John Wiley & SonsISBN: 0-471-77191-0
Chapter One The Triangle Investment Club Dinner Hacking Through the Hedgehog Jungle
I went to the Triangle Investment Club dinner at the Century last night. There were about 25 guys there, about half from hedge funds and the other half very aggressive long-only managers. The age mix was about half and half, too. There were plenty of distinguished oldies with curly gray hair and husky voices who roll their words, but also a lot of sleek-looking young guys who talk very fast. Young or ancient, everyone there was a big-time investor running public, competitive money of one type or other.
Triangle is an investment club of mostly guys who have dinner once a month to exchange ideas and take one another's temperatures. I don't go that often. You must be in the mood. You have to be capable of putting (and keeping) your game face on because, although everyone is ostensibly friendly and jovial, the members are some of the most intensely competitive people in the United States. There is definitely an edge to the interaction and conversation. It's not exactly a relaxing, friendly evening with old tried-and-true comrades in arms.
It was the usual routine. We stood around with drinks for half an hour or so and gossiped mainly about how tough it was to make money. I chatted with Jonathan, a big-time hedge fund mogul who must be worth a billion dollars and flies everywhere in his own Gulf Stream. I've known him since he was a young analyst at Tiger, Julian Robertson's legendary hedge fund. I like him. He is one of those guys who tells you exactly what's on his mind.
Tonight he is shaking his head. A week from now is his oldest daughter's tenth birthday, so last night he asked her what she would really like for her big double-digit birthday. She looks at him and says, "I can ask for anything?" He says, "Yes." She says, "You won't get mad? My wish involves an airplane." He's stunned. What has he wrought? Poor little rich girl! She wants her own plane. With trepidation he says, "Okay. What is it?" "Daddy," she says, "I'm almost 10 years old, and I've never been on a commercial airline flight. All the other girls at school have. What I really want is for you to take me to a real airport, check in, go through security, get searched, stand in line, and fly commercial to someplace. Daddy, never having done it is really embarrassing." Hedgehogging with children is not easy!
KIBITZING, GILDING, AND SANDBAGGING
Then we go in to dinner at a long table with candles and fresh flowers, and immediately Leon, who had the chair last night, gets things going and we begin to go around the table. In no more than four minutes, each guy is supposed to elucidate his favorite stock or concept and the reasons why. Everyone takes notes, and there is a lot of kibitzing. Because there are many mammoth egos present, the chair has to be ruthless about cutting speakers off or we would be there all night. There are some guys who say they get a lot of ideas out of the dinner. I don't find that I do, but you do come away from the evening with a sense of what the mood of the members is and what the hot areas are.
Last night I got a sense of confusion. The mix between longs and shorts was pretty balanced. Some of the stories boggle the imagination, with lots of aggressive supposition. With energy hot, one young guy told a fantastic tale about a Malaysian wildcat oil company that had a structure at offshore Borneo, which rivaled the North Sea. Sure! A mutual fund manager told of a new surgical process that cuts the risk of impotence from prostate surgery by 75%. Then there are the usual market-cap-to-eyeballs stories about new and old Internet adventures, and wondrous tales about everything from health-food chains to nanotechnology.
It is assumed you're going to be recommending what you already have a position in. Most guys announce their positions before talking. As always, there was a lot of cynical, sardonic byplay, with certain notorious offenders being accused of gilding (as in gilding the lily) and an occasional joking cry of "Sandbagger." Gilding is just what it sounds like-when you dress up your story to take it to the party by exaggerating the fundamentals in your favor. In other words, if you are plugging Symantec and making the case that it's cheap because it's going to have big earnings next year, you might, in the spell of the evening, jack up your earnings estimate from $3.50 a share to $3.75, when even $3.30 would be a minor miracle. But who can forecast earnings of an exotic tech company anyway, and why not dream a little?
Gilding is a relatively minor offense because, to some extent, everybody does it all the time. The members have very sensitive built-in BS detectors, so egregious gilding backfires and tarnishes the credibility of the gilder. Also, members who know the story being presented have no compunction about rudely interrupting and correcting the gilder. This can be quite embarrassing, but it's all part of the charm of the evening. If a guy tells a good, original story and nobody interrupts, it means that the tale is at least fresh and maybe for real.
Sandbagging is a much more serious crime. You can even get kicked out of the club if you're caught red-handed, en flagrante so to speak. Sandbagging is when you tell a story and egregiously gild it, hoping to attract buyers at the same time you are actually secretly selling the stock. It's one thing to promote the story of what you own or are short, and as noted, most members make it clear that they have a position one way or the other in the merchandise they are talking about. It's quite another to sandbag. Sandbagging is dishonest, cheating, a violation of the rules of the money game.
JUST BECAUSE YOU'RE A SNAKE DOESN'T MEAN YOU'RE NOT A MONEYMAKER
One guy who used to be a member, Richard, was always suspected of being a sandbagger, but it's a capital offense and very hard to prove, and as long as nobody got hurt, it was overlooked. Richard, incidentally, is one of those guys who insists on being called Richard and not Dick.
Now there are some slick, slimy guys in the big-time hedge fund business who traffic in stories and even in forms of inside information. Richard is as slick and slimy as they come, although he has a smooth, cultured, Harvard veneer, wears fancy suits, and talks with a hint of a Boston accent. But just because you're a snake doesn't mean that you are not a moneymaker. Richard has been around for a long time, and one of the other members was even in business with him for a while. That ended in a nasty lawsuit. Richard once arrogantly described himself as a self-made man, and his former partner interjected, "and you worship your creator." Richard is very smart, very obnoxious, and has made a lot of money, mostly for himself. He tells a stock story with great certainty and precision, and so I guess that's why we all put up with him for so long.
Years ago, Richard and I played singles tennis four or five times. It was a horrendous, mind-twisting experience, even though I knew I was better than Richard. If a shot I hit was in but close to the line, he would often, but not always, call it out. If he hit a ball that was clearly out but only by a couple of inches, he would walk up toward the net and stare at the spot. To a certain extent, it was intimidating, and you found yourself hesitating on out calls if they were close. When I got a run of points going, Richard would insist on sitting down and retying his shoes for five minutes. Sometimes, he would miscall the score, always in his favor.
I talked to other guys about it, and they had the same problem. One guy told me that Richard once wanted to start a set over when his opponent was ahead three-love. The problem with confronting Richard was, were you going to make a huge scene and accuse him of cheating? No, it would be too ugly, with people on adjacent courts listening in and thinking that you are both total jerks. So you end up playing carefully and not hitting balls close to the lines. Each time I played him, I resolved it would be the last, but he would press me to play again. As I said, I definitely knew I should beat Richard, but the cheating and the byplay were so unnerving, and my mind was so bent that the fourth time we played, he won, which further enraged me, especially since he immediately told the other guys about it as if it were the usual thing.
Richard finally went a shenanigan too far with the Triangle group. One night a couple of years ago, he told an intriguing story about a company that had secretly developed a weight-loss drug with no side effects that really worked. He rattled off the names of compounds nobody had ever heard of. You took a pill twice a day, and presto, in a month you had lost 10 pounds! Obviously, such a drug would be an absolute blockbuster with obese Americans! He told us he had seen the results of the blind tests, and he cited data from the Stanford Research Group and the AMA. Food and Drug Administration (FDA) approval was imminent. A number of the guys knew of the company, which was a legitimate biotech with some real scientists but a flabby balance sheet. It had announced it was working on a weight-loss drug that was promising, but the biotech analysts, of course, were skeptical. Guys were intrigued by the story. When they work, biotech stocks can be moon shots. Richard was asked a lot of tough questions, and he handled them well. I told you he was a smart, savvy guy. "Look," he said, "the former chairman of Pfizer is a director of Stanford, and I've known him for years. We all know nothing is a sure thing in genome land, but he tells me extensive tests show the pill works wonderfully with rats, and best of all, they haven't found any side effects to speak of. The rats pee a lot more than normal, but their dispositions don't change. Do what you want. I've got a big position, and I'm adding to it."
The next day, some of the guys put in buy orders and were a little surprised when they got filled quickly and in size. Surprise wasn't their emotion two weeks later, when the company suddenly announced one morning it was withdrawing the FDA application. Apparently, the drug did cause rats to lose weight, but it also gave them inoperable, incurable stomach cancer, resulting in death. The stock price instantly collapsed. I was at the next meeting, which Richard did not attend. At dinner, one of the guys, John, told how he had been suspicious when his order got filled in a flash, so he had checked who the big seller was. It was the broker Richard always used!
The members looked at each other the way I suppose the apocryphal Western posse looked at each other when they finally figured out who was the cattle thief. John is a large, serious man with big hands, and during cocktails at the following month's dinner, he and a couple of other guys confronted Richard. Richard squirmed and said he had sold only a little stock to lighten his position. "Get out of here, you piece of crap," said John quietly, and Richard did. He doesn't come to the dinners anymore, and I heard he had moved to Los Angeles.
IT'S A JUNGLE OUT THERE, AND THE HEDGEHOGS ARE KILLING THEIR GOLDEN GOOSE
Anyway, after dinner last night, some of us sat around and gossiped about hedge funds. The members of the Triangle, opinionated veterans of the investment wars, are not shy about expressing their opinions, and we all have known each other for years. The insults flew like shrapnel on a bad day in Baghdad. It began when someone remarked that there are now 8,000 hedge funds in the United States, and that hedge fund capital has exploded from $36 billion as recently as 1990 to probably around a trillion dollars today. A long-only manager sourly said something along the lines of the following: "The golden age for hedge funds is about over, and it will end with a bang, not a whimper. The larger capital and the bigger talent pool now being deployed by hedge funds mean that the pricing of everything from asset classes to individual securities is under intense scrutiny by manic investors, who stare at screens all day, have massive databases, and swing large amounts of money with lightning speed. This has the effect of bidding up the prices and reducing the returns of all mispriced investments. Obvious anomalies now disappear, almost instantly. In effect, the alpha available for capture by hedge funds has to be spread over more funds with bigger money, resulting in lower returns on invested capital for hedge funds as an asset class. Risks will also rise as hedge funds have to take larger, more concentrated positions. You greedy hogs are in the process of killing your own golden goose. It's not only endangered, it is about to die. " "Don't you wish," one of the hedge-fund guys replied from the bottom of his brandy glass. "The golden goose was plumper and sturdier than you think."
"Global macro is headed for a bust," another guy said, looking at me. "Too much rookie money. You had better make it quick." I just stared at him.
"It's a jungle out there in macro now," he went on. "There are so many macro players and momentum investors, they're bumping into each other. There must be a couple of hundred new macro hedge funds formed in the last six months by guys who think they are the next Stan Druckenmiller or Lewis Bacon. Some of these guys are so green, they can confuse you with their stupidity, and they are big and clumsy, so they can hurt you if you bump into them. And then, stumbling around are the proprietary trading desks of all the big investment banks, plus various rogue central banks like Bank Negara and the Nigerians. Last week, I got crunched between an Asian central bank and some rookie hedge fund guy who panicked on his first macro trip. It's all very disorienting!" The guy, despite his alleged bruises, looked tanned and rested, so I ignored him.
"It's like the money game; our nice old game is being played at faster and faster speeds by bigger and rougher guys, so it's getting tougher and more dangerous all the time," another hedge-fund guy said glumly. "Everybody is on steroids. The violence level is soaring. It's like the NFL."
"As more and more funds are unable to earn sufficient excess returns to justify their fees," another guy said, "the love affair with hedge funds is bound to cool. But not before all that excess capital takes its toll on the performance record and exalted reputations of the big stars. The alpha pool of the whole hedge fund industry is not growing, but the number of guys trying to drink from it is. Ask not for whom the bell tolls; it tolls for thee."
"I'm not so sure the alpha pool isn't growing," I argued. "As all these new, naive, trigger-happy crazies, long on aspiration and short on experience, enter the business, a lot of them will get creamed. Then their losses will expand the alpha pool for the rest of us." I noticed one of the veterans was looking at me kind of funny, as though he was thinking, "Who are you, punk, to go talking about naive talent?"
"Leverage, leverage, leverage-that's what is going to wreck you guys eventually," said the long-only guy. "Actually, since LTCM with its huge balance sheet and various forms of tail optionality (whatever that means) blew up, hedge funds have been reducing leverage. Instead of them, it's their investors, both individuals and the fund of funds, who are putting on the leverage. The clients of the fund of funds are unhappy with the meager returns they are getting, so the fund of funds goes to the bank and borrows. And the banks, particularly the European ones, are falling all over themselves to offer credit to their wealthy individual clients to leverage up their hedge-fund holdings. Theoretically, it makes sense. A basket of diversified hedge funds has lower volatility than one fund, so why not leverage it up to magnify the returns?"
"Yeah," said somebody else. "It makes sense until a bolt from the blue, a tsunami wave, a two- or even three-standard-deviation event happens, and then the you-know-what hits the fan. The hedge fund basket has a 10% drawdown not in a year but in a month, and a big leveraged fund of funds could be down 15% in a flash. What happens to the whole hedge-fund universe then? I'll tell you what. The frightened fund of funds clients redeem, the fund of funds in return have to redeem from their hedge funds, and the whole asset class does an extreme shrink. Furthermore, there are no safe havens. The long-short market-neutral funds get killed, too, because when they have forced liquidations, their longs go down and their shorts go up."