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Kass: The Smart Guys Continue to Lose

Doug Kass

I am particularly struck by the recent series of high-profile investor blunders by the "smart guys" -- namely, large corporations, entrepreneurs (especially of a real estate kind) and savvy investment and hedge fund managers -- which are proof positive how difficult 2008 to 2009 might end up being for investors.

-- Doug Kass (Jan. 7, 2008)

Back in January, I wrote that smart guys were losing their shirts, a sign for us mere mortals that the going was getting tough this year and next.

Below are some examples that I cited 10 months ago of large investment boners made by some smartypants, even before the credit market disaster spilled over and doomed equities (with updates in parentheses):

• In August 2007, Bank of America (BAC Quote) acquired a $2 billion minority stake in Countrywide Financial at $18 per share. (Countrywide no longer trades as Bank of America acquired the company at less than $5 a share.)
• In late November 2007, the Abu Dhabi Investment Authority acquired $7.5 billion of Citigroup (C Quote) stock convertible at $37 and higher. (Citigroup's shares now trade at $6.)
• During the course of the past six months, entrepreneur Joe Lewis has acquired nearly 10% of Bear Stearns. It is not clear what his average cost is -- around $100 is a reasonable guess -- but he is believed to have a paper loss of at least $250 million. (Bear Stearns has since filed for bankruptcy.)
• Real estate developer Harry Macklowe acquired a number of trophy midtown Manhattan office properties from Equity Office Properties at the height of the market's values and before the seizure in the credit markets. An inability of rolling over the debt could crush the Macklowe real estate empire. (It almost did bankrupt him.)
• In May 2007, ESL's Ed Lampert announced that it acquired an initial stake worth about $800 million in Citigroup. At that time, the shares traded about $53. He is generally believed to have substantially added to his holdings in Citigroup since then. (Again, Citigroup's shares now trade at $6.)
• Pershing Square's William Ackman acquired 10% of Target (TGT Quote). Ackman first disclosed his position in July 2007, when the shares traded at about $65. (Target's shares now are priced at $32.)
• Former SEC commissioner and now hedge fund activist Richard Breeden has raised his stake in Zale (ZLC Quote) to almost 6 million shares -- he first filed with about 4 million shares in September 2007 -- or over 13% of outstanding common stock. SAC's Steve Cohen, the very best hedgie extant, also made a 13D filing back in September 2007. Back then, Zale shares traded in the mid-$20s. (Zale's shares closed at $5 yesterday, and more on that below.)
• Less than one month ago, Warburg Pincus acquired $1 billion of MBIA (MBI Quote) at $31 per share. (MBIA's shares now trade at $5.)

For those reasons and others, in late November 2007, I suggested that we had entered "The Hardest Stock Market to Navigate Ever."

The next five years in the capital markets seem destined to be unlike the last five years. The most significant difference is that the egregious use, generation and packaging of debt will not be repeated -- and the consequences of that leverage will be adversely seen in areas of the world economies that we had never contemplated.

From my perch, the bulls continue to think very linearly and seem to be missing how significant the role of credit was to past growth and how significant a pullback in credit will be on future growth. Significantly, the markets continue to underestimate the consequences of leverage and are overestimating the prospects for corporate profit growth.

-- Doug Kass (Oct. 22, 2007)

As such, I had consistently offered some rare advice in late 2007 that bears repeating: Keep investing/trading positions small as volatility and fundamental disappointment will occur with greater regularity. I went on the suggest that a more hostile economic environment, at best, will lead to substandard stock market returns; at worst, it will lead to large losses. And I cautioned that the next shoe to drop could be disintermediation (outflows) and closures in the hedge fund industry, which also came to pass.

Since my column on the smart guys losing appeared on these pages in January, many more previously well-regarded hedge funds and acquisitive smart guys in the chase for superior investment performance and concentrated ownership positions, with the most conspicuous example perhaps being Ed Lampert in his ownership of Sears Holdings (SHLD Quote), have lost a boatload of money.

Yesterday, I was especially struck by the news that the shares of Zale dropped by 40%, to a multidecade low.

My long held view has been that the jewelry market's competitive landscape had changed with the emergence of formidable online competitors, such as Blue Nile (NILE Quote) and others, and that Zale's business model would be challenged and its secular profit growth diminished.

Former SEC Commissioner Richard Breeden apparently didn't agree with me. As mentioned previously, his Breeden Capital Management established an 8-million-share position (25% of the outstanding) in Zale. Since the initial 6-million-share stake was established in 2007, Breeden Capital acquired another 3.45 million shares in late December/early January between $13.42 and $16.21 per share. Zale's shares closed at $5.38 a share yesterday.

The smart guys are continuing to lose big.

Berkshire Hathaway's (BRK.A Quote) Warren Buffett might be one of the only exceptions to the rule whereby an investment manager prospered by taking concentrated invested positions; most just don't.

Indeed, the bear market of 2008 has brought many of them to their knees, uncovering some naked emperors in their faulty company analyses and far too aggressive acquisitions of shares at overvalued price levels.

Learn from their mistakes.

Stay diversified, keep investing/trading positions small, and be opportunistic.

Doug Kass is the author of The Edge, a blog on RealMoney Silver that features real-time shorting opportunities on the market.