My New Crush: Stanley Druckenmiller

I have a new (intellectual) crush: Stanley Druckenmiller. If you don’t share my feelings, you will after you read his Jan 2015 speech at the Lost Tree Club. Portfolio management related excerpts below: Diversification, Sizing

“I think diversification and all the stuff they're teaching at business school today is probably the most misguided concept...And if you look at all the great investors that are as different as Warren Buffett, Carl Icahn, Ken Langone, they tend to be very, very concentrated bets. They see something, they bet it, and they bet the ranch on it. And that's kind of the way my philosophy evolved, which was if you see - only maybe one or two times a year do you see something that really, really excites you. And if you look at what excites you and then you look down the road, your record on those particular transactions is far superior to everything else, but the mistake I'd say 98 percent of money managers and individuals make is they feel like they got to be playing in a bunch of stuff. And if you really see it, put all your eggs in one basket and then watch the basket very carefully.”

“…you don't need like 15 stocks or this currency or that. If you see it, you got to go for it because that's a better bet than 90 percent of the other stuff you would add onto it.” “So, how did I meet George Soros? I was developing a philosophy that if I can look at all these different buckets and I'm going to make concentrated bets, I'd rather have a menu of assets to choose from to make my big bets and particularly since a lot of these assets go up when equities go down, and that's how it was moving.

And then I read The Alchemy of Finance because I'd heard about this guy, Soros. And when I read The Alchemy of Finance, I understood very quickly that he was already employing an advanced version of the philosophy I was developing in my fund. So, when I went over to work for George, my idea was I was going to get my PhD in macro portfolio manager and then leave in a couple years or get fired like the nine predecessors had. But it's funny because I went over there, I thought what I would learn would be like what makes the yen goes up, what makes the deutsche mark move, what makes this, and to my really big surprise, I was as proficient as he was, maybe more so, in predicting trends.

That's not what I learned from George Soros, but I learned something incredibly valuable, and that is when you see it, to bet big. So what I had told you was already evolving, he totally cemented. I know we got a bunch of golfers in the room. For those who follow baseball, I had a higher batting average; Soros had a much bigger slugging percentage. When I took over Quantum, I was running Quantum and Duquesne. He was running his personal account, which was about the size of an institution back then, by the way, and he was focusing 90 percent of his time on philanthropy and not really working day to day. In fact a lot of the time he wasn't even around.

And I'd say 90 percent of the ideas he were [ph.] using came from me, and it was very insightful and I'm a competitive person, frankly embarrassing, that in his personal account working about 10 percent of the time he continued to beat Duquesne and Quantum while I was managing the money. And again it's because he was taking my ideas and he just had more guts. He was betting more money with my ideas than I was.

Probably nothing explains our relationship and what I've learned from him more than the British pound. So, in 1992 in August of that year my housing analyst in Britain called me up and basically said that Britain looked like they were going into a recession because the interest rate increases they were experiencing were causing a downturn in housing. At the same time, if you remember, Germany, the wall had fallen in '89 and they had reunited with East Germany, and because they'd had this disastrous experience with inflation back in the '20s, they were obsessed when the deutsche mark and the [unint.] combined, that they would not have another inflationary experience. So, the Bundesbank, which was getting growth from the [unint.] and had a history of worrying about inflation, was raising rates like crazy. That all sounds normal except the deutsche mark and the British pound were linked. And you cannot have two currencies where one economic outlook is going like this way and the other outlook is going that way.

So, in August of 1 92 there was 7 billion in Quantum. I put a billion and a half, short the British pound based on the thesis I just gave you. So, fast-forward September, next month. I wake up one morning and the head of the Bundesbank, Helmut Schlesinger, has given an editorial in the Financial Times, and I'll skip all the flowers. It basically said the British pound is crap and we don't want to be united with this currency. So, I thought well, this is my opportunity. So, I decided I'm going to bet like Soros bets on the British pound against the deutsche mark.

It just so happens he's in the office. He's usually in Eastern Europe at this time doing his thing. So, I go in at 4:00 and I said, ‘George, I'm going to sell $5.5 billion worth of British pounds tonight and buy deutsche marks. Here's why I'm doing it, that means we'll have 100 percent of the fund in this one trade.’ And as I'm talking, he starts wincing like what is wrong with this kid, and I think he's about to blow away my thesis and he says, ‘That is the most ridiculous use of money management I ever heard. What you described is an incredible one-way bet. We should have 200 percent of our net worth in this trade, not 100 percent. Do you know how often something like this comes around? Like one or 20 years. What is wrong with you?’ So, we started shorting the British pound that night. We didn't get the whole 15 billion on, but we got enough that I'm sure some people in the room have read about it in the financial press.”

Mistakes

“I've thought a lot of things when I'm managing money with great, great conviction, and a lot of times I'm wrong. And when you're betting the ranch and the circumstances change, you have to change, and that's how I've always managed money.”                “I made a lot of mistakes, but I made one real doozy. So, this is kind of a funny story, at least it is 15 years later because the pain has subsided a little. But in 1999 after Yahoo and America Online had already gone up like tenfold, I got the bright idea at Soros to short internet stocks. And I put 200 million in them in about February and by mid-march the 200 million short I had lost $600 million on, gotten completely beat up and was down like 15 percent on the year. And I was very proud of the fact that I never had a down year, and I thought well, I'm finished.

So, the next thing that happens is I can't remember whether I went to Silicon Valley or I talked to some 22-year-old with Asperger's. But whoever it was, they convinced me about this new tech boom that was going to take place. So I went and hired a couple of gun slingers because we only knew about IBM and Hewlett-Packard. I needed Veritas and Verisign. I wanted the six. So, we hired this guy and we end up on the year - we had been down 15 and we ended up like 35 percent on the year. And the Nasdaq's gone up 400 percent.

So, I'll never forget it. January of 2000 I go into Soros's office and I say I'm selling all the tech stocks, selling everything. This is crazy. [unint.] at 104 times earnings. This is nuts. Just kind of as I explained earlier, we're going to step aside, wait for the net fat pitch. I didn't fire the two gun slingers. They didn't have enough money to really hurt the fund, but they started making 3 percent a day and I'm out. It is driving me nuts. I mean their little account is like up 50 percent on the year. I think Quantum was up seven. It's just sitting there.

So like around March I could feel it coming. I just - I had to play. I couldn't help myself. And three times during the same week I pick up a - don't do it. Don't do it. Anyway, I pick up the phone finally. I think I missed the top by an hour. I bought $6 billion worth of tech stocks, and in six weeks I had left Soros and I had lost $3 billion in that one play. You asked me what I learned. I didn't learn anything. I already knew that I wasn't supposed to do that. I was just an emotional basket case and couldn't help myself. So, maybe I learned not to do it again, but I already knew that.”

Probably one of the few people in this world who knows what it feels like to lose $3 billion dollars in a single day. For additional reading, please see our previous article titled Mistakes of Boredom.

Psychology

When asked what qualities he looks for in money managers:

“Number one, passion. I mentioned earlier I was passionate about the business. The problem with this business if you're not passionate, it is so invigorating to certain individuals, they're going to work 24/7, and you're competing against them. So, every time you buy something, one of them is selling it. So, if you're with one of the lazy people or one of the people that are just doing it for the money, you're going to get run over by those people.

The other characteristic I like to look for in a money manager is when I look at their record, I immediately go to the bear markets and see how they did. Particularly given sort of the five-year outlook I've given, I want to make sure I've got a money manager who knows how to make money and manage money in turbulent times, not just in bull markets.

The other thing I look for…is open-mindedness and humility. I have never interviewed a money manager who told you he'd never made a mistake, and a lot of them do, who didn't stink. Every great money manager I've ever met, all they want to talk about is their mistakes. There's a great humility there. But and then obviously integrity because passion without integrity leads to jail. So, if you want someone who's absolutely obsessed with the business and obsessed with winning, they're not in it for the money, they're in it for winning, you better have somebody with integrity.”

“If you're early on in your career and they give you a choice between a great mentor or higher pay, take the mentor every time. It's not even close. And don't even think about leaving that mentor until your learning curve peaks. There's just nothing to me so invaluable in my business, but in many businesses, as great mentors. And a lot of kids are just too short-sighted in terms of going for the short-term money instead of preparing themselves for the longer term.”

Liquidity

“…earnings don't move the overall market…focus on the central banks and focus on the movement of liquidity… most people in the market are looking for earnings and conventional measures. It's liquidity that moves markets.”

However, to borrow from Soros’ reasoning within the Alchemy of Finance, one could argue that anticipated earnings influence market participant behavior and therefore influence liquidity.

Other

“…never, ever invest in the present. It doesn't matter what a company's earning, what they have earned. He taught me that you have to visualize the situation 18 months from now, and whatever that is, that's where the price will be, not where it is today…you have to look to the future. If you invest in the present, you're going to get run over.”

Low Net Exposure Won’t Save You

I’ve been noticing quite a few 2009-vintage long/short equity hedge funds (the 137% gross, 42% net exposure variety) with steadily expanding capital bases, via both portfolio compounding and capital inflows. The latter is understandable given the spectacular return trackrecords of these funds. Yet, ever the skeptic anytime I observe capital chasing performance, I’d like to share an anecdote with my Readers. A few weeks ago, I met someone who relayed the following Stanley Druckenmiller story (for more on Stanley Druckenmiller, be sure to check out these articles):

In 2007, a list of hedge funds was shown to Stanley Druckenmiller and his opinion of those managers requested. Glancing at the list, Druckenmiller pointed to a few and said, “These guys will blow up. They don’t understand that when things get bad, they need to take down gross, not just net.” Lo and behold, the predictions of Druckenmiller once again proved true – those funds blew up in 2008.

Regardless of whether the story is actually true or false, I think it still conveys a valuable point. In extreme environments, the leverage associated with high gross exposure is dangerous, even if you carry a low level of net exposure, because the underlying assets will behave erratically as historical correlations breakdown.

How many of these newly minted 2009-vintage long/short, high gross low net, equity funds, with swollen egos after years of outperformance, will know/remember this when the storms approach? Only time will tell.

Stanley Druckenmiller Wisdom - Part 3

Here is Part 3 of portfolio management highlights extracted from an interview with Stanley Druckenmmiller in Jack D. Schwager’s book The New Market Wizards. Be sure to check out the juicy bits from Part 1 and Part 2. Druckenmiller is a legendary investor, and protégé of George Soros, who compounded capital ~30% annualized since 1986 before announcing in 2010 that his Duquesne fund would return all outside investor capital, and morph into a family office.

Liquidity, Making Mistakes, Position Review

“The wonderful thing about our business is that it’s liquid, and you can wipe the slate clean on any day.”

Liquidity makes it easier to change your mind and to deal with mistakes. This is why people talk about the “liquidity premium.” Theoretically, this flexibility is worth something. But how does one place a value or price upon liquidity (or illiquidity for that matter)? The Pensioner in Drobny’s book Invisible Hands has some interesting thoughts on this.

Our next point on liquidity has to do with a comment that Seth Klarman made about “re-buying the portfolio each day” and the related implications (of opportunity cost, hurdle rate, etc.).

For example: Prices in the marketplace are constantly shifting. Does your portfolio currently offer the best risk-reward profile given present market conditions, or can you improve it by buying or selling certain securities/assets? Mariko Gordon of Daruma Capital has some really interesting insights on portfolio review, decluttering, and improvement (made possible by liquidity).

Remember, investors of private assets do not have this luxury – so take advantage of liquidity wisely.

Sourcing, Liquidity, When To Buy

Q: Did you have any difficulty putting on a position of that size? A: No, I did it over a few days’ time. Also, putting on the position was made easier by the generally bearish sentiment at the time.

People often say that historical returns are not indicative of future performance.

Well, this is also true for trading liquidity: historical liquidity levels are not indicative of future liquidity.

Liquidity is not stagnant! What is liquid today may not be liquid tomorrow, and vice versa. This is why I find it funny when people reference historical trading liquidity. I’ve seen securities seesaw from trading a miniscule 30,000 shares a day, to more than 1MM shares a day.

Also, to Druckenmiller’s point, the time to buy (or sell) is often when there’s a liquidity imbalance somewhere in the marketplace. Liquidity imbalances have the ability to drive prices down (or up).

Volatility, Catalyst, Liquidity

“…I focus my analysis on seeking to identify the factors that were strongly correlated to a stock’s price movement as opposed to looking at all the fundamentals. Frankly, even today, many analysts still don’t know what makes their particular stocks go up and down.”

“I never use valuation to time the market…Valuation only tells me how far the market can go once a catalyst enters the picture to change the market direction…The catalyst is liquidity…” 

Look for reasons behind price movement (volatility), such as liquidity imbalances as mentioned above.

Stanley Druckenmiller Widsom - Part 2

Here is Part 2 of portfolio management highlights extracted from an interview with Stanley Druckenmmiller in Jack D. Schwager’s book The New Market Wizards. Be sure to check out the juicy bits from Part 1. Druckenmiller is a legendary investor, and protégé of George Soros, who compounded capital ~30% annualized since 1986 before announcing in 2010 that his Duquesne fund would return all outside investor capital, and morph into a family office.

Portfolio Management

“I’ve learned many things from him [George Soros], but perhaps the most significant is that it’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.”

This is the very essence of portfolio management. We all have endless opinions on ideas, inflation, direction of markets, etc. But it's what we do with these opinions - the conversion into P&L and trackrecord - that ultimately determines our success or failure as investors.

In this industry, sometimes people become obsessed with "being right" or "proven right" - which is likely a natural behavioral tendency. But I agree with Druckenmiller, it doesn't matter if you're right or wrong. When utilized skillfully, portfolio management has the ability to amplify correctness and mute errors.

When To Buy, When To Sell, Sizing

“Soros has taught me that when you have tremendous conviction on a trade, you have to go for the jugular. It takes courage to be a pig. It takes courage to ride a profit with huge leverage. As far as Soros is concerned, when you’re right on something, you can’t own enough.”

Making Mistakes, When To Sell

“Soros is also the best loss taker I’ve ever seen. He doesn’t care whether he wins or loses on a trade. If a trade doesn’t work, he’s confident enough about his ability to win on other trades that he can easily walk away from the position. There are a lot of shoes on the shelf; wear only the ones that fit. If you’re extremely confident, taking a loss doesn’t bother you.”

Closing out a losing position takes a lot of courage. It is usually a task that is easier said than done because it goes against our natural psychological tendency to avoid confronting or admitting our mistakes. The act of selling a losing position echoes of finality – no hope for a brighter outcome just around the corner, no possibility of savaging the situation.

However, there are also benefits. As Druckenmiller points out, it lets you walk away to fight another day – perhaps at an easier battle. Also, it frees up mental and time capacity in not having to babysit that losing position.

Ask yourself honestly: how much time did you spend in the chaotic era of 2008-2009 babysitting losers vs. concentrating on finding new opportunities?

Cash

“By mid-1981, stocks were up to the top of their valuation range, while at the same time, interest rates had soared to 19 percent. It was one of the more obvious sell situations in the history of the market. We went into a 50% percent cash position, which, at the time, I thought represented a really dramatic step. Then we got obliterated in the third quarter of 1981…Well, we got obliterated on the 50 percent position we still held.”

“You have to understand that I was unbelievably bearish in June 1981. I was absolutely right in that opinion, but we still ended up losing 12 percent during the third quarter. I said to my partner, ‘This is criminal. We have never felt more strongly about anything than the bear side of this market and yet we ended up down for the quarter.’ Right then and there, we changed our investment philosophy so that if we ever felt that bearish about the market again we would go to a 100 percent cash position.”

Below, I highlight two sides to this perennial cash debate:

(Some) Fund Managers say: My goal is to compound capital (and to build an awesome trackrecord). Holding a cash balance makes sense at certain times of the cycle, such as when I don’t see any worthwhile opportunities (2005-2007), and this will prevent (temporary) impairments of capital. However, I will stay vigilant with both eyes open, and redeploy the moment opportunities reemerge. If you leave the cash with me, I won’t have to spend time raising capital at exactly the moment when I should be spending all of my time focused on investing (2008-2009).

(Some) Clients say: I am fully aware of market cycles and the merits of holding cash while waiting for better bargains. However, when I gave your fund capital to invest, I have already allotted for a cash balance elsewhere in my overall portfolio. If you move toward cash, it skews my actual cash exposure to higher than anticipated within my asset allocation. Therefore, I want you to be fully invested at all times.

There is no right or wrong answer here – both sides have valid points. At its core, this debate originates from a mandate communication issue. Before taking on a client, make sure he/she understands your views on cash balance. Before allocating capital to a fund, make sure the “cash mandate” complements your asset allocation strategy.

Stanley Druckenmiller Wisdom - Part 1

Druckenmiller is a legendary investor, and protégé of George Soros, who compounded capital ~30% annualized since 1986 before announcing in 2010 that his Duquesne fund would return all outside investor capital, and morph into a family office. Many of our Readers reside in the House of Value, but I believe that value investors can learn from those with more trading-oriented or macro philosophies – especially in terms of volatility considerations, trade structuring, and capital preservation.

The following portfolio management highlights were extracted from an interview with Stanley Druckenmmiller in Jack D. Schwager’s book The New Market Wizards. Be sure to check out Part 2 & Part 3.

Trackrecord, Capital Preservation, Compounding, Exposure

“Q: Your long-term performance has far surpassed the industry average. To what do you attribute your superior track record?

A: George Soros has a philosophy that I have also adopted: he way to build long-term returns is through preservation of capital and home runs. You can be far more aggressive when you’re making good profits. Many managers, once they’re up 30 or 40 percents, will book their year [i.e., trade very cautiously for the remainder of the year so as not to jeopardize the very good return that has already been realized]. The way to attain truly superior long-term returns is to grind it out until you’re up 30 or 40 percent, and then if you have the convictions, go for a 100 percent year. If you can put together a few near-100 percent years and avoid down years, then you can achieve really outstanding long-term returns.”

“Many managers will book their profits when they’re up a lot early in the year. It’s my philosophy, which has been reinforced by Mr. Soros, that when you earn the right to be aggressive, you should be aggressive. The years that you start off with a large gain are the times that you should go for it. Since I was well ahead for the year, I felt that I could afford to fight the market for a while. I knew the bull market had to end, I just didn’t know when. Also, because of the market’s severe overvaluation, I thought that when the bull market did end, it was going to be dramatic.”

We’ve discussed the importance of capital preservation, and its complementary relationship to long-term compounding. Here is Drunkenmiller’s well-articulated version of the same concept…plus a fascinating twist.

As dictated by the Rules of the Game, the scorecard in the investment management world is your trackrecord in the form of calendar year returns. The concept of earning the “right to be aggressive” in certain calendar years echoes in my mind like a siren song, so dangerous yet utterly irresistible.

Most traditional value investors would not dare dream of enacting such a brazen act. But, if you keep an open mind to ponder and digest, it makes a lot of sense.

UPDATE: One Reader (and friend who is very very bright) suggested that the genius behind the "right to be aggressive" derives from its utter contradiction of traditional value doctrine.  Buffett and Munger would say wait for an opportunity and then be aggressive.  Druckenmiller's effectively saying that he doesn't think you can ever truly know when it's a great time....so you wait until you know something for a fact: that you are having a good year.

Expected Return, Opportunity Cost

“…an attractive yield should be the last reason for buying bonds. In 1981 the public sold bonds heavily giving up a 15 percent return for thirty years because they couldn’t resist 21 percent short-term yields. They weren’t thinking about the long term. Now, because money market rates are only 4.5 percent, the same poor public is back buying bonds, effectively lending money at 7.5 percent for thirty years…”

Sadly the situation has deteriorated further. Today, money markets yield ~0% and thirty year bonds pay ~3%.

It’s important to remember that portfolio expected return should not be determined solely based upon returns available today, but also opportunities around the corner, not yet visible. This is what makes opportunity cost so difficult to determine – it's often a gut judgment call that involves predicting the availability of future expected returns.

Team Management

On working with George Soros:

“The first six months of the relationship were fairly rocky. While we had similar trading philosophies, our strategies never meshed. When I started out, he was going to be the coach – and he was an aggressive coach. In my opinion, Gorge Soros is the greatest investor that ever lived. But even being coached by the worlds greatest investor is a hindrance rather than help if he’s engaging you actively enough to break your trading rhythm. You just can’t have two cooks in the kitchen; it doesn’t work. Part of it was my fault because he would make recommendations and I would be intimidated. After all, how do you disagree with a man with a track record like his?

Events came to a head in August 1989 when Soros old out a bond position that I had put on. He had never done that before. To make matters worse, I really had a strong conviction on the trade. Needless to say, I was fairly upset. At that point, we had our first let-it-all-out discussion…Basically, Soros decided that he was going to stay out of m hair for six months.”