T2 Partners eagerly anticipated investor letter (H/T maketfolly.com) is finally here and what a doozy it is!
Why was it eagerly anticipated? Well in early December T2 managing Partner Whitney Tilson publicly disclosed his short trade analysis on Netflix ($NFLX).
Whether that analysis was posted as a genuine critique of the stock or as an attempt to pressure the price, no one can know for sure, but there are many arguments for and against such a post. In any case I commend him not only for putting his analysis up for scrutiny, but also for acknowledging in his most recent January investor letter that he was wrong, albeit belatedly and significantly lighter in the wallet.
From the January T2 Investor letter:
“Over time we’ve been quite successful shorting fads, frauds, promotions, declining businesses, and bad balance sheets. Where we have had much less success, however, especially in recent months, is shorting good businesses that are growing rapidly, even when their valuations appear extreme. Such open-ended situations, regardless of valuation, are very dangerous, so going forward we will avoid them entirely unless we have a high degree of conviction about a specific, near-term catalyst.”
My first reaction was, hang on a minute, If in the future you are only going to go short based on a high degree of conviction, what was your conviction for shorting in the past? Granted, in an earlier post I suggest that success is never guaranteed, no matter your educational pedigree or tenure in the business, but a necessity in trading and investing is confidence and a high conviction in your analytical conclusions. The question is, when and how to reevaluate that conviction?
My second reaction was, judging from his original argument regarding NETFLIX ($NFLX) it seems the reason Mr. Tilson held onto the stock as long as he did, and even added to the position was due to a high degree of conviction in his analysis that $NFLX was overvalued.
Over at The Big Picture, Barry covered his 8 Basic rules for shorting stocks, and I would like to posit that a 9th rule to consider is the psychology involved in holding a short position. T2’s $NFLX saga is a worthy candidate for such a behavioral finance case study.
Behavioral finance is the study of the influence of psychology on the actions of financial practitioners and the subsequent effects those actions have on markets. Behavioral finance is interesting because it goes some way to explain the inefficiency that exists in the market, by way of human irrationality. Bye, Bye Efficient Market Hypothesis!
The basics of behavioral finance are that humans are prone to cognitive biases that cause us to throw rational, linear thought to the wind. The T2 $NFLX trade, exhibited evidence of many of these cognitive biases, in fact Mr. Tilson even brought up the very notion of being biased.
The emotional side can be even more difficult. Numerous studies of investor behavior (the field is called behavioral finance) show that once an investor has a position in a stock, there are tremendous biases to seek confirming information, ignore disconfirming information, and not admit a mistake. We don’t claim to be immune from these emotions, but we’ve studied them extensively and do our best to block them out
The cognitive biases that stand out to me were overconfidence and confirmation bias – particularly underemphasizing the impact of growth(international and domestic), failure to account for sentiment surrounding the stock and overemphasizing the impact of increased content costs – and escalation bias, whereby T2 continued to invest in $NFLX even tough it was a losing trade, perhaps to the detriment of a winning trade.
First, we think it’s healthy to disclose and fully analyze our mistakes (although in this case we are not yet conceding that we’ve made a mistake in our analysis, but we obviously made a mistake in terms of timing our entry into the position).
This is after admitting in the very first sentence that :
We’ve lost a lot of money betting against Netflix (NFLX), which is currently our largest bearish bet, in the form of both a short and put position.
This is a clear indication that having knowledge or information does not always lead to taking action.
We are all guilty of these and more biases in our investing/trading lives, and it is particularly helpful for the beginning trader, finance professional, or retail do-it-yourselfer to see that even one as storied as Mr. Tilson is not immune.