I have found the story of Allan Mecham to be fairly typical. You have probably never heard of Mecham because his fund is structured as a hedge fund, and so SEC rules prevent him from advertising and state that he must limit the number of his investors to a few hundred who must be wealthy.

The companies he buys trade at a discount to their intrinsic value because the “smart money” will not buy them, usually (but not always) because the company is too small to attract the attention of large investors. If the smart money does buy them, they usually do not stay with the investment for very long; the typical non-index mutual fund turnover rate is over 100%. In many ways the story of investment in these companies parallels the predicament of Mecham’s fund. The smart money that will not invest in the companies that Mecham buys shares a philosophy with the smart money that will not invest in small, concentrated, contrarian funds.

The following are the typical characteristics of the philosophy and processes used by small, value investors such as Mecham. They:

• Make investment decisions alone because groupthink generally leads to poor investing results. As Mohnish Pabrai once said, it is doubtful that Warren Buffett would have made one of the most successful investments of his career–taking a stake in American Express that amounted to 40% of his fund’s assets–if he had to answer to an investment committee or justify the investment to a pension fund consultant;
• Are usually somewhat quirky and do not have the pedigree or use processes that Wall Street understands, at least not before they have $1 billion in assets under management (AUM). After a billion dollars in AUM, Wall Street understands even gibberish. To Wall Street, Buffett was just some quirky guy in Omaha before he had a few billion in AUM. And, by Wall Street, I mean every potential investor in Meacham’s fund–seeders, incubators, funds of funds, pension funds, family offices, and other high net worth investors. At a recent family office (FO) conference that I attended, every speaker said that FOs–once the mainstay investor in small, quirky, value-investing startups–have gone the way of big institutions seeking to invest only in large, well known managers who have the infrastructure to gather assets;
• Because of the “institutionalization” since 2000 of the processes used by FOs and other high net worth investors, it is nearly impossible to find funds like Arlington that launched after 2000. We now know of the huge success stories such as Arlington, Klarman’s Baupost; Einhorn’s Greenlight; Pabrai’s Pabrai Funds; and Tilson’s T2 partners. These once-tiny value funds all launched before 2000–almost all with less than $1 million AUM–and grew through word of mouth. Can you name one that launched after 2000? Those that launched after 2000 have had little chance to raise capital in the new institutional environment;
• Are contrarian–buying when others sell, and selling when others buy
• Are structured as hedge funds because 1. SEC rules severely restrict the way mutual fund managers operate (e.g. SEC rules force diversification–”di-Worsification” as Peter Lynch liked to say–limit the ability to manage risk by hedging and selling short; and limit the ability to use leverage to exploit extraordinary contrarian opportunities and special situations); 2. mutual funds must be able to meet redemptions every day and so are not conducive to long-term thinking; and 3. mutual funds have higher startup costs;
• Do not try to predict where the market is heading but hedge market risks when the costs of hedges are cheap such as when everyone thinks the market can only go higher. In fact, they usually do not make explicit predictions for the companies in which they invest because they know that those predictions are rarely accurate (See the evidence for this in any of about one hundred sources such as Dreman’s Contrarian Strategies (Just added the latest edition to the bookstore above))
• Do not take in a lot of money because they know that true value opportunities are few and that sitting on a lot of unused cash would only hurt their investors’ returns. Even if the smart money suddenly realized that funds like Mecham’s were safe investments that delivered excellent long-term results, Mecham would not likely take in much more than he is managing now;
• Know that senior managers rise to the top of their organizations because of their inordinate salesmanship abilities and so meetings with companies are likely to lead to biased analyses. Meetings with management should therefore be avoided, or kept short and limited to extracting a vital piece of information that could not be obtained any other way;

I have a personal story. I write this blog anonymously because I do not want to run afoul of SEC rules regarding solicitation. A high net worth investor–a doctor from North Carolina–managed to track me down because he liked what he read here and wanted more information in order to invest in my fund. My law firm said he had to fill out a questionnaire before I sent him any information.

The doctor filled out the paperwork, but I could only send him the PPM after I received his information and determined that the fund was a suitable investment for him. The PPM is boilerplate but I told him that I could not take any investment from him until he had taken a little over a month to digest it. He still has not seen the results that the fund delivered, but he did ask general questions about the fund, which I launched in 2010. The information I gave him demonstrated that my fund started with ten times the assets and ten times the number of partners as Mecham’s fund, and from what I gathered in the article, twice the number of fund employees as Mecham.

Doctors like the one who contacted me were once the angels of startup funds like mine and they reaped the rewards; yet, it has been almost three months since I heard from him. As of today, I have nine investors in my fund made up of one family member, one former fund employee, six former colleagues from prior firms in which I worked, and one former client from a firm in which I last worked in 1997; no one that I have known for fewer than fifteen years.

The traditional investors who invested in funds like mine no longer invest in funds like mine. It is sad, and not just for entrepreneurial fund managers. Maybe it is the Madoff effect or severe risk-avoidance after two bubbles burst last decade, but it is especially sad for anyone who needs to fund a future liability–i.e. everyone. The story about Mecham opens with him in a conference room in New York City surrounded by potential investors who are peppering him with questions, trying to gauge his ”sophistication.” It would be funny, if it weren’t so sad.

http://www.smartmoney.com/invest/strategies/the-400-man-1328818316857/#tabs

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Really? See what CNBC’s Cramer said at the end of September, long after NFLX peaked in July:

http://www.youtube.com/watch?v=aTOXlWi96Gw&feature=player_detailpage#t=2s.

Most of the people who today are saying that they expected this are lying…to themselves. They are not trying to pull the wool over your eyes; they have pulled the wool over their own. They extrapolated out for several more years the rise from $50 in January 2010 to $304 on July 2011. They envisioned what they would do with the proceeds of a sale in 2015 of their 100 or 1,000 shares when the price of NFLX reached $7,000. So, paying six times sales in July was as natural as breathing. 

If you think it is easy being short a company like NFLX, then were you? An analyst as thorough as there is and an experienced short seller—Whitney Tilson—could not hack it. It seems he could not stand the day-after-day upward momentum in this stock, often in large chunks, and he covered his short earlier this year just a few months after writing an excellent piece on why NFLX was a great short.

I am beginning to firmly believe that contrarianism is something that one is born with or seriously conditioned for at a young age. To be a good short seller, one has to have contrarianism in their DNA or their brain needs to be wired a certain way early in life.

I have attached a chart of NFLX’s price movement. The numbers are staggering to me, it had a momentum all its own. If you were not short in this period but today believe the 75% drop was inevitable, try to imagine what it was like at the various inflection points in this chart before July 13, 2011.

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Our fund declined 13.7% in August vs. -5.4% for the S&P 500, -4.0% for the Dow and (minus) 6.4% for the Nasdaq.  Year to date, it’s down 22.1% vs. -1.8% for the S&P 500, +2.1% for the Dow and -2.2% for the Nasdaq.

On the long side, our portfolio got clobbered across the board despite generally good company-specific news regarding our major holdings (discussed below).  Amidst a tumultuous month in the markets, investors dumped stocks that were even slightly illiquid, or that are valued primarily on future, rather than current, profits – both traits that characterize many positions in our fund.

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However, don’t put it past these investors to try to throw another NFLX party tomorrow. It is only a matter of time before the partying must stop.

http://blogs.wsj.com/marketbeat/2011/07/25/netflix-hammered-after-revenue-miss/?mod=yahoo_hs

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T2 Partners November 2010 Shareholder Letter

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