In a column for the Financial Times, money manager and columnist Whitney Tilson — one of those who predicted the housing and financial crises — discusses the “tricky” process of trying to alter one’s approach based on the lessons of the past year, and examines some changes that he and another star manager have made.
Tilson say that many investors are likely enduring some serious cognitive dissonance — that is, they are having trouble reconciling their belief that they know what they are doing as investors with the reality that they have lost a good deal of money.
“The unproductive response to this discomfort is to rationalise it away, absolving yourself of responsibility for losses because of proverbial “circumstances beyond your control,” writes Tilson. “More productive, but also tricky, is to ask what lessons you can draw from recent errors that will make you a better investor. The reason I consider this tricky is because the recent market environment has been so unusual that it may be that lessons arising from it won’t be the ones that will help you profit in the future.”
Tilson highlights Mohnish Pabrai as one star manager who has already made some changes in his approach based on the past year. Pabrai used to employ a “10 by 10” approach, putting 10 percent of his funds into each of his top ten ideas. But after being hit hard in 2008, Pabrai is now using greater diversification, so that, except for rare occaisions, no one investment will make up more than 5 percent of his portfolio. He’s also trying to take smaller positions in stocks if they are highly correlated, or if they have highly asymmetric risk/reward profiles.
As for Tilson, while his bet against the housing and financial sectors paid off, he says he still made mistakes over the past year. What has he learned? “What we’ve learnt the hard way in the past year is, first, that the earnings of very few companies are immune to a terrible economy,” he writes, saying that his firm mistakenly thought Barnes & Noble was already priced so low that it could nicely weather the storm. “Second, even if earnings hold up, the multiple that investors are willing to pay probably will not.”
Tilson says he sees much more pain for the economy as the massive deleveraging continues. “As a result, the consensus view of economists that US gross domestic product growth will be negative in the first and second quarters of this year but will then turn positive after mid-year, is unlikely to occur,” he warns. More likely, he says, is a scenario in which GDP growth remains negative through 2010, with stagnant growth — rather than a strong recovery — following.
That doesn’t mean Tilson is avoiding stocks. But, he says, it has changed the stocks he’s focused on. “We’re putting significant emphasis on cash-rich balance sheets that will protect us on the downside if things get even worse than we expect,” he writes. He also sees opportunities in some special situation stocks “in which we believe there has been forced selling or there are specific upside catalysts that could help offset challenges to near-term operating results.”
What is his firm selling? More traditional, low-price/earnings value plays. “While such stocks can often prove fruitful, in an environment in which it is so difficult to have confidence in earnings estimates – and when our view of overall economic prospects is so dismal – we’re finding what we think are better and safer alternatives among asset plays and special situations,” he says.