Columbia Business School

Columbia Business School AT THE VERY CENTER OF SUS NESS Inside this issue: 25th Annual Graham & Dodd Breakfast Craig Effron Jeff Gramm Shane Parrish Jon Salinas Student Ideas P. 3 P. 5 P. 19 P. 30 P. 39 P. 47 Editors: Brendan Dawson MBA 2016 Scott DeBenedett MBA 2016 Anthony Philipp MBA 2016 Brandon Cheong MBA 2017 Eric Laidlow, CFA MBA 2017 Benjamin Ostrow MBA 2017 Visit us at: www.csimaAnfo Heilbrunn : IurGraham&Docks INO csi ma CI UMBIA SI UUL N I INVESTMENT MANAGEMENT ASSOCIATION Jon Salinas Jeff Gramm Graham & Doddsville An investment newsletter from the students of Columbia Business School Issue XXVI Winter 2016 Craig Effron of Scoggin Capital Management Craig Effron is the co-portfolio manager of Scoggin Capital Management, which he founded with partner Curtis Schenker in 1988. With approximately $1.75 billion in assets under management, Scoggin is a global, opportunistic, multi-strategy Craig Effron event-driven fund. Scoggin focuses on identifying fundamental long/short investments through three primary strategies including event driven equities with a catalyst, special situations, and distressed credit. Mr. Effron began his career as a floor trader on the New York Mercantile Exchange and New York Commodity Exchange. Mr. Effron received a BS in Economics from the (Continued on page 5) Jeff Gramm '03 of Bandera Partners Jeff Gramm manages Bandera Partners, a value hedge fund based in New York City. He teaches Applied Value Investing at Columbia Business School and wrote the upcoming book "Dear (Contotsed on par I?) Shane Parrish Shane Parrish of Farnam Street Shane Parrish is the curator behind the popular Farnam Street Blog and founder of the Re:Think Workshops on Innovation and Decision Making. !Continued on page 30) Jon Salinas '08 of Plymouth Lane Capital Management Jonathan Salinas founded Plymouth Lane in April 2013 and acts as sole portfolio manager to the Fund. Prior to founding Plymouth Lane, Jonathan worked as an analyst at Marble Arch Investments, a long/short hedge fund manager. Before joining Marble Arch, Jonathan served as a consultant at ZBI Equities, a long/short hedge fund manager operated by Ziff Brothers Investments. Prior to ZBI, he was an analyst at Festina Lente Investment Management, a concentrated, value-oriented investment manager, and worked as an analyst in capital markets and research divisions at UBS AG. !footnotd on page 39) EFTA00300912 Page 2 Welcome to Graham & Doddsville Meredith Trivedi, the Heilbrunn Center Director. Meredith skillfully leads the Center. cultivating strong relationships with some of the world's most experi- enced value investors. and creating numerous learning opportunities for students interested in value invest- ing. The classes sponsored by the Heilbrunn Center are among the most heavily demanded and highly rated classes at Columbia Busi- ness School. Professor Bruce Greenwald. the Faculty Co-Director of the Heilbrunn Center. The Center sponsors the Value Investing Program. a rigor- ous academic curriculum for particularly committed stu- dents that is taught by some of the industry's best practi- tioners. HeilbrunriCen:er I, g-Graham&Dockl csima (c‘ukto.A SIJt,:ta INVIESTPACNT MWAIMEINT ASKICIAIION We are pleased to bring you the 26th edition of Graham & Doddsydre. This student-led in- vestment publication of Colum- bia Business School (CBS) is co- sponsored by the Heilbrunn Center for Graham & Dodd Investing and the Columbia Stu- dent Investment Management Association (CSIMA). In this issue, we were fortunate to speak with three investors and the founder of the popular blog Farnam Street. Craig Effron of Scoggin Capital Management discusses the evo- lution of his firm and his invest- ment approach from commodi- ties to the stock market. Craig offers insights into his risk man- agement mentality, challenges facing the investment manage- ment community, and creative ways to express investment theses while managing against downside risk. He shares recent case studies in the event-driven space and opportunities he cur- rently see in distressed credits in Puerto Rico and energy. Jeff Gramm '03 of Bandera Partners discusses his book on activism "Dear Chairman: Boardroom Battles and the Rise of Shareholder Activism" and walks through current Ideas including Famous Dave's (DAVE) and Star Gas Part- ners (SGU). Shane Parrish discusses the origination of Famam Street and his focus on becoming a better learner, as epitomized by Warren Buffett and Charlie Munger. Shane explains how these learnings apply to becom- ing a better investor and shares his hopes for Farnam Street and its readership. Jonathan Salinas '08 of Plym- outh Lane Capital discusses his experiences with varied invest- ment approaches and mentors and how his background lead- ing up to founding Plymouth Lane has contributed to the firm's world view and how he seeks to invest Jonathan also shares current ideas DHX Media (DHXM) and Sequential Brands Group (SQBG). This issue also highlights pho- tos from the 25th Annual Gra- ham & Dodd Breakfast, held on October 9th, 2015 at the Pierre Hotel in New York. This event brings together alumni, students, scholars, and practi- tioners for a forum on current insights and approaches to investing. This year's breakfast featured a conversation with Philippe Laffont of Coatue Man- agement moderated by Profes- sor Bruce Greenwald of Co- lumbia Business School. Lastly, we are proud to bring you pitches from current stu- dents at CBS. We feature final- ists from the Darden at Virginia Investing Competition. Colum- bia Business School's inaugural CSIMA Stock Pitch Challenge, and Alpha Challenge at UNC Kenan-Flagler. The three finalist ideas from our classmates include: Marc Grow '17, Benjamin Ostrow 'I?, and Evan Zehnal '17 — Dexcom Inc (DXCM) Short; Nielsen Fields '17, Joanna Vu '17, and Adam Xiao '17 — Quest Diagnostics (DGX) Short and Justin Hong '17, Zachary Rioter '17, and Cristo- bal Silva '17 — XPO Logistics (XPO) Long. As always, we thank our interviewees for contributing their time and insights not only to us, but to the investment community as a whole, and we thank you for reading. - G&Dsville Editors Keynote speaker Philippe Laffont addresses attendees at the 25th Annual Graham & Dodd Breakfast Attendees gather at the 25th Annual Graham & Dodd Breakfast EFTA00300913 Page 3 25th Annual Graham & Dodd Breakfast — October 9, 2015 at The Pierre Hotel Mario Gabelli '67 at the Graham & Dodd Breakfast with keynote speaker Philippe Laffont Professor Bruce Greenwald with Philippe Laffont at the Graham & Dodd Breakfast Sid and Helaine Lerner speak with Heilbrunn advisory board member Tom Russo Heilbrunn advisory board members David Greenspan '00, William von Mueffling '95, and Jenny Wallace '94 EFTA00300914 Page 4 +Columbia Business School The Heilbrunn Center for Graham & Dodd Investing GABELLI FUNDS SAVE THE DATE FORTHE 7th ANNUAL "From Graham to Buffett and Beyond" Dinner Friday,April 29, 2016 6 . to 9 . The Omaha Hilton 1001 Cass Street • Omaha, Nebraska Tickets will go on sale in March at EFTA00300915 Page .5 Craig Effron Craig Effron (Cononued (mm page 0 Wharton School of Business of the University of Pennsylvania. Graham & Doddsville (=): Could you tell us about your background and how you came to investing? Craig Effron (CE): It's important. because I am not the traditional hedge fund story. I didn't work two years in investment banking and then go to Harvard Business School. I went to Wharton for undergrad. I did not get into NYU Law, but I got into Duke. I went down to Duke for a weekend with my parents and everybody there was 6'4" and blonde. I said. ". not going to do very well here. Socially, I cannot go here." My parents said. "I tell you what, take a year off, defer, and then reapply to NYU a year later and hopefully get in." During that year. I met up with two buddies for a card game at Penn. They were playing for stakes that I had never even known existed. I said, "What do you guys do for a living?" One said, "We trade commodities. On the floor, we buy and sell gold and silver. It's really fun and you should come check it out." I had been working at EF Hutton. which was big in everything, but they went bankrupt in the '80s. I had gotten a job there right after school and worked there for a few months. But, then I played in this card game and, afterward, went down to the floor with my friends. I thought, "Wow, this looks like a lot of fun." Somehow. I convinced my parents to lend me forty thousand dollars to try my hand at trading commodities. I said that if I didn't do well, I would go to law school a year later. I did well. I learned a lot about life and about commodities and trading. And I was fairly good at it. The problem with commodities trading is that it ends at 2:30 in the afternoon. When you're 24 years old you can get into a lot of trouble if you're done at 2:30pm unless you have something to do. I decided to start learning the stock market. I had gone to Wharton for undergrad and somewhat thought I knew what I was doing. but I didn't really know how to invest. About five years into trading on the COMEX. I started doing risk arbitrage. That was the heyday of Mike Milken. I thought I was a genius because every time there was a deal announced. automatically —within a week—there would be a topping bid. Then there would be a third bid; it was crazy. Everyone on the floor knew about my success trading stocks. They all gave me their money, as my friends, to run for free. I did that for a year and it was fun. I had about 30 accounts and I was doing it for free. Paul Tudor Jones, who stood next to me in the ring, was a good buddy of mine and said. "You know what? Run my money, as well. But one caveat: I want you to charge me a fee." I asked, "Why do you want me to charge you a fee?" And. being as smart as Paul is, he said. "Because if you charge me a fee, you will pay attention to my account first." He was dead right. After about a year of managing Paul's money and these other accounts. I realized that I liked doing this more than trading commodities. I left and told everybody I was going to put together a fund called Scoggin with my partner Curtis Schenker, who is still my partner. Here's a key element of our partnership and how Curtis and I complement each other—it's an important fact about Scoggin. Curtis was my best friend before we started Scoggin. He's my best friend still. Curtis and I keep each other grounded. We realize we caught a 30 year bull market. We weren't that smart. We happened to have money under management, and it worked out. Curtis and I don't take ourselves too seriously. He has always been Mr. Naysayer. and Mr. It's- Always-Bullish. He's the guy who kept us in business a lot because I would've been a lot more aggressive during the technology bubble. He said. "Craig. leave it alone. This is not what we do. We don't know what that means. We're not doing that." And of course later technology blows up. That's why it works, and that's why we're still best friends and still partners. Part of this Scoggin charm. if you want to call it that, is that we still are friends first and partners second. I think it sort of flows through the whole office. The average tenure of my analysts here is 10 to 12 years. There are a few new guys who are two or three (Continued on page 6) EFTA00300916 Page 6 Craig Effron years but basically I have 12 analysts, and six or eight of them have been here since before 2000. It's a very nice feeling to know that I can go on vacation and know that not going to have someone blow me up. Incidentally, the name "Scoggin" comes from a camp that Curtis and I went to in Maine. I met him there and we reunited at Penn. We started Scoggin together with these 30 accounts. Curtis's money, and my money. It was about $3 million in total and that was how we started in 1988. To put it in perspective, as a hedge fund with $3 million in 1988. we were not even the smallest while the biggest fund was about $80 million. MI: At that point were you just focused on risk arbitrage? CE: Yes, that's all we were doing at that point. We were up a lot of money in '89 and in September of '89 the biggest deal in history was United Airlines. The deal blew up and everybody in my world went out of business. We went from up 65% to up 20%, which is a big draw down, but still up 20%. Before this, I had been competing to attract the best talent, but I couldn't afford to hire many of them. Now, they were working for free because they were all out of work. I hired a restructuring analyst. a long/short analyst, and others whom I could never have afforded before that. That is when Scoggin was really born because we could now do things besides just get lucky with Mike Milken doing topping bids. We could still do risk arbitrage, but now we could get involved in distressed credit. spin-offs, and restructuring —anything that has an event. We went from running $3 million to running $3 billion by the late 2000s. We sort of stopped raising money because I liked my life and I didn't want to be a manager of people; I wanted to be a manager of money. And, mostly. I wanted it to be my own money. Then '08 happened. We had no losing years until 2008. We had twenty years where every year we made money. At that point we were up 17.5% net to investors. 2008 occurs and. "I realized how fleeting success can be in a market, whether it's a stock market or a commodities market. My whole perspective on investing has been, and hopefully will continue to be, not to lose." depending on which fund you look at we lost between 20% and 30%. To my investors. I was known as a "Jewish T-bill." This is a very bad thing to be known as—not the "Jewish" part but the "T-bill" pan. Because when you then have a losing year, they say. "Oh my God, it's not a T-bill." Then they start to realize, "Wait a minute, he's got risk after all. We thought you were really safe. We thought you couldn't lose." I had to go through this whole process for my investors explaining why they shouldn't pull their money out. A lot of them did a year later. We blew up after redemption dates so the investors had to wait to redeem. We made most of the money back in 2009, but they were all so stunned about what had happened that we lost about 25% of our capital through redemptions in 2009. That was a learning experience for me. You don't ever want to have people think you are what you are not Then the Madoff thing happened the same year, so they started saying. "Wait a minute. Madoff didn't lose money for 20 years either." I actually had to explain why not Madoff to my big investors. They knew I wasn't yet they had to check the boxes to make sure I wasn't actually Madoff. Were they institutions? CE: Yes, they're my big guys. and they were worried that they were going to be fired from their jobs. Imagine having another fraud that you invested in. A lot of institutions were invested with Madoff. The reality is that a lot of the fund is my money and Cunis's money. If you do the math, we can do much better making good returns on our own money than with management fees. Except this year we are losing money. It's the second time we're losing money since 2008. We are down about 10%. It's really nauseating because we have done a good job to be down 10%—that's what's scary. We've done very few things wrong. but those things we have done wrong (Continued an page 1) EFTA00300917 Page 7 Craig Effron Matthew Baredes '17. Matheus Romariz '16. and Nicholas Turchetta '17 volunteer at the Graham & Dodd Breakfast have been fatal in 2015. : Could you talk about how you think about managing the downside in your portfolio? CE: Let's go back to the floor experience. Managers you've spoken to in the past and with whom you will speak in the future are probably "traditional analysts." They come from good schools, they learn at Morgan Stanley or Centerview Partners how to be an analyst. They start becoming investors and that's their thing. I am totally different. I am a trader. I am a risk manager. I was very successful on the floor because I didn't go out of business. I remember when I was 23 or 24. there were the "Michael fordans" and the "Tom Bradys" of the floor. They were famous. They were the big traders who traded hundreds of lots.. there for about six to nine months and a little baby trader at this point. I get tapped on the shoulder by a veteran trader. He was one of the biggest traders in gold. He taps me on the shoulder one day and says, "Hey. can I talk to you? wondering if I could borrow some money from you. I had a little problem: I was short gold." Gold went crazy and he went out of business. I said. "I don't have any money to lend you—. 23 years old—but I appreciate that thought." I said to myself. "Wow this guy was a millionaire." He was looking for money because he went out of business. I realized how fleeting success can be in a market, whether it's a stock market or a commodities market. My whole perspective on investing has been, and hopefully will continue to be. not to lose. Relatively speaking, making money is easy. It's avoiding losing that's important and much more difficult. This 10% down year is going to cost me two years of money. I can tell you next year will be a very "I've learned that people tend to give you a one-year grace period. They realize that the is flat for the year but the real market is not. There are 327 stocks down this year out of 500 in the with a handful outperforming." difficult year as well. In fact, if we fight back to even in two years I will be happy. The key to our business, I've learned, is this: don't go down. It's fatal to a lot of firms. The average age of a hedge fund that goes out of business is seven years. We're on our 27th year. That's not by accident. We had 20 years of never losing. We had 2008. we also lost 3% in 2011. and now this year: three losing years out of 27. That's how you stay in business. A lot of very good investors have blown up. Some have come back from it, but not typically. You're given one chance to go out of business and that's it in our industry. You can't redo it. 2008 was different. People gave you a free pass in 2008. Otherwise, if you lose money of any real size, you're out of business pretty quickly. There's another smart guy down the street who has done really well and he will take your money. : How much more competitive is the hedge fund industry now compared with when you started? CE: Here is a crazy scat: when I started business there were 300 hedge funds in the world. There are now over 10.000. We were the 165th biggest in 1990 with maybe $30 million. 155th in 2000 at around $1 billion. and we were 177th in 2008 at $3 billion. No matter how big we got. we never got any bigger relatively. It's symptomatic of the issues we're having now in our business. There's too much money in it. The business was an amazing business when no one knew what it was. In my world, at your age. mediocrity in my business made you very wealthy. People wanted to be invested in hedge funds. They didn't care if you were the best. They wanted to be in a hedge fund; that was the cool thing to be in the '90s. If you were just mediocre, making 8% a year. people were delighted because they were doing it in a hedge fund as opposed to doing it in a mutual fund. Now you're in a position where it's not good to be a hedge fund unless you're really good at it. (Continued co page 8) EFTA00300918 Page 8 Craig Effron People that were terrible were making tons of money on management fees. That all changed in 2008: they went out of business. Now, in our business, if you're not in the top 20%. you don't make any money. and that's the way it should be. Like any business, you should be required to be in the top percentile of performers to remain in business. That's the new dynamic, the new normal in my world. If you aren't good at it, you actually are out of business. Every year, I've got to be good again because there are many options out there. Whether it's another hedge fund or a quant fund, there are so many options that people say. "Look, we love you as a person. but you're making no money for me." Now for 2015. we are down between 10% and I I% at this point, and we have had very few redemptions. I've learned that people tend to give you a one-year grace eriod. They realize that the is flat for the year but the real market is not. There are 327 stocks down this year out of 500 in the with a handful outperforming. Those are companies like Google and Amazon? CE: Out of those stocks that are up, it's about six that make a difference. That's not what I do. I don't trade Google (GOOG) and Amazon (AMZN). If I did, I wouldn't need to be in this business. IN doing things that are "tricky" or "clever." and not so much this year. obviously. It's not just me. Because, as you know, my world is getting destroyed. We are trading on events that theoretically have catalysts. and that has been a horrible business this year. Did the catalysts not come through or did the catalysts not matter much? CE: Some didn't come through and some came through and ended up with bad results. I'll give you a case in point which I find amazing. Starwood Hotels (HOT) went up for sale in June. The stock at the time was at $80/share. Everybody had a break-up value of somewhere between $90 and $105. On June 15th. when Starwood announced that the company was up for sale, the stock was up a little bit that day. Then the market "There are a lot of things out there that are scaring me. But, ■ paid to play, and that's what I do. But I don't play with leverage." blew up and the stock was down into the $60s. By the time the market came back about a month later, the stock was at $75. In the first week of November management announced there were three buyers. One is a Chinese buyer who owns The Waldorf; one is Hyatt Hotels (H): and one was an undisclosed name. The stock goes from $75 to $78 because it's going to be an awfully good deal. Five days later they announce a deal with Marriott (MAR) at $70: a take-under. I had not seen that in 25 years. Now obviously there's more to the story. Maybe it's because something is going on in the company that I don't know about. We thought, "There are three buyers. We are going to make a lot of money." We lost 10% overnight on that trade. That's just one example of what is going on this year. Also, Mylan (MYL) was trying to buy Perrigo (PRGO) this year. It was a big deal. Mylan came in hostilely and Perrigo had no defenses. They went down to the last week, where they needed 50.1% of the votes to vote "yes" for the deal from Mylan. If you vote "yes," you make $20; it's that simple. If you vote "no," the stock will go down and you lose $15. There's a $35 differential. In the history of the world, I've never seen people vote without their pocketbooks under consideration. Not only did it not go through. but also the deal lost by a lot. What I learned was that people like making money, but there are things they like more. In this case, they liked the CEO of Perrigo so much that they felt badly for him. They said, "Let this guy try to make it." They hated Mylan's guy.. not saying I loved him. but he was offering me $20 more than where the stock was trading. They chose not to take the $20 and lose $15 instead. I thought it was a no- brainer. It was the biggest position on the street and people got destroyed. Who (ConSued an page 9) EFTA00300919 Page 9 Craig Effron would think that people would throw off $20 and take a $15 loss? But, that's what we're reading now. Did they think there would be additional bidders? CE: No. we were already past that. We thought initially there would be. Now it is the last day: it's over. Either you take the $20 or you table it. In all my years doing this business, I've never seen people not take the money. It was a big difference. Not like it was a $2 premium. It was $20 on a $140 stock. When things like that happen in my world, it's hard to make money. make that bet every day of my life. It's just how it goes. MI: Do you know anything about the make-up of the votes? CE: It was every arbitrageur. representing about 25% of the float. They voted "yes," obviously. The indexers ended up voting "yes." which had been a big issue. When I heard the indexers were going to be voting "yes." I said, "This is going to be a no-brainer." Every plain vanilla or Fidelity of the world had a one-on-one with the CEO on that Thursday of the vote. And that guy pleaded. He said, "Guys, you are going to end up owning Mylan stock. He's a criminal: he does terrible things. Perrigo has real brands. Give me a year to make this up to you. Just give me that year and, if I don't do something in that year, I'll get another buyer." They bought into it. All the institutions, which are the main voters, all voted his way, and all turned on the day before the vote. We all had thought they would take the money, because everyone takes the money. That's what IN dealing with this year. The events space has been a disaster, an unequivocal disaster. Unless you're long Amazon and Netflix (NFLX) and the Jim Cramer FANG stocks, you're having a really lousy year. If you're an energy- related guy. you're out of business. Things are bad in retail, too. Macy's (M) is the gold standard and it is down 50% this year. Hospitals and HMOs were obliterated the last two months, I don't know why. If you're in the wrong sectors, you think it is a bear market like 2008 versus the market being very quietly up 1%. "Don't be so big where your eyes are bleeding and you've got to get out. Size your positions so that you can withstand what happens if you are wrong." You don't use a lot of leverage. Was that a product of 2008 or have you always been more conservative? CE: No. it was a product of me being on the trading floor and realizing what can happen. Leverage is a two-edged sword. It's wonderful when the trade is going up, but you're out of business quickly when it goes the other way. I have friends, and they're brilliant guys, who have four or five- times leverage now, and I always wonder. "How do they sleep at night?" If, God forbid. something happens out of the blue, the next day they're losing something like 15% or 20%. But look, that's how they were brought up. I was brought up a different way because I was a commodities trader where leverage was a bad thing. You could get blown away by being too big. For the last five years, it has been fine because the Fed had your back. It's been a very easy market until this year. Once the Fed stopped QE the market became difficult. So what it really shows is that most of us have just been gliding along because of the QE wind at our backs. And now that QE's done. that's why the market has been flat. QE is over and now we have the prospect of higher rates. There are a lot of things out there that are scaring me. But. paid to play, and that's what I do. But I don't play with leverage. Now, we do use a modicum of leverage, maybe 120% gross, but not 300% gross. Could you go into a bit more detail? CE: Our average exposure is about 120%. Our net is about 45% long. That's where we usually run. We go as low as 80% gross and 20% long. We're always long. You guys should know one thing the markets go up over time. That's just how it is. If you try to play the short game at the wrong time, you'll lose money. You don't want to be short (Continued on page In) EFTA00300920 Page 10 Craig Effron markets over a long period of time. We all watched the ten- year period from 2000 to 2010. That was a flat period. I had never seen that before. Remember, I saw gigantic periods. The '90s grew at around 20% a year, the '80s averaged 10% or 15% a year. So 2000 to 2010 was an interesting period. But, yes, we're low-leverage guys. Building on the topic of risk management, let's consider a situation like Perrigo where what you thought would happen did not occur. Can you talk about how you think about the next steps? CE: I've learned over my many years doing this that you never sell the first day of a bad event. That is for amateurs because there are guys that are so big that their eyes are bleeding and they have to get out. If you look at where the stock is on day one versus day 30, 99% of the time every sale you made was bad. You wait a month and then you can reassess. Perrigo is no different. Perrigo opened at $135.1 closed my eyes, I didn't do a thing. It's now $150. Now we're getting out. We made our $15 back. So now we broke even on the trade, but we lost the $20 we would have made. People that sold on day one and day two and three, are kicking themselves. Last year, AbbVie blew up the big deal with Shire. Shire went down $100. If you waited one year, it was higher than the bid. Is that because of the tax inversion? CE: That's what it was—it was the tax inversion. It was because AbbVie was scared of getting yelled at by Obama. So they blew it up. They traded from $250 to $150. Settled around $180 for the next two or three months, then went back to $260. Now it's back to $220. What we have learned here is, "Don't be so big where your eyes are bleeding and you've got to get out." Size your positions so that you can withstand what happens if you are wrong. In Perrigo, we only lost 50 basis points on that break, because I knew I didn't want to be selling it badly. Normally, if been up for the year we probably would have risked 1.5% on that trade, that's how good I thought it was. It was an overnight binary bet. That is not a big bet if it was 1.5%. But it is when you're making a bet on red or black. =: How concentrated are your positions? CE: We have about 20, maybe 30, positions, and our biggest are between 5% and 7%. We have nothing smaller than 1.5% or 2%, and we average probably 4%. We're very focused on protecting against the downside, and that drives our risk management approach and portfolio construction. People have this view of hedge fund guys, that they are like magicians and that there is voodoo going on. There is no voodoo. You guys are as good as I am at this. Your opinion is as valid as mine is. I've been doing it longer; that is the difference. I've seen the examples of ideas from your classes. There are brilliant people. My analysts are not any more brilliant than you; they just have experience doing it. What students miss a lot is the practical matter of the stock For some of the short ideas, I ask, "Do you realize the short interest in this thing?" They realize there's not just a downside of losing X amount in an upside case. When you and the whole world are short a stock, you go out of business too many times. People your age often don't understand technical aspects of the market. They understand that a stock is not worth $20—its only worth $10. Okay, that doesn't mean it's going to $10. It could go to $50 before it goes to $10 and does that mean you made a good decision or not? Some people will say in interviews that their best idea was long Apple. I ask, "Ok, when did you buy it and for what price did you buy it? Ok, $220. Did it go up or down first?" They usually say, "Well, it went down first." I say, "Oh, okay. Where did it go to?" If he says, "To $85 or $90," that guy is not getting hired because he thinks that is okay. He lost half his money on the way to making three times his money. Well he's out of business at that point. There is no more company. It's easy to say, "Yeah, I owned Apple at $200." But there is a middle chapter there. It went to $80 first, when Jobs was dying, then $600. I don't look at a good investor as a guy who has lost half my money first; that's terrible. It's very important to understand that every idea might be worth five times at some point, but if you lose half first, it doesn't really matter. Hedge fund managers that are good understand that and they have stop-losses where they don't let that happen. Some (Continued on page 1 I) EFTA00300921 Page Craig Effron people go out of business because they say, "Well, it's worth $200. It is trading now at $120.. not getting out here. It was just $150." Then it goes to $90, then the next crash comes, and then you're out of business. So we have a pretty hard stop on things here. When one of my analysts comes up with an idea I say, "First of all, one to ten, how much do you like it?" If it's not at least a seven. I don't do it. If it's a nine or a ten I say, "Okay, I want to know right now at what price you're selling it and at what price you're admitting you're wrong." I want to do this when we are unemotional. Investors have a tendency. and so do I, to marry positions. You think a stock is your wife, your girlfriend. It's not. Stocks don't know you own them. They really don't. But when you own a stock, it's like your girlfriend, you can't get rid of that stock. It's true, and that is an emotional response that we all have. If I said on day one. "Hey. you like this stock ABC? Our target is $70. it's trading at $40. Where are you admitting you're wrong?" I want to know. There's no discussion that way. If it goes down that amount, whatever it is that they say. I get the message, and at that moment getting out because I don't want to think "Well, stay with it because, they're wrong. The market is getting it wrong." I hate that comment, "the market is wrong here." The market is never wrong. I learned it in the commodities business and re-learned it in the stock market. When you own a stock that you think is worth X and is trading half of X. you're wrong. Something is missing. You find out later what it was. The market is always right and it tells you it is right. Once in a while, you're smarter than the market. Not much. So my analysts all realize they need to have a stop point because if they don't, they'll get married to it. I will revisit something after I've got out of it, because you find. when you have sold a "If I can't trade options and limit my losses, I've got to bring my gross down because I don't want to get caught in being long common stock that can go down a lot more than the options can. Options are wonderful vehicles." position. whether it's been good or it's been bad, that you have a liberated feeling. You can look at it objectively. You are no longer married to it. But when hope becomes a strategy. you're lost. This year. the times that we lost, it hasn't been one name. That's the crazy thing. It's been a menu of things that have gone wrong. So, I can't say I've been killed in one name. I lost 80bps here, 60bps here, and all of a sudden we're down 10%. And the hedging has been killing us. When you generate high returns do you typically have a few big winners? CE: Out of our 30 positions, ten are meaningful, and of the ten we hope to have three or four that are home runs. A home run means up 50% to 100%. Year to date, three out of our top five positions are down 50%. We didn't ride it all the way down, but that's where they're down now. Micron Technology was at $36. It's trading at $15. YPF is an oil company in Argentina. down from $27 to $15. The last one, Applied Materials. was an arbitrage deal that blew up. Three of our biggest positions got destroyed. That's never happened to me during all my years of investing. What do you think went wrong with the Micron investment? Was it increased competition? CE: Micron is crazy. We owned it two years ago. We have owned it for a long time. We bought it at $15: we sold half at $30 and kept half. Up until three years ago. there were many players in this space. They always competed on price, and they always blew everybody up. It got down to three: Samsung, Micron, and Tsinhgua Unigroup. We said, "Finally. Price rationality. There's no way they're going to break price. They're having a great run here. They'll just keep price and it'll be good." Then Samsung ruined it for everybody. Once Samsung started a price war everybody joined in and now prices in MRAM and DRAM have gone down by half. We figured. (Continued on page 12) EFTA00300922 Page 12 Craig Effron "Finally, three rational pricers." We were wrong. There are only two. That was a big problem for us. How do you decide when to sell? You mentioned asking analysts for stop losses. CE: Micron is a good example. We bought one- and two-year LEAPS in 2013, because it was very volatile stock. We had already bought shares before at $7 and it was up 100%. The LEAPS that we paid $3 for were trading at like $17 or $18. We sold the LEAPS and bought short term options struck at $25. So we use options a lot to limit our risk when they're priced appropriately. When the VIX is trading at 11 or 12 for the general market, you can do tons of wonderful things with options. When it is trading at 19 like it is today, a lot less so. It's hard. If I can't trade options and limit my losses, I've got to bring my gross down because I don't want to get caught in being long common stock that can go down a lot more than the options can. Options are wonderful vehicles. I took courses in Wharton on options pricing, I learned all the theoretical models. That's not what talking about. El talking about actually understanding what they mean. In 2008. Bank of America had traded down to $4/share, like it was going to go bankrupt. They had calls that were trading at one hundred vol, which is humongous. The $5 call was trading at one hundred vol. That meant, instead of paying $0.38 I was paying $0.48. People were thanking me for putting in an order to buy those options because I was paying way too much for them, a dime more than they're worth. A dime on $0.38 is a gigantic move. But playing for dollars here. So, I bought thousands and thousands of Bank of America. $4 or $5 calls, while the stock was trading at $4. Then luckily, a month later, Bank of America went from $4 to $7 overnight. All the calls at $0.48. which were worth only $0.38. were now trading at $3, and the guys who gave them to me got destroyed. Options are always mispriced to some people who don't understand optionality. Another good example. SunEdison is in the news right now. We bought a boatload of $3.00 and $3.50 calls last week. The bet was very simple: half the world is betting it is going to go bankrupt. while half is betting it isn't. The short interest in it was forty percent. I might be wrong here, but saying the option is mispriced. I can buy calls that look really expensive, trading at one hundred vol again. And, again, they're a dime more than they should have been. So we bought a boatload and just sold about half of them for about $1.00 profit on a $0.40 call. It's a great risk/reward. We were risking $0.40 to make $1 versus paying $3.20 for the stock and maybe losing $3. Now one hundred vol is really high. but they still did not understand that if it didn't go bankrupt it was going to be a long term option now on SunEdison. Do you use options a lot in the event-driven space because option pricing cannot effectively price a future event? CE: Yes, all the time. For example, in SunEdison. people did not understand the ramifications of this deal. If SunEdison does not go bankrupt. it means they're going to be okay. They may have a 10 or 20 year life now. The stock is a long term option. It is worth much more than they think it is worth. Today. Sun Edison changed the deal with Blackstone on its debt. so the stock is up $1.00. Options players didn't appreciate that this is no longer a candidate for bankruptcy. When that happens all the calls are long term options and they should be priced higher. I have a lot of notional exposure sometimes, but only risking X. When we are invested in a stock that has vols in the high teens or low twenties, we will almost always use an in-the-money call. If we get a terrorist attack one night and DuPont goes from $70 to $60. we are in the money $5. I know what risking and still controlling all the shares because there is about ninety percent delta to the stock. It gives you a lot of sleeping ability. I don't need to go out and hedge my book when I know all I can risk is $5. but I have an upside of infinity if DuPont does well. Mega-cap stocks have very low vols. Another crazy thing regarding options: where in the world, as a value of an asset goes higher, does insurance cost go lower? If your house doubles in value. they require double the insurance payment to insure your house. In the M. and stock markets in general, as prices go higher, vols go lower and the price of options get cheaper. It's totally counter- (Continued on page Ii) EFTA00300923 Page 13 Attendees at the Graham & Dodd Breakfast Craig Effron intuitive. So. my Nirvana was during 2012 - 2014 when the market was going up slowly every day. Vol was I I, I could go long all the stuff I liked and buy protection on the market for cheaper than it was a year earlier when the market was lower. It's insane. How can the market be less risky at today's price than it was 20% lower? That's how I made all my money. by getting very long in stuff that I loved, and being short the market an equal amount through very cheap puts because they were mispriced. What happens to vol when the market goes down? MI: It goes up. CE: A lot. So you get the vol expansion and the delta expansion by the market going down making your puts more worthwhile. It's like a triple whammy in your favor, and yet it happens. Maybe if it was a situation where earnings were growing more quickly than the market was appreciating? But that wasn't the case in 2012 and 2013. CE: Even if that's the case, I don't care. The minute the market blows up. for whatever reason, delta expands and vol expands. You have a 2x reason why it works. Your puts, which were at 12 VIX go to 22 VIX. That alone is a home run. Plus you have it working because the market is going down. When the market blew up in August that was the prime example. We were long a ton of puts for August expiration. which we do all the time, and that saved our month. We didn't lose any money in August because we had puts that went from $1 to $20 from both the volatility aspect and the price aspect. That hadn't "Another crazy thing regarding options: where in the world, as a value of an asset goes higher, does insurance cost go lower? If your house doubles in value, they require double the insurance payment to insure your house. In the M, and stock markets in general, as prices go higher, vols go lower and the price of options get cheaper. It's totally counter-intuitive." happened to us since 2008. Remember that insurance is cheaper as the market goes higher. not more expensive, which is a wonderful thing. MI: With respect to incentives, people get paid on a yearly basis, so managers only look out on a yearly basis. Do you think that creates an even more skewed incentive structure for LEAPS, so that they're even less appropriately priced? We were talking about how options are priced, but LEAPS are multi-year. CE: LEAPS are a wonderful vehicle. The problem that guys in my world have is liquidity. quarterly or annually. What you have to be careful of is having a mismatch of what you own versus your liquidity terms. Long-term, locked-up money doesn't really exist much in my world anymore. Also, LEAPS have different taxes. There's a dirty little secret about our business. You should ask managers what their after-tax returns are. For example, if I talk about making 17% net. • a fraud. I made 17%, but it was almost all short -term in those days. Now. Joel Greenblatt was always an after -tax guy. He traded LEAPS all the time because he said, "I. not paying taxes at short-term rates." He made more than I did because he was paying 20% and I was paying 50%. His stated number in his book is 40%. CE: You're right, and he's the best there ever was. It was 40% on a long-term basis. The guy's a tax genius. He was a Wharton five-year guy and he learned about accounting. I said, "Oh, making money is great." I was a dumb guy. and he always said to me. "You're not tax efficient." I just wasn't thinking because I was making these very good headline numbers. When you play in my world. which is event-driven, if there's a takeover tomorrow I can't be long-term. It's over. What am I going to do about it? A lot (Contotsecl on pore 14) EFTA00300924 Page 14 Craig Effron of what I did wasn't my decision. IN not a stock picker. remember.. an event picker. We've done more stock picking in the last few years because it's been the place to be. But, generally, our holding period, unless it is distressed, is less than a year. Lately we're about 70% short- term, 30% long-term which is about as good as I can get. I= Is there anything else you find challenging in this environment? CE: Before 2008. the risk-free rate was 5%. That's a fair risk- free rate and we were making about 15% net. We were three times risk-free net and I was considered a hero. What's risk -free rate now, you think? Call it lid? If I make 8%, eight times the risk-free rate, and getting yelled at. What it means is that we are doing things that are much riskier now than it was before 2008 to get eight times. Investors don't get that. Guys making 15% are either highly leveraged, or crazy lucky and good. But sometimes you've got to accept the fact there's no money out there. There are times to reap and sow. This is not a reaping time: this is a crying time. We see the markets doing what they're doing now because of the Federal Reserve and Europe, Japan, and China taking on the mantle of the US Fed. It's very scary. I'll tell you what's going on here: asset inflation, whether it's bonds, or real estate, even more so. Residential real estate is trading at one caps in New York. A one cap! The world is beyond what I understand now, but I know one thing: there's going to be an end to this. I thought it might've been this past fall, but I was wrong. It is going to be ugly. MI: How does that factor into your and your investors' risk appetite? at a point now in my life where my investors are all risk averse. None of them need to get rich; their goal is to stay rich. It's a big difference. Business school students can afford to be risky, do what I did, play options, and live to make money. Once someone turns 40 or 50. has kids, and a house, they need to make a nice living and avoid going backwards, and I did the wrong thing going backwards this year. Have you considered pursuing something similar to Pershing Square. where you establish a permanent capital vehicle so you can have more flexibility or take a longer term view? CE: There are only a few Bill Ackmans out there. I cannot do that. Dan Loeb did it. Bill did it. and David Einhorn did it. Those are the three guys that created permanent capital. They deserved it. We don't deserve it. Bill is the smartest guy I've ever met. There is nobody smarter in this world, in my opinion, in what we do. There is nobody more impressive to hear a story from. He's the best presenter I've ever met. He deserves permanent capital because, over time, he will make a lot of money. David Einhorn is also very impressive —different than Bill. but equally impressive. Dan is a great guy who has done extremely well. But permanent capital would be a great thing for me because I would have a much longer term view of the world. : Would you consider creating your own family office? CE: One day that may end up happening. For instance, there are bonds out in the distressed world that are literally unbelievable, but I can't buy them because they were unbelievable a week and a half ago and now they are three points lower. I don't have the luxury of being down 6% in a month trying to make my money next year. Firms like Oaktree and Apollo with longer term money are buying hand over fist right now. They're all suffering near term losses because energy bonds have gone down considerably. and continue reaching new lows, but they know that over time, over their investment horizon, it's going to be fine. My horizon is quarterly or yearly, so I don't have that ability. I have to be more on top of things and hope I can catch the bottom. That can be difficult. : Do you have the ability to set up separate portfolios? CE: Some of our larger investors have set up separate accounts, and in those we're buying. The accounts ar