Under the Hood: Passing on an incredible investment opportunity

February 20, 2015

Are you curious about my investment decision-making process? In this post, I give you an exclusive look on how my investment mind works.

On February 11, 2015, I wrote this letter to my partners:

Dear Partners,

I wanted to give you a behind the scenes look on how I think about investments that don’t make it to our portfolios.

In the last few weeks, I came across a 4Q14 slide presentation of Pershing Square Capital Management. Pershing Square is now the largest hedge fund in the world. The fund is managed by Bill Ackman. I have known about Bill for 7 years now, but have not really done much research on him.

Recently, I have been reading “The Education of a Value Investor” by Guy Spier. Guy is both an amazing investor and person. I highly recommend that you read his book if you have time. We have so many things in common. We share a similar life path, philosophy and even investments. In his book, he speaks highly of Bill Ackman.

Yesterday, I sent you a video recommendation explaining a fundamental economic theory. In the suggestions box, was a video on Bill Ackman. Because of the Pershing Square presentation and Guy’s book, I couldn’t help but click on the video. Before you know it, I was going through hours worth of his public appearances. His investing style is slightly different from mine, but I was really intrigued by two of his holdings, Fannie Mae (FNMA) and Freddie Mac (FMCC).

If you remember, FNMA and FMCC, along with Bank of America, AIG, and others, were taken under conservatorship by the US government during the financial crisis. Today, only FNMA and FMCC are under conservatorship. Both FNMA and FMCC are essential to the financial system. Without them, millions of Americans would not be able to get a mortgage.

Both FNMA and FMCC have more than paid back what they borrowed from the government, and yet the government continues to mandate their conservatorship and require both to give 100% of their earnings to the government in perpetuity. Many claim this is unlawful, and have sued the government.

After this point, I remembered that one of my heroes, Bruce Berkowitz, has been actively involved in the litigation of FNMA and FMCC. He recently had a conference call with his investors, and his thoughts on both companies are consistent with Bill Ackman’s.

After reviewing company filings, I came up with the following conclusions:

  • There is a decent chance (likely over 50%) that FNMA and FMCC will eventually be taken out of conservatorship after some restructuring.
    1. This will take some time, and there is no way to predict how long.
    2. If this scenario comes to fruition, the current stock price ($2+), will shoot up to $20-$40+ over the long-term. That is 10 to 20 times your money. Even if this scenario takes 10-20 years to come to fruition, that is an incredible return.
    3. Bill Ackman and Bruce Berkowitz are two of the most intelligent people I know, and they are confident that this is the only logical outcome, but I can’t take their word for it. Like all of our investments, I don’t rely on the judgment of others. I need to have my own solid understanding of the business and its prospects before investing a dime. Politics and law are outside my circle of competence, so at this time I don’t have a solid understanding of the situation.
  • If the above scenario doesn’t happen, we will incur a permanent capital loss. The worst case of which is losing all our money.

Bottom line (based on my limited knowledge): Decent chance we’ll hit a home run, some chance we’ll lose everything.

Most investors would invest at least a small portion of their money in both FNMA and FMCC. Why not?

If this were Texas Hold’Em poker, imagine yourself holding pocket AA versus someone else with pocket KK before any of the other cards come out. All poker players will take this bet every time. You’d be an idiot if you didn’t.

While poker skills are highly transferable to investing, my style of investing is a little different. In poker, your strategy is to make bets where you “win big and lose a little.” Some value investors, like Mohnish Pabrai, employ this strategy, but Warren Buffett’s style suits me better.

Warren Buffett says “Rule #1: Don’t lose money. Rule #2: Don’t forget Rule #1.” I don’t like having my worst-case scenario as losing all of my money; even though I can limit FNMA/FMCC to just 1% or so of our portfolios.

My biggest character weakness is the potential to become overconfident. Realizing this potential weakness, I need to create structures and rules in place to prevent this weakness from blinding me. As such, I am going to tie my own hands and stay away from this incredible investment opportunity.

Why? If FNMA and FMCC turn out to be home runs, I will think I am one of the best investors in the world. This will fuel my hubris and potentially influence me to take bigger “gambles” in the future, when we will have more capital to lose.

We have a lifetime of investing ahead of us. My goal is not to maximize our net worth this year, or in 5-10 years, my goal is to maximize our net worth over our lifetime and for our beneficiaries’ lifetimes.

Just like in my last update for one of our bigger investments, I am restraining my current self in chasing shorter-term returns to protect my future self from losing much more in the very long-term.

As Howard Marks says “To finish first, you must first finish.”

I have pictures of Warren Buffet, Charlie Munger and Donald Yacktman in my office and I imagine that they would advise me to put this in the too difficult pile.

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So for now, I’ll pass on this investment opportunity, but continue to monitor the situation, do some research, and increase my knowledge. I have a friend who used to work for Charlie Munger’s law firm who will help me gather more data. I doubt I will ever get comfortable investing in these two companies until all the cards are on the table, but when it does, I’ll be ready and maybe we can still make a little bit of money.

Best regards,

Earl

 

I hope the letter to my partners gives you a good picture of our firm’s investment process. If you know anyone who is interested to learn more about Wealtharch Investment Services, please share this post with them.

I would love to hear your comments and questions.

Disclosures:

  • This blog post is for illustration purposes of Wealtharch Investment Services’ investment process only. We are not recommending the purchase of these securities. Please consult your financial advisor before taking any action.
  • Wealtharch Investment Services do not own any of the securities mentioned and we do not plan on buying these securities in the near future.

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