Lessons from Dr. Michael Burry from "The Big Short" | Episode 191 - a podcast by Bryan Ellis - SelfDirected.org
from 2016-02-05T20:51:19
The best-selling book and movie The Big Short tells the inside story of how Dr. Michael Burry made a huge fortune for his hedge fund clients by betting against the real estate market… and how those clients ultimately didn’t appreciate him despite a HUGE profit. And I may be the only person in America who thinks so, but I think the clients were right and Dr. Burry was wrong. I’m Bryan Ellis. I’ll tell you why right now in Episode 191.
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Hello, SDI Nation! Welcome to the podcast of record for savvy self-directed investors like you!
Have you ever read the book “The Big Short” by Michael Lewis? If not, it’s a great read… and I really enjoyed the movie too, which is solidly over 2 hours long and felt like it was over in a flash.
So I totally recommend the book and the movie… it’s a really fascinating explanation of what led up to the mortgage meltdown, and how it really was just a function of greed and carelessness.
Part of the story involves Dr. Michael Burry. He trained as a neurologist and got the degree and was a resident, but clearly his passion was in the financial world. He had a website in the late 1990’s where he posted information about his stock picks and analysis leading to those picks. His picks were so successful that he got the attention of some major financial players like Vanguard investments and the prominent investor Joel Greenblatt of Gotham Capital.
To condense the story a bit, Burry quits medicine, starts a hedge fund called Scion Capital using some inherited capital, and continues to excel. His first year brought a profit of 55%. Soon, he had over $500 million under management and was turning money away. But near the beginning, he attracted a large investment from Gotham Capital, who was Burry’s founding investor.
Dr. Burry was clearly a brilliant man… clearly the reason Gotham was willing to give him millions of dollars for value-based stock investing.
But Dr. Burry spread his focus a bit. He recognized that there was a problem, and the problem was that the booming real estate market was built on a house of cards called EASY MONEY… that millions of people were being given loans they couldn’t afford for more than just a year or two during the low introductory teaser rates. Dr. Burry recognized that there would be a huge wave of defaults soon after those teaser rates expired.
Dr. Burry’s analysis turned out to be right… very, very right. So in 2005 – while real estate was still raging hot – Dr. Burry convinced Goldman Sachs to sell him credit default swaps against loans that Burry saw as risky. Goldman thought Burry was a sucker, sold him the swaps, and 2 years later, Burry had profited by more than $700 MILLION dollars, making his investors – including Gotham Capital – a huge, huge fortune.
Curiously, Dr. Burry quit managing money after that experience. He made a huge fortune, and doubtlessly could continue to do so as a money manager, because he absolutely has an eye for both risk and value… a rare thing, for sure.
But here’s the thing… between the time Burry bought those swaps in 2005 and cashed them in for a huge profit in 2007, some bad things happened. At first, the real estate market didn’t decline right away, and so those swaps lost value… very quickly. Then to compound the problem, Goldman and the other brokerages who were responsible for pricing those swaps didn’t exactly do so in an honest way. In fact, they aggressively took advantage of the situation by pegging the value of subprime mortgages as being far higher than any reasonable person would believe, thus causing the value of Burry’s swaps – which were really just a form of insurance – to sink in value, even though the opposite should have been happening.
Burry held on, and in 2007 made a huge profit. But in 2006… things didn’t look good. For the first time, Burry’s fund was losing money… and a LOT of it… and worst yet, he was losing money on an investment – credit default swaps – that was outside of Dr. Burry’s core competency, which was value-based stock investing.
This didn’t settle well with Burry’s investors. It was a bad time… open revolt… and many of Burry’s investors… including his biggest client and original investor, Gotham Capital, rather forcefully demanded that Burry exit the trades and return their capital.
It was a very bad time at Scion Capital… Burry had never experienced losses, and now he had investors who were losing confidence in him very aggressively, and demanding their money back.
So Dr. Burry took an extreme step – he invoked a provision in his investor agreement that allowed him to delay the right of his investors to withdraw their capital… and that, of course, caused a huge problem as well, with lawsuits flying and tempers flaring and a generally awful situation.
When it was all said and done, it turned out that Dr. Burry was right. He made a huge fortune, and so did his investors.
But Burry decided to get out of the business of capital management… largely, it appears, because he felt unappreciated. The movie closes with Dr. Burry sending an unsolicited email to Gotham Capital that said, simply, “You’re welcome.”
Ok, so here’s the thing: The entire movie is set up to narrowly cast the blame for the mortgage meltdown on Wall Street – and there’s certainly lots of blame there, though it’s ABUNDANTLY CLEAR that the real blame belongs to good ole Uncle Sam.
But the move also makes a point of glorifying Burry and the fact that he was right – and his big evil investors were wrong – and that they profited from his talent and never said thank you.
My friends: Burry’s investors were right, and Burry was wrong. The fact that he was ultimately profitable isn’t relevant.
I’ve told you over and over again on this show that as self-directed investors, we must use the S3 standard to judge all of our investment choices: Simple, Safe and Strong. Those words have some subjectivity, for sure – after all, we’re not all the same.
But the real issue is that Dr. Burry did something VERY DIFFERENT with his client’s capital than his history suggested he should do. Dr. Burry was a brilliant stock picker… brilliant is an understatement. But he had no substantive experience trading credit default swaps. He was not a real estate or mortgage investor. And he wasn’t well connected with that world. In short, he had only purely academic reasons to think that his hypothesis would prove out.
It did prove out, of course, to his and his investor’s benefit. But even though he was profitable, even though was right on that investment in an astounding, career-defining kind of way, he did something wrong: He did not respect the capital of his investors. It wasn’t that he didn’t comply with his legal commitments to them. He certainly did. But he quite substantially showed disrespect for their own judgement when he made a major shift in direction… and for an entire year, the objective evidence was the Dr. Burry was very, very wrong… and his fund was hemorrhaging tens of millions of dollars… dollars that belonged to his clients, not to him.
Again, Dr. Burry was proven right in the end. But that’s not the whole issue. You see, if an investment causes you to worry… that’s a bad investment. The financial results just don’t justify that. It means that EITHER the investment is just a bad idea overall, or maybe that you’re using money in the deal you can’t afford to lose. Either way… consistent, ongoing stress from an investment means it doesn’t FEEL strong to you… and whether we like it or not, those feelings are what brings stress. And stress isn’t a good thing. Take it from a guy who had a heart attack at the tender age of 39… and learned some really, really hard lessons about simplifying life and reducing stress as a result.
To be clear, I admire Dr. Burry. I wish I had his intellect. But he didn’t respect his investor’s capital… and he provides a great case study for why it’s so critical that you work only with people who really, truly do respect your capital just as much as you do.
My friends, invest wisely today, and live well forever.
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