‘There can be few fields of human endeavour in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.’
John Kenneth Galbraith, A Short History of Financial Euphoria
We so easily forget the lessons of the past.
Each new shiny bubble comes bearing the same old dull promises of easy riches.
While the actors and locations may change, the plot is never different.
Cataracts of greed impair people’s ability to see the repeating patterns of bubbles past.
Sadly, it’s only after the bubble has burst that 20/20 hindsight is restored.
A one-eyed visionary
In looking back to look forward, let me tell you a story about a man with a glass eye who saw what others could not.
At the age of two, Michael Burry lost an eye to cancer.
After finishing high school in San Jose California, Burry studied economics and pre-med at University of California.
After graduating with a medical degree from the Vanderbilt University School of Medicine, Dr Michael Burry commenced a residency in neurology at Stanford Hospital and Clinics.
In his spare time, he pursued his hobby…investing.
The competing agendas of medicine and investing saw Burry come crashing down…literally.
He was so tired from studying both fields of interest he fell asleep — standing up — during surgery. He crashed into an oxygen tent that had been purpose built for the patient.
In 1996, while still studying medicine, he contributed articles to the share discussion site, Silicon Investor.
His successful stock picks came to the attention of serious investors…Vanguard, White Mountains Insurance Group and Joel Greenblatt (founder of hedge fund Gotham Capital).
Burry never finished his residency at Stanford Hospital and Clinics.
In November 2000, Dr Burry shut down his website and started the hedge fund…Scion Capital.
The performance of the fund would be benchmarked against the S&P 500 Index.
For a little perspective, this was the environment Michael Burry started his business venture in…the S&P 500 Index was on the slide and the US was months away from an official recession (the grey-shaded bar).
Source: Macro Trends
It’s one thing making successful stock picks in a raging dotcom bull market, but it’s a ferocious bear market that really tests an investor’s knowledge and mettle.
Before we look at Scion Capital’s performance, this is an extract from Dr Michael Burry’s first investor letter written on 8 January 2001:
‘As I write this, I personally have over $1 million invested in the Fund. You should understand that this amount represents the vast majority of my net worth, and the entire amount of my net worth aside from that required for daily living expenses. I maintain no personal securities account aside from the investment in the Fund, and my entire professional focus is this fund…’
Burry’s interests were totally aligned with his investors (or as he called them, fund members). The same cannot be said for a good percentage of the investment industry.
So how did Scion Capital perform in those ‘tech wreck’ years?
This is from an interview Business Insider did with Michael Lewis (author of The Big Short) (emphasis added):
‘Burry is a contrarian by nature and is willing to look at companies and society differently than other people.
‘For that reason, he was early on the call that the internet had way overvalued companies with little to no revenue or profitability. He began shorting those stocks immediately and his hedge fund went up like a rocket ship. In the first year, Michael J. Burry returned 55% even though the S&P 500 fell 12%. The market continued to fall dramatically the next two years yet Burry’s fund returned 16% and 50%, making him one of the most successful investors in the industry.’
Many hedge funds — like LTCM — achieved outperformance by using borrowed funds to magnify returns…and also losses.
In his letter to investors on 3 July 2001, Burry stated (emphasis is mine):
‘As I do not gear the Fund’s buying and selling of securities to general market views but rather to available values in individual securities, it is likely that I will allocate capital to simple cash when I have difficulty find reasonable investment opportunities.’
Burry’s exceptional returns were achieved by astute investment selection…no gearing required.
He was also advising fund members that if he couldn’t find value in the market, then the best place for their money was in simple cash.
And that’s advice worth remembering in times where the TINA (there is no alternative) mentality is so rife. There is always an alternative. Cash.
Nothing attracts money like stellar performance.
By the end of 2004, Scion Capital had assets under management of US$600 million…and Burry was turning money away.
In 2005, Burry starting seeing what others didn’t…the connection between declining lending standards and the emerging US housing bubble.
For a little context, here’s an extract from an interview with Ben Bernanke in July 2005 (emphasis is mine):
Interviewer: ‘What is the worst-case scenario, if in fact we were to see [house] prices come down substantially across the country?’
Bernanke: ‘Well, I guess I don’t buy your premise. It’s a pretty unlikely possibility. We’ve never had a decline in house prices on a nationwide basis. So what I think is more likely is that house prices will slow, maybe stabilize: might slow consumption spending a bit. I don’t think it’s going to drive the economy too far from its full employment path, though.’
In mid-2005, Michael Burry bought the premise that Bernanke didn’t.
He convinced Goldman Sachs and other investment firms to create a product that didn’t exist…credit default swaps against subprime-mortgage bonds.
Burry knew patience was needed with this investment.
Subprime loans were initially offered as ‘teaser’ loans…offering a low rate for the first two years and then the low introductory rate would be adjusted up to the prevailing higher rate.
Hence, the loans were called ‘Adjustable-Rate Mortgages’ (ARMs).
The following is an extract from his letter to members on 7 November 2006 (emphasis is mine):
‘Most of these subprime mortgage pools will likely see maximum foreclosures a little over two years into the life of the pool. The reason is that most subprime mortgages included in these pools — typically 80% of the mortgages in the pool — are adjustable rate mortgages…
‘Since the Funds shorted mortgage pools mostly originated in spring through late summer 2005 [March to August 2005], I expect the pools shorted will see maximum stress during the latter half of 2007. No one shorting these tranches would expect to see a payoff during the first year of holding the short and likely not even during the second year.’
With hindsight we know Burry had 20/20 vision on what was coming. However, not all his members could see what he did…even though they had been forewarned.
The cost associated with holding the fund’s short positions — think of it as paying insurance premiums — started to mount up.
The fund’s performance suffered accordingly…while the S&P 500 Index kept going strength to strength.
If you saw the movie The Big Short, you’ll know that even with the advance notice given in the 7 November 2006 letter, investors — primarily his seed funder Joel Greenblatt of Gotham Capital — were demanding their money back in early/mid-2007.
Such was the conviction in his thesis, Burry gated — closed — the fund to redemptions.
Understandably, legal action ensued.
As we know, Dr Michael Burry’s conviction paid off just as he had predicted.
In late 2007 and early 2008, the defaults on subprime loans began mounting up as loan rates were ‘adjusted’ upwards.
Poor quality borrowers could not afford the higher level of repayments.
In what came to be termed ‘jingle mail’, keys to houses were posted to banks.
In April 2008, Burry liquidated the fund’s short positions.
The final outcome:
‘Burry earned a personal profit of $100 million and a profit for his remaining investors of more than $700 million. Scion Capital ultimately recorded returns of 489.34% (net of fees and expenses) between its November 1, 2000 inception and June 2008. The S&P 500, widely regarded as the benchmark for the US market, returned just under 3% including dividends over the same period.’
Turning US$1 million into US$100 million in less than eight years. Pretty impressive.
You are being warned
What’s Burry seeing now?
This tweet — dated 22 February 2021 — was the last one from Burry’s now deleted Twitter account…
When this mother of all bubbles does burst — and it will — those who failed to heed the warning will be looking forward to a very uncertain future.
Editor, The Rum Rebellion
Vern is also the Editor of The Gowdie Letter and The Gowdie Advisory — investment services designed to help everyday Australians avoid the financial pitfalls of a volatile economy and make informed decisions to grow their wealth for generations to come.