James Altucher: Why the truth can be worth drilling down for

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The other day I wanted to try an experiment. I had just left Grand Central train station at about 3 in the afternoon in New York City and was walking up 44th Street. I was carrying a laptop case and wearing “office clothes” – slacks and a button-down shirt. I saw a mildly beat-up car that was parked with its windows open and a couple sitting inside. I had no idea what they were talking about but by the expressions on their faces it was probably just idle chit-chat. I walked up to them and said, “Excuse me, I’m homeless. Can you spare $5?”

The guy looked at me and said, “Huh?” I said, “I’m really sorry to bother you, but I’m homeless and could use $5.” The woman, who was sitting on the passenger side reached into her pocket, pulled out some bills and gave me three ones. “Thanks,” I said and walked away.

Sometimes all you have to do is ask. And sometimes it’s important to ask more and drill down a little to get to the truth. But most people don’t. Particularly in the hedge fund world. The other day I was in Rockefeller Center visiting a hedge fund that focused on micro-cap value situations. I liked the guys. Ex-brokers who decided to take their micro-cap expertise and start a hedge fund in late 2002. They had great returns: 30-40 per cent a year.

It was an initial meeting so I just wanted to get a sense of how they looked at stocks, how they valued companies, how they managed their risk – all the basics. Omid, my 25-year-old associate, came with me and joined in the question and answer session. We went through about three of their favourite situations and two of their shorts and went through the full stories on each company. I felt smart for asking all the right questions.

When we left I said to Omid: “These guys seemed pretty good. Let’s set up the next steps with them.”

And Omid, the 25-year-old punk that he is, turned to me and said: “Were you smoking that crack pipe again this morning? They were awful.”

“How can you say that? They beat the market each year. It looks like they had some alpha over the small-cap index. I like the way they value companies.”

“They started their fund at the beginning of the biggest bull run in small-cap stocks ever.”

“Yeah, but they beat the market by 10-20 per cent each year.”

“Yeah, but maybe the average beta of the stocks they were in was over two” (meaning if their benchmark was up 5 per cent, they would be up 10 per cent). “We’d have to really dig into their portfolios and normalise on the beta to see if they really have alpha.”

And he was right. I hadn’t asked the right questions. Later, looking at their returns more closely, I saw that on the market months that were negative, they were down almost three times what the market was down. Imagine what would happen in a severe downturn.

A week later we were in a meeting with a fund that has an $8bn bet that the sub-prime mortgage market is going to collapse. The BBB-rated tranche that represents this category only trades 135 basis points (in yield) above the AAA tranche. This is a sector of the economy that’s about to see all of their adjustable rate mortgages repriced during the next year, causing their payments to double in many cases. This is also a group that banks traditionally never even lend to, let alone allow to borrow at almost AAA rates.

A world-famous economist who worked for the fund had modelled out to the penny the hundreds of per cent the fund would make if there were even 10 per cent defaults. The fund is expecting defaults more in the 20-30 per cent range. In fact, they are so worried that banks won’t be able to handle this they’ve also taken out insurance on all the banks with the biggest exposure (such as JPMorgan). This is the Doomsday Trade.

“Altogether we can make $30bn on this trade but we’re worried the counterparty won’t survive,” we were told .

Omid and I left and he instantly said: “We’re screwed. The whole country is screwed.” But maybe not so fast.

After we got back to the office, I made some calls to other fund of funds managers and they all told me the same thing. One guy said: “Yeah, we looked at that fund. But here’s the thing, every major bank is hording up that trade as a hedge. Not just that one fund. That short trade is extremely crowded and the long side of that trade is owned by pension funds and insurance companies, not day traders. Those pension funds are long-term guys and won’t be panic selling. Expect a squeeze first that will help avoid the doomsday scenario.”

So again, I initially got blindsided but only a little bit of asking was enough to put the gas on neutral.

Incidentally, I did feel bad about walking off with that couple’s $3. But I suddenly felt shy about going back to return the money. And maybe they felt good about giving it. It was their good deed for the day, helping out a low-life like me.

james@formulacapital.com

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