. Now, the part that Buffett missed was that US shoe companies would have lower demand over time as the demand for imported shoes would just take off. And these imported shoes had much better economics, mainly due to the lower labor costs associated with creating those shoes. Essentially, Buffett and Munger overestimated the moat of Dexter's shoe. He saw the tremendous success of H.H. Brown over the past couple of years, and he got lazy in his thinking when it came to purchasing Dexter. From 1994 through 1999,

Starting point is 00:29:22 their shoe revenue declined by 18 percent and profits were down by 57%. And to make matters worst, In 1999, of the 1.3 billion shoes that were purchased in the U.S. in that year, 93% of them came from abroad. And that's where the low labor cost was, remember. In the year 2000, Buffett acknowledged the massive mistake of purchasing Dexter and the compounding of his mistake by paying for the company with stock instead of financing it with cash or debt. Buffett's method of dealing with overconfidence is to think of investing as if you were given a punch card with 20 holes in and these represent all the investments you can make in your life. And the intention with this punch card is to really think carefully about each investment you make

Starting point is 00:30:07 and not take shortcuts in your thinking or your investing process. Next, we turn to the big mistake of Bill Ackman, which I'm sure many in the audience know what this one is going to be all about. One of the worst mistakes you can make as an investor is getting emotionally attached to an idea, or even making an investment essentially a part of who you are. So when people hear about this company, they think about your name. Charlie Munger has talked a lot about having the willingness to part ways with your best love ideas.

Starting point is 00:30:36 Psychologically, once we've made a personal investment that we own public and we tell our friends or we announce it on a podcast in my case, it is so, so difficult for us to part ways with it because nobody naturally likes a person who constantly changes their mind. And essentially, they just constantly flip-flop on their ideas. You can think of politicians, constantly flip-flopping. and then people just don't really like them that much. But with investing, the world is always changing. And our opinions must change with the world once we realize that investment has turned sour.

Starting point is 00:31:08 So to Bill Ackman here, he started in the hedge fund world in 1993, and at the age of 26, he started Gotham Partners. Batnik describes that they found success early on through the classic old school value investing approach, and that helps them grow from $3 million in the AUM in 1993 to $568 million. million at their peak in 2000. And similar to Steinhart, he got into trouble by straying away from what he was really good at. They started making these ill-timed bets. They ran a really concentrated style and they got into these ill-liquid investments. And then investors had had enough.

Starting point is 00:31:43 So Gotham was actually forced to shut their doors by the end of 2002. Batnik then describes Ackman as one of the most competitive investors the industry has ever seen. So in January of 2004, Ackman relaunched a fund of his own called Pershing Square Capital Management, which he still manages today. All of a sudden, after he launched the fund, Akman no longer wanted to invest the old-fashioned way of buying these cheap, unloved stocks and waiting for their valuations to re-rate. He turned into one of the most aggressive activist investors of his era. For those not familiar, an activist investor is someone who purchases a large stake in a company, and then they have the intent of enacting these changes on the company in a way that they think will be more value-acreative to

Starting point is 00:32:26 shareholders. This can mean that the current business is being mismanaged or some unprofitable business units need to be sold off. Activist investing is of course difficult because you're essentially telling managers how they should be running their business. But Ackman described himself as, quote, the most persistent person you will ever meet. Companies that Ackman had targeted included MBIA, Inc., Target, Sears, Valiant, J.C. Penny, and the most widely known company was Herbalife. So Herbalife was a company that Ackman was very much not bullish on. He was quite a bear. He shorted the company, and he made it very publicly known that he had done so. Even though he had no requirement to do it, he didn't have to file a 13F letting everyone know he was short the company.

Starting point is 00:33:10 He just was very public about it. Now, as many in the audience might know, Urbalife is a Los Angeles-based scam. company that sells weight loss products and nutritional supplements. At the time Ackman got into this ordeal, they did $5.4 billion in sales, and they actually had the highest paid CEO in America. Ackman accused Herbalife of being a pyramid scheme, and he gave all these presentations all about why he believed what he did about the company. Yes, one crowd, has anyone ever purchased a herbalife product? He described one of their top products as a $2 billion brand that nobody has ever heard of.

Starting point is 00:33:48 Ackman simply couldn't believe that a company could sell 10 or 20 times as much product as their competition, but do so without a single store. And this company actually ended up selling through their independent partners, who then went on and sold that product for them. So they sold the product to the partners, the partners sold the product to the customers. And he found that the vast majority of these distributors really weren't making any money at all. The money was made for herbal life, not in people actually

Starting point is 00:34:16 consuming their products, but in recruiting all these different distributors who would buy the product from them. Ackman had a three-hour presentation with 334 slides that showed how Herbalife's product was over 60% more expensive than their competitors. He gets into the science behind the products and every single thing you can imagine he had looked into. The presentations out there actually on YouTube, if anyone wants to watch it, it's three hours long, and that's how you'll know that you probably found it. In 2012, on CNBC, he stated, quote, You've had millions of low-income people around the world who have gotten their hopes up that there's an opportunity for them to become millionaires or some number like that.

Starting point is 00:34:55 And they ended up being duped. We simply want the truth to come out. If the distributors knew the probability of making $95,000 a year was a fraction of 1%, no one would ever sign up for this. And we simply wanted to expose that fact. The company has done their best to try and keep that from the general public, end quote. So from Ackman's perspective, if most of your distributors lose money, then they're eventually going to want to part ways with Herbalife.

Starting point is 00:35:22 And he called it a pyramid scheme because according to him, if you have all these distributors leaving, then you need to continually get new distributors to come in and then fill in on the sales that had been lost from those distributors that have been left. Ackman also told Bloomberg that this was the highest conviction investment he has ever made. And this whole deal with Herbalife ended up going on for years. He first got into it in 2012, and at one point, his short position was valued at north of $1 billion. And with the way he was so public about it, he practically stamped his entire reputation on this bet. After the presentation he did, it actually sent the stock tumbling by 35% on the downside,

Starting point is 00:36:03 and other investors apparently thought the stock was too cheap. Dan Loeb, through his hedge fund, third point, he purchased 8.9 million shares, which was over 8% of the business. Loeb said that the short sellers report had dramatic claims about the company. Then a week later, activist investor Carl Icon purchased nearly 13% of the business. Part of the potential appeal was that if Herbalife stock were to rise by even a certain amount, then that could trigger Ackman to receive margin calls and turn them into a forced buyer of shares, which could, of course, send the stock higher through a short squeeze. This is why it's so dangerous to short a stock and why most investors should probably avoid ever doing so,

Starting point is 00:36:43 because the downside risk of shorting is unlimited. Batnik writes, the key to successful investing, especially when you're a contrarian, is to have people agree with you later. But when you're so public about your investments, whether you're running a hedge fund or your own brokerage account, it makes it so much harder. Dealing with your own emotions is challenging enough. Dealing with the emotions and the pressure of others is even harder. When we're verbal about our investments, we lose track of why we're investing in the first

Starting point is 00:37:11 place, which is to make money. If his investors were the only ones who knew about this herbal life position, he could have easily said, we were wrong, covered his position, and moved on, end quote. Now, this book by Battenek was published in 2018, and Ackman was still short the company at the time of writing, but Ackman did actually exit this position in Herbalife in early 2018. Long story short, if you're going to make an investment public, do so knowing full well you may need to change your mind on the company next week if the facts change or if things really start to turn against you within the business. Second, don't get married to your investments and completely tie your identity to them

Starting point is 00:37:50 because if you do, it becomes psychologically incredibly difficult, if not impossible, to walk away from it. Now, in looking back at some of the best track records from these great investors, Stanley Drucken Miller is one of those investors that comes to mind as having one of the very best track records. According to the book here by Batnik, Druck and Miller achieved a 30% average annual return over a 30-year period. Now, to put this into perspective of just how impressive this is, $1 that compounds at 30% for 30 years would be worth over $2,600 at the end of that time period. It just almost seems unfathomable that this is even possible.

Starting point is 00:38:30 Before getting to the story in the lessons from Drac and Miller, Battenick talks about Charlie Ellis's book, Winning the Losers' Game. game. In this book explains that in a game like, say, tennis, professional tennis players win points, whereas amateur players lose points. Professional tennis players have this laser-like precision through these extended rallies, and then eventually one of their shots becomes just out of reach for the other player. Whereas with the amateur tennis players, their matches aren't really filled with rallies, but they're filled with faults, missed shots, and mistakes. This can be directly tied to investing. Amateur investors generally buy stocks after they've advanced and gone up, and then they sell them after the decline.

Starting point is 00:39:13 Colin Roche, who's actually a popular guest on her show here, he stated, the stock market is the only market where things go on sale and all the customers run out the store. This type of behavior leads to investors not only underperforming the market, but also underperforming their own investments. Batnik writes, the spread between investment returns and investor returns, is known as the behavior gap, and it is a permanent feature in any markets where human beings transact. It exists because the collective behavior of millions can overwhelm our senses.

Starting point is 00:39:47 Fear and greed do not respond well when under assault, and the market is notorious for forcing unforced errors." It's interesting to think about how the market has a way of causing the most amount of pain to investors and the maximum amount of frustration. While the overall stock market tends to increase around 8 to 10% on average per year, it actually isn't that common that stocks actually achieve these returns in any given year. So 8 to 10% is what you get on average over long periods of time. Most years are either really, really good or pretty mediocre.

Starting point is 00:40:21 So in the really good years is when investors, they tend to pile in, they get excited, and then when the stock market falls, investors bail out, and it just feeds on itself on the upside and the downside. I think back to 2021, how practically everyone was excited about the stock market and everyone wanted to get invested and find the next hot stock. I actually joined TIP in later 2021 and I still remember people texting me, you know, asking what stock I should buy, what do I think of XYZ cryptocurrency? Now, the reality is that most of the money that's made in the markets, it's when you

Starting point is 00:40:54 purchase when no one's really excited about stocks or when everyone was afraid of stocks in March 2020. When people aren't texting you about a particular investment, it's probably a good chance to take a look at it and see what its valuations at. When everyone's really excited about it, that's probably the time to get out, if anything. I dive into this concept extensively when I covered Howard Marks' book mastering the market cycle back on episode 559. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up and customers now expect proof of security just to do business. That's why VANTA is a game changer.

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Starting point is 00:44:44 Now, turning back to Drunken Miller, he is widely known for being one of the best global macro investors of all time. Drunken Miller approaches the market from a top-down perspective, and he understands the big picture and these big economic sea changes and how they're going to impact market prices. At 28 years old, Drunken Miller started Duquesne Capital Management in 1981. And right off the bat, he got off the to a really strong star and he had this really good sense of predicting how markets would move. For example, going into October, 1987, Drunken Miller's fund was 130% long. And that month is, of course, when we saw Black Monday strike.

Starting point is 00:45:22 It was the worst day in stock market history as the Dow crashed by 22.6% in a single day. Despite this, he was able to sidestep the market volatility and still ended up making money that month. So entering the month, he was long, 130% going into that month. And he still made money despite Black Monday happening during October. You know, that week was a really, really volatile week. So he was in and out on different trades. Fast forward to 1989, he shorted the Japanese stock market,

Starting point is 00:45:51 which he called the best risk-reward trade he had ever seen. And here, 34 years later, the Niki stock market still trades below where it traded at at that time. And then Drunken Miller is also well known for his famous trade with George Soros, of shorting the British pound. With $7 billion in AUM, he wanted to sell 5.5 billion British pounds short and put the money into Deutsche Marks, and he ran this idea by George Soros. Both Soros and Drunken Miller felt that it was really a sure bet, and even with the Bank of England spending $27 billion in an effort to defend the currency, it wasn't enough to keep

Starting point is 00:46:26 it from just collapsing. When the levy broke and the pound crashed, they both made a billion dollars in that trade, and they're both pretty famous for it, frankly. Drunken Miller, like all these great investors, had his fair share of losses, though. In 1994, he had an $8 billion bet against the yen, and the yen ended up rising by 7%, and he lost $650 million in just two days. Drunken Miller's big mistake was during the tech bubble. In 1999, he made a $200 million bet against overvalued tech stocks

Starting point is 00:46:59 that ended up rising even more, and the bubble hadn't yet collapsed. And this costed his fund $600 million. He had hired a couple of young traders at the time to help him get in touch with the market. And they had drunk the Kool-Aid of technology bringing in an entirely new era for investors. Drunken Miller was struggling to find his footing during this time. And meanwhile, these two new young traders, they were just absolutely crushing it by buying into these tech stocks. And Drunken Miller's ego was personally hurt to have these young guys showing him up on how the game of investing was done. Then prior to the bubble bursting, Drunken Miller told the Wall Street Journal, I don't like this market.

Starting point is 00:47:37 I think we should probably lighten up. I don't want to go out like Steinhardt. But what he did was the exact opposite. He loaded up on Veracine at $50 a share. And then looking at Veracine's stock chart here, it looks like this was around the fall of 1999 when it was $50 a share. The next thing you know, the stock just absolutely took off. It increased by five times by early 2000 to around $200,000. 140 to share, and then Drunken Miller doubled his bet to $600 million.

Starting point is 00:48:07 He thought that Veracine would be immune to any crash of this bubble, but it definitely was not. After the bubble bursted, Veracine dropped by over 98% to under $5 per share. The fund dropped 21% in 2000, so it wasn't a totally catastrophic drop overall in the portfolio relative to some of these other investors. Drunken Miller really knew better than to think that these tech stocks were cheap by any means. He just happened to act impulsively in light of others getting rich here. Batnik writes, few people are spared from unforced errors.

Starting point is 00:48:43 In the way they usually manifest themselves is because we can't handle people making money when we aren't. Then Drunken Miller stated, I bought $6 billion worth of tech stocks, and in six weeks I had lost $3 billion in that one play. You asked me what I learned, I didn't learn anything. I already knew that I wasn't supposed to do that. I was an emotional basket case and I couldn't help myself. So maybe I learned not to do it again, but I already knew that." Turning to Chapter 11 here, this covers the dangers of concentrated investing as shown in

Starting point is 00:49:14 the example of Sequoia. Now, diversification is one of the more widely known rules of the game of investing. The last thing you want to do as a relatively new investor is jump into this game of investing, put all your money into one stock and then watch your entire portfolio collapse because you're too concentrated and too overconfident on that one pick. On the other hand, most of the returns in a portfolio are going to come from a select few number of names. If you're good at individual stock selection, then oftentimes your best, say, three ideas are going to be much better than your 50th best idea. So why even bother with the 50th? There's that saying that you should

Starting point is 00:49:52 concentrate to get rich and then diversify to stay rich. It's probably, Practically impossible to have a portfolio wiped out if you're well diversified across sectors and asset classes more broadly. But to get rich relatively quickly, then one of the best ways is to concentrate your portfolio. You know, Elon Musk, he got rich through concentration in his Tesla and SpaceX equity ownership. Jeff Bezos, he owned Amazon stock, Buffett owned Berkshire. You know, there's so many examples of this. I'm also reminded of this incredible stat that since 1926, just four, four years, you know,

Starting point is 00:50:27 4% of stocks have accounted for all the gains in the stock market. So if you're going to concentrate, to hit it big, you're going to need to own part of that 4% of companies that have those super normal returns. In hindsight, these big winners, they look really obvious, but in real time, they aren't so apparent. The trouble with holding the big winners is that they almost also have these big, big drawdowns. And the reality of the drawdowns is that when a company's stock gets cut in half, most of them end up not recovering.

Starting point is 00:50:55 So it can be really difficult, emotionally, psychologically to hang on during that volatility. And here enters Sequoia. Bill Ruyn was the investor that Warren Buffett recommended people invested with once he wound down his partnership in 1969. Ruane's the one that managed the Sequoia Fund. Over 47 years, the Sequoia Fund outperformed the S&P 500 by 2.6% annually, so Bill ran a really, really successful fund here. In 2010, Sequoia added a large position to Valiant pharmaceuticals at $16 per share.

Starting point is 00:51:29 The stock gained 70% that year and it quickly became the fund's second largest holding. Then in the first three months of 2011, it gained another 76%. What Sequoia liked about Valiant was that they didn't need to invest heavily into research and development like many other pharmaceutical companies. What they would do is buy existing companies with approved products and then raise their prices of those drugs. For example, when Valiant bought Medicus, they increased the price of their drug from $950 to $27,000. Sequoia described Valiant's CEO Mike Pearson as exceptionally capable and shareholder focused. Politicians, of course, see companies like Valiant as price gougers

Starting point is 00:52:10 who, you know, they have these predatory pricing practices that many would call unethical. Then in October of 2015, Citron Research published a report accusing Valiant of accounting fraud, and comparing them to Enron. That day, shares of the company fell by 40% before recovering to only being down 19% that day. When Valiant shares would continue to fall and they were down by 50%, accusations of fraud were just tormenting the company. And Sequoia put out a letter reiterating that Valiant's management team had done a masterful job.

Starting point is 00:52:42 With their high conviction in the company, they doubled down and they increased their bet, making it 32% of Sequoia's assets. Thomas Heath from the Washington Post, he described the situation as follows. What Sequoia married itself to was an offshore drug company that borrowed heavily to buy other drug companies. They cut costs and research, then raised prices on many older drugs to astronomical heights." Eight months after defending the CEO in the company, Sequoia would end up exiting their entire position.

Starting point is 00:53:14 I pulled up the stock chart here of this one too, and it looks to be under the ticker BCH now, And it's just an insane chart. You have this massive run-up from 2010 through 2015, and then this thing just collapses straight down. August 2015, it was around $250 a share, and Sequoia sold their shares after a 90% drop in the high $20 range. And this looks to be around the early 2016 timeframe. We always hear about the great investors who use concentration to their advantage. But it's also important to remember that there are going to be a lot of investors who concentrate their portfolios, and it ends up working against them because their larger positions ended up

Starting point is 00:53:54 being bad bets. Sequoia's concentrated strategy, it worked well for a really long time, and then it eventually came to tarnish them severely as their assets under management fell by almost half from $9 billion to under $5 billion. When you look at the stock chart and you look at companies like Apple or Microsoft, essentially they're just going straight up and to the right. And remember that for every Apple and every Microsoft, There are companies like Valiant and companies like Enron that just fell off a cliff almost overnight, and they lost investors billions.

Starting point is 00:54:27 Transitioning to another chapter here, one of my very favorite stories here from the book was the story of John Meanor Keynes. That was covered in Chapter 12, and this chapter is titled The Most Addictive Game. The reason many of you are listening to this episode is likely because you just love the game of investing. That is certainly why I'm a host here at TIP and sharing all these lessons from all these investing, greats and these great books. It's a game that I just find really fascinating, and ironically, the more I learn, the more I realize I need to learn. Paul Tudor Jones explained in the 1987 documentary title, Trader, during my second semester, senior year in college, he always said, I've always liked backgammon, chess, those types of games. And he said, if you think those are

Starting point is 00:55:10 fun, if you really enjoy that type of stimulation, then I'll show you a game that is the most exciting and most challenging of all. And here, of course, he's talking about the stock market. In Paul Tudor Jones, he has said that once he hits a certain mark in terms of wealth, he would eventually retire and just quit the game. But in 2023, he's worth over $7 billion and he still manages money for a living. With $7 billion in his name, to give you a sense of just how much money this is, he could spend $100,000 every single day and it would still take him $191.9 years until he runs out of money. So it's safe to say that he isn't investing just for the money and what the money gives him directly. Batnik writes, this is the most addictive game on the

Starting point is 00:55:57 planet because it's a game that never ends. Then Batnik talks a bit about how the odds are determined in the stock market. He uses the example of pretending you knew with complete certainty that Apple's earnings were going to increase by 8% every single year for a decade. And he asked you to think about whether that would give you confidence to buy the stock or not. And he argues that if you knew earnings were going to increase by 8% over the next decade, that shouldn't give you confidence to buy it because it depends how fast the market expects Apple's earnings to grow. And it also depends how fast the overall market is growing. He's making the point that even if you know the number one driver of stock returns with certainty, which is a company's earnings, then that still

Starting point is 00:56:40 wouldn't tell you whether you're making a good bet or a bad bet. And the other missing ingredient, that can't be determined with a model is investors' moods and their expectations. Batnik writes, With investing, the odds are determined by investors' expectations, and they're not published on any website. They're not quantifiable because they're subject to our manic highs and depressive lows. You can have all the information in the world, but humans set prices, and decisions are rarely made with perfect information, and quote.

Starting point is 00:57:10 Then he ties in John Meador Keynes here, and all the great work he has done for us. Keynes wrote several international bestsellers, revolutionized institutional asset management, and practically built the global monetary system as we know it. And then there's a quote from Buffett here that he has famously said, If you understand chapters 8 and 20 of the intelligent investor in chapter 12 of general theory, which was written by Keynes, you don't need to read anything else and you can turn your TV off. So clearly, Keynes is a pioneer in the investing space. He started out his investing career, actually investing in currencies.

Starting point is 00:57:45 He was a student of markets and he started to earn a lot of money from book royalties and speaking engagements, so he directed his attention to where he felt like he had an edge. He ended up not doing very well in currencies, so then he transitioned to commodities using a top-down macro approach. In trading commodities, he lost 80% of his net worth when those crashed during the 1920s. So he was still trying to figure out what approach worked best in markets. In talking about this macro approach to investing, Batnik writes, figuring out how interest rates affect currencies and how labor affects prices and how all of this affects our investments

Starting point is 00:58:23 is tantamount to putting together a three-dimensional puzzle where the pieces are always moving, end quote. At King's College, Keynes was responsible for managing the endowment fund, and he had trouble there as well, at least early on. And this is no surprise as the Great Depression was just around the corner. The fund was highly levered going into it, and it lost 30% in 1930, another 24% it lost in 1931. In his macro insights, after that crash, they weren't really helpful either, as he expected low interest rates to help fuel and boost the economy. Batnik reflects on this saying Keynes had accomplished more in 10 years than most economists would accomplish in a lifetime.

Starting point is 00:59:05 And brilliant as he was, his superior intellect did not provide him with superior insights into short-term market movements." Initially, he thought that this frequent trading would benefit him and allow him to achieve his own destiny. But his returns through this short-term approach didn't suggest that to be true. Then he did a complete 180-degree turn in his approach. Instead of making these short-term speculations on currencies and commodities, he shifted his focus to being a long-term investor in public equities. He put his ego to the side, and he gave up on trying to forecast interest rates, forecast currencies, and how that would affect the economy. He wanted to buy businesses where he believed that the assets and the earning power of those businesses

Starting point is 00:59:51 justified it trading well below its underlying value. Then Batnik has this great piece that summarizes the takeaways from this chapter as well. He writes, quote, the intellectual flexibility for a macroeconomist, one with a huge ego, no less, to shift from a top-down to bottom-up approach is truly remarkable. He surrendered to the reality that forecasting investors' moods is nearly impossible, and it's mostly a waste of time. Everybody likes to think they're long-term investors, but we don't pay enough attention to the fact that life is lived in the short-term. Long-term returns are all that matters to investors, but our portfolios are marked to market every day. So when short-term turbulence arrives, long-term thinking flies out the window.

Starting point is 01:00:38 Keynes referred to our tendency to get swept up by the short-term thinking as animal spirits, which he described as the spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by qualitative probabilities, end quote. Then from 1928 through 1931, the endowment fell by 50% relative to the 30% fall for the UK market. However, from 1932 through 1945, he grew the fund by 869% while the UK market only grew by 23%. That's an average annual return of 19% for Keynes and just 2% for the overall market. He was able to improve his investment results because he quit trying to play the impossible game of trying to predict the animal spirits of the short-term movements.

Starting point is 01:01:30 And he was able to stick with the long-term approach when it wasn't working well, knowing full well that eventually gravity would take hold and give the value to businesses that they deserve to be valued at. Through this approach, he's able to just roughly assess what a business is worth rather than needing some precise figure. He's known for saying that it's better to be roughly right than precisely wrong. He also discovered that, that playing this long-term equity investing game, it was much more winnable, and you just had to roughly assess the value of these businesses rather than speculate on where the Japanese the end should be trading at exactly. Then in the final chapter of the book here, Batnik explains

Starting point is 01:02:11 how he has made many of the classic mistakes that many investors make. If you're listening to this episode and you do implement some of these strategies that he mentions, maybe successfully, maybe unsuccessfully, this isn't my way of saying that these are the wrong way of going about things. But just that many have found, Batnick concluded that through experience, the odds really aren't stacked in your favor in many of these investing strategies. He tried his hand at trading, investing in triple leverage DTFs, buying options, following the investment picks of people on Twitter. And I'm sure many people in the audience, myself included, can relate to at least one of these methods that, you know, it's kind of seen as something that's a way to get rich quick,

Starting point is 01:02:51 but you, most people end up losing a lot of money. The big takeaway is that every single one of us has probably made a big mistake in investing at some point in their careers. Understand that we've all been there. And the most important thing is to reflect on those mistakes and see what can be learned from them. Batonick ends the book with, The difference between normal people and the best investors is that the great ones learn

Starting point is 01:03:15 and grow from their mistakes, while normal people are set back by them, end quote. All right, so that wraps up today's episode. This was a really fun one to put together, so I really hope you enjoyed it as well. Michael Batnik wrote a great book here, and we'll have that linked in the show notes for anyone that's interested in picking it up. I definitely thoroughly enjoyed the book, so if you enjoy this episode, I think you'd like the book as well. Thanks for tuning in, and I hope to see you again next week.

Starting point is 01:03:42 Thank you for listening to TIP. Make sure to subscribe to millennial investing by the Investors Podcast Network and learn how to achieve financial independence. To access our show notes, transcripts or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision consult a professional, this show is copyrighted by the Investors Podcast Network. Written permission must be granted before syndication or rebroadcasting.

We Study Billionaires - The Investor’s Podcast Network - TIP579: Big Mistakes by Michael Batnick

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