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How Value Investing Paid Off in the Crisis

An article by from the New York Times Dealbook

The value investing thesis, championed by the Columbia University professors Benjamin Graham and David Dodd in the 1930s, was simple: find cheap stocks being sold below their intrinsic value, buy them, and then sell them when the market wakes up.

Michael Burry, who runs Scion Capital, a Silicon Valley-based hedge fund, made a fortune for his clients following the basic value investing tenets for much of his career. But as Michael Lewis explains in his new book, “The Big Short: Inside the Doomsday Machine,” Mr. Burry found that the value investing thesis extended beyond just buying stocks in cheap companies — it could also be used as a basis to justify betting against financial instruments that had gone out of whack, like subprime mortgage securities.

“If you are going to be a great investor, you have to fit the style to who you are,” Mr. Burry told Mr. Lewis, according to the book, which was excerpted in the current issue of Vanity Fair. “At one point I recognized that Warren Buffett, though he had every advantage in learning from Ben Graham, did not copy Ben Graham, but rather set out on his own path, and ran money his way, by his own rules … I also immediately internalized the idea that no school could teach someone how to be a great investor.”

In Mr. Burry’s case, he used the basic value investing tenets as a blueprint to justify his bets against the subprime mortgage market at a time when most insiders did not really understand what an Alt-A mortgage was. But as any good contrarian value investor, Mr. Burry had to stomach losses and take lots of grief from his investors up until the day the bottom fell out of the mortgage market in 2007.

In 2005, according to Mr. Lewis’s book, Mr. Burry became obsessed with mortgage-backed securities. After reading hundreds of prospectuses on these complicated financial instruments, Mr. Burry concluded that they were sort of the antithesis of a value investment and were more like ticking time bombs. Mr. Burry would have to bet against these securities if he wanted to make money off them.

So he called all the major investment banks hoping that they would create and then sell him a credit default swap on the pools of mortgages. Mr. Burry had stepped outside the world of picking stocks and trading them on a public exchange and moved into the new world of finance where financial products can be created and sold outside the view of regulators and the public. Goldman Sachs, Deutsche Bank and Bank of America were happy to oblige — selling him what amounted to be insurance on mortgage-backed securities that he knew were troubled.

His investors caught wind of his ploy and balked at how their money was being allocated. They had given him money to make value investing bets — find the undervalued stock and bet on it, not find the overvalued esoteric security and bet against it. Investors were not happy, but could not pull out their cash as they were locked up in Mr. Burry’s fund for at least a year.

“I have heard that White Mountain would rather I stick to my knitting,” Mr. Burry wrote to his hedge fund’s original backer, according to the book excerpt in Vanity Fair, “though it is not clear to me that White Mountain has historically understood what my knitting really is.”

As Michael Lewis explains in his book: No one seemed able to see what was so plain to him: these credit-default swaps were all part of his global search for value. “I don’t take breaks in my search for value,” he wrote to White Mountain. “There is no golf or other hobby to distract me. Seeing value is what I do.”

So Mr. Burry bought credit default swaps on $750 million worth of subprime mortgages and hunkered down, waiting for the value to be unlocked when those mortgages started to default and the securities holding them collapsed.

Mr. Burry was one of only a handful of investors that bet against the subprime market at the right time. Soon after he began buying credit default swaps on subprime mortgages, others piled in and the banks stopped issuing the insurance. Some banks, like Goldman Sachs, would be able to sell the credit default swaps it issued on subprime mortgages to third parties, like the American International Group, just before the bottom fell out of the market.

Mr. Burry was vindicated and made $725 million off his bet for his clients and $100 million for himself.

To read the original article, click here.

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