A Review of 'The Billion Dollar Mistake'

by: Bruce Schrader

CoverA colleague of mine recently explained that the game is about making less mistakes than the next guy; ‘you’ll hit a homerun maybe twice a year, but you’ll make mistakes 20 times a month, minimizing mistakes is the way to be successful’. And this is what Stephen L. Weiss’ The Billion Dollar Mistake (published John Wiley & Sons in 2010) is about. As described in the introduction to the book, it is not a how to invest” book, but a book about “how not to invest”. What follows, like most Seeking Alpha reviews, is not so much a book review, but a synopsis of the key takeaways to help us all become better investors.

The book details the billion dollar mistakes made by the following 10 famous investors:

Who: Kirk Kerkorian, perhaps best know for running Las Vegas casinos, grew up with minimal formal education. From a young age he had a variety of jobs (including flying planes to Europe during the Second World War). He established himself by implementing a strategy of buying (undervalued) businesses, running them for a short while and then selling them for a profit (or in the case of MGM (NYSE: MGM), repeatedly buying and selling the same business for greater and greater profit).

His Error: Kirk acquired a 10% interest in Chrysler at $9/share, the price proceeded to move to past $60. Despite a failed takeover bid (Daimler (NYSE: DDAIF.PK) was the eventual winner), Kerkorian sold his position and booked nearly $3B. A similar move with GM (NYSE: GM) netted him a mere $110M. Of the big 3, only Ford (NYSE: F) was left. And with Ford came disaster. Instead of learning from his experiences with Chrysler and GM and coming to the realization that the auto industry was about to enter a decline, Kerkorian continued his existing strategy of buying auto manufacturers; in doing so he lost nearly $700M.

Take Away: Don’t let your passion outweigh your discipline. Kerkorian's strategy was one of discipline and patience. But with Ford, his interest was in owning an auto manufacturer and he neglected to learn from his previous experiences. He was not as disciplined as he had been and did not realize that the economy had changed.

Who: David Bonderman is the head of TPG group, a private equity firm with a focus on distressed markets. Trained as a trial lawyer, Bonderman first worked for the U.S. Attorney General, and then as partner at a law firm. This stage of his career brought him in front of the Supreme Court a number of times. Bonderman moved to the private equity world when an associate he met while practicing law hired him to be COO of a LBO firm. Bonderman did well in the LBO game, he sold American Savings and Loan for 3 times what he paid. Bonderman (and a colleague, Coulter) eventually went out on his own. Bonderman saw the recent credit crisis as being analogous to the savings and loan crisis of the 1980s (the same crisis that brought him his initial success). Using the 80s as a guide cost him.

His Error: Bonderman had ties to Washington Mutual, he was once on its board, was close to the CEO, thought he knew the business and thought he knew how to play distressed financial institutions. Therefore, when WaMu came up for sale, it was not a hard decision for Bonderman to save the company. Bonderman decided it was time to buy another distressed financial institution which he thought, just like before, the government would backstop. It didn’t and Bonderman’s investment in WaMu lost his company $1.35B, and others related to the transaction lost $6.7B more.

Take Away: Beside the fact that Bonderman had only a week to perform due diligence (an important step despite his relation to the company), his true mistake was to expect things to play out in a similar manner as they had in the 1980s. Despite two Bushes leading the country, an individual’s response to a crisis is not guaranteed. Likewise, Washington Mutual had changed significantly during his absence from the board. He should not have relied on his dated knowledge to make his investment decision. Going back to the well can be dangerous; treat each investment (even in familiar names) as if it were new. As for the 6.7B that others lost – that teaches us that the smart money is not always right.

Who: Aubrey McClendon, who had the honour of being the highest paid CEO in 2008, also lost nearly 2B in stock in his company Chesapeake Energy Corporation (NYSE: CHK). Chesapeake Energy was founded in 1989 on $50,000 and grew quickly to a $25B company. The strategy used by McClendon, and his partner Ward, was to use a high degree of leverage to acquire natural gas properties. This was a great strategy as natural gas prices increased and government incentives abounded.

His Error: Aubrey used leverage not only in building Chesapeake, but also in building his portfolio, which included substantial investments (equity and stock options) in Chesapeake. When energy prices, including natural gas, tumbled in 2008, McClendon got hit.

Price Chart of Natural Gas

(Price of CHK and Natural Gas 2007-2010)

The leverage in his account resulted in a margin call and McClendon, despite his conviction that prices would rebound, was forced to sell nearly his entire position in the company that he founded. He lost nearly $2B.

Take Away: Be aware that leverage can magnify returns and loss, and, as with McClendon, losses can come quickly (he was forced to sell his position over three days). We can also take from this story the need to diversify - McClendon had nearly all his assets in Chesapeake stock (and $100M in french wine). I would also add that a key to diversifying is to limit you investments in your own company. Your biggest asset is your job; owning shares in your company, although a sign of faith, can hit you twice as hard if your company falters. Aubrey was in the best position to understand Chesapeake and the natural gas market, what he forgot was that certain forces are beyond his control.

Who: Bill Ackman Got into finance right after graduating from Harvard. He started, with a college friend, Gotham Partners, a real estate fund of sorts, which he grew from $3M to just over $550M. Not too bad, even if it was an extension of the family business. But the firm collapsed shortly into the new millennium. Next came Pershing Square, Ackman’s activist fund. He invests based on six criteria; (i) the company should be mid or large cap, (ii) no single shareholder should control the business, (iii) the company should not be dependent on capital markets, (iv) it should have little financial leverage, (v) there should be value to unlock, and (vi) Pershing Square should be able to unlock the value. To implement this strategy takes time, due diligence and discipline. An example of this strategy in action is when Ackman convinced Wendy’s (NYSE: WEN) to spin off Tim Hortons (NYSE: THI). Ackman thought that Wendy’s was dwarfing the value in Tim Hortons – Wendy’s stock doubled.

His Error: Ackman had two “billion dollar” mistakes. First, with Borders (NYSE: BGP). Ackman saw his success with Barnes & Noble (NYSE: BKS) and thought he could replicate it with Borders. The problem was there was poor management (although other activists might see this as potential value to unlock – by replacing management), and even worse, there was a high degree of leverage; two of Ackman’s criteria were not met. Finally, Ackman did not go activist quickly enough, he held his position hoping for a turnaround. By the time he took an active role, it was too late. Second is Target (NYSE: TGT), here Ackman used leverage (through options) to acquire a large stake in Target, a company that he saw as well managed. In the sinking economy of 2008, Target's earnings dropped and the stock fell 10%; Ackman’s options fell 90%. Although the stock eventually recovered, Ackman’s timing was off, and he lost over a billion.

Take Away: Stick to your disciplines. If you only invest with good managers, don’t invest with poor managers. If you don’t invest in companies that use leverage, then don’t invest in companies that use leverage (Borders) and don’t use leverage yourself (Target). Your investment style defines you and how you make decisions; changing this style abruptly can cause much financial pain.

Who: Nick Maounis Born into the world of finance (both his parents were involved in the field), he got his first job out of college as a currency trader and quickly moved into convertible bond trading. When a senior trader left the brokerage house to start a hedge fund, Maounis followed. He then started his own fund, which he called Amaranth Advisors. The fund was a multi-strategy fund, equity, debt, commodities etc. He picked the best, let them grow, and most of all encouraged them to talk to each other (cross fertilization). Maounis moved into the energy markets and hired Brian Hunter to lead the way. To retain Hunter, Maounis let him return to Calagary, Alberta away from Amaranth, Connecticut headquarters.

His Error: Brian Hunter, out of Calgary, made large bets on the spread of natural gas futures, expecting the spread of near term (summer) contracts to widen from longer term (winter) contract. It worked in April, making the fund $1.2B, but turned in May and failed in September when the fund lost $6B and collapsed. Despite any claims that there was market manipulation, the bets on natural gas spreads was a true multibillion dollar mistake.

Take Away: For a multi-strategy fund, by the end, it seemed as if the fund had one strategy: energy trading. And to boot, it was focused on one talent, Brian Hunter. Despite contemplating and understanding the risks, the fund did not, until it was too late, attempt to mitigate its risk. Nick Maounis, who was a skilled trader, became too involved in the running of the fund business and less in the asset management. He let others, who he had faith in, manage the money and this cost him dearly. Very fittingly, Maounis’ new fund has adopted the mantra “doveryai, no proveryai” (Translated from Russian, “Trust, but verify”) – it seems that Maounis has learned from his mistakes.

Who: Leon Cooperman starting out in GS research group, which he eventually ran, Cooperman moved onto his own firm in the early 90s. But the story really starts with Viktor Kozeny. Kozeny was born in Czechoslovakia, and made his initial fortune when the Czech Republic moved away from its communist origins. Kozeny set up a fund to purchase the previously privatized companies. He charged 7%, and with opaque securities laws in the new capitalist regime, Kozeny made a fortune; many of his investors did not. With this track record Kozeny saw a similar opportunity in Azerbaijan, sought billions in investments, including an investment from Omega Advisors, Cooperman's fund. Kozeny did not contact Cooperman directly; instead, he paid off a high ranking employee to pitch the idea to Cooperman.

His Mistake: This example, unlike the previous, is fraught with fraud and illegal acts; it would seem hard to fault Cooperman. However, Cooperman failed to look at the information first hand, he trusted his employee (who was being paid by Kozeny) and trusted the information provided by Kozeny. Kozeny lied, broke contracts and did a lot worse. Worse yet, it was nearly impossible for Cooperman to get the full information on his Azerbaijan investment, simply because in such a foreign market, transparency is not always provided.

Take Away: Be careful who you trust, be careful of markets with little oversight, and always ask more questions.

Who: Richard Pezna Went to Wharton and then moved into the oil industry, he helped AMOCO for a short while bid on fields in the Gulf of Mexico. He moved into equity research and then became a large cap buy side investor. During the early 1990’s (during the first Bush presidency, the first Gulf war, and a credit crisis in the banking industry), Pezna bought out of favour bank stocks, and did well with Citigroup (NYSE: C).

His Mistake: 2008 seemed like a similar period, another Bush was in the White House, there was again a war in Iraq and bank stocks were out of favour. Like others in this book, (Kerkorian, Ackman etc) Pezna tried to return to the well and was punished for it.
Citi Price Chart

(Price Chart of Citi during Pezna's first and second kick at the can)

Pezna returned to Citigroup and also took on a large portion in Freddie (OTCQB:FMCC) and Fannie (OTCQB:FNMA). Pezna valued securities based on what he considered to be their earnings after the current crisis. As we now know, Freddie and Fannie collapsed, and with them, Pezna lost.

Take Away: Use history as a guide, but only that. It is just a guide, and each time an opportunity arises, in Pezna’s case a declining value of financial stocks, you should analyse what has caused the decline and determine if the past is being repeated or if this time is different.

Who: Geoff Grant, born in the States, as a child he moved to Rhodesia. Prior to the conflict that would eventually see the fall of Rhodesia and the rise of Zimbabwe, Grant moved back to the States to study at Columbia. Grant got a summer job at Morgan Stanley (NYSE:MS), which, after graduation, morphed into an FX position at the bank. Within 5 years, he was asked to help open the MS Tokyo office and shortly thereafter, GS snapped him up to run their FX desk in London. Fourteen years later, Geoff left GS and retired, of sorts, to California. Quickly, a co-worker from the GS London office (another ex-pat, Ron Beller) asked Geoff if he would join him in starting a hedge fund.

His Mistake: Geoff Grant was an FX guy, but when he started the fund in 2006, markets were calm, there was not enough volatility to make money. So they shifted strategies, added equity and credit guys to the team and hoped for the best. As part of the shift, the fund entered a pairs trade of sorts, buying AAA ABS and selling triple B’s. As we now know, the credit crisis hit, the AAA and BBB tumbled, but the AAA had further to fall and Geoff Grant’s fund lost $2B.

Take Away: In 14+ years in the financial markets Grant became a great trader with an expertise in the foreign exchange markets. When he started the fund these were not hot markets to be trading in. The excess return had (temporarily) shifted to credit markets, and Grant and Beller went chasing these gains, and delved into markets that they did not know as well and it cost them dearly. Invest within your area of expertise and avoid style drift.

Who: Adolf Merckle. This story ends tragically, with Merckle taking his own life after his mistake. Merckle ran the family business, HeidelbergCement; a company with nearly 12B (Euros) in revenue. He was, before his mistake, one of the 100 richest people on the planet.

His Mistake: In 2008, the economy began to slow and the auto sector across the globe for the most part was hit hard. Many Germans saw that the price of Volkswagen (OTCPK:VLKAY) stock had not declined as much as other securities, in part because Porsche was slowly growing its stake in the company. Assuming that the Porsche stake would continue to grow slowly, as it had done since 2005, many shorted the VW stock. However, Porsche had decided to acquire VW. Under German law, had Porsche acquired stock directly they would have needed to disclose their intentions, instead they acquired cash settled options and no disclosure was needed. When Porsche finally revealed its hand, it had 43% of VW shares outright and an additional 31% in cash settled option.

VW Stock during the Short Squeeze

(VW Price Chart showing the short squeeze)

The government owned 20% of VW, meaning just over 94% of VW shares were tied up. But 12% of VW shares were shorted. Porsche had effectively cornered the market and the shorts, Merckle among them, got squeezed. In all, the shorts lost up to $6B.

Take away: The take away is more than just knowing the dangers of short selling (shorters should look at how “crowded" the short is and the short interest ratio). It is also about understanding the corporate and exchange rules. In the United States, Porsche would likely be required to disclose its intentions, but Germany has different rules (some better, some worse) and in this case, the rules had detrimental effect on shorts and favorable effect on Porsche.

Stephen Weiss (the book's author) got a little preachy in this chapter, and talked about alternatives to shorting, including using double short ETFs. In my opinion, this is a ridiculous notion as, because of the way the double shorts and double long ETFs are rebalanced, in volatile but flat (or to a lesser extent, trending) markets, even if you are right in your directional call you can actually lose money (or more likely, not see returns equal to double the market).

Who: Charles Davis is chairman of Davis Selected Advisers – a firm started by his great grandfather. Charles initially thought that he would not follow in the family footsteps, and considered seminary college, but eventually moved to the world of finance, cutting his teeth at a number of banks before moving to Davis Selected Advisers. The firm was a value shop, often focusing on financials, including insurance companies.

His Mistake: Since the '70s the firm had a stake in AIG, however Charles upped the stake in the mid to late 2000’s. Unlike the typical investment of Davis Selected Advisers, AIG was a complex behemoth, which was nearly impossible to understand and analyse. AIG was unlike any other insurance company which the firm had traditionally invested in.

Take away: Succinctly, if you don’t know, or can’t know, what you are buying, don’t buy it.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.