the intensity of the hurricane season and political developments,
and were less respectful than we should have been of market psychology
and its effect on price momentum.We first sold oil short in May at
around 40, and we squirmed as it promptly rallied to over 42.Then on
the last day of June, it fell to 36.That afternoon, we actually considered
covering some, but we didn’t. Our analysis indicated oil was still materially
overpriced.Why lose our position?
We were just plain wrong. Oil prices proceeded to climb and began
a virtually vertical ascent as terrorism and sabotage in Iraq, a tax dispute
in Russia, a strike in Nigeria, and a presidential recall vote in Venezuela
roiled the market for crude. Convinced that these were temporary disruptions,
and reassured by announcements of increases in OPEC production,
we increased the size of our short position. Our fundamental
analysis and our model continued to say that the equilibrium price of
oil was somewhere between 28 and 32 a barrel. Inventories were building,
OPEC was pumping, and the world economy was slowing.We reasoned
that if oil could overshoot its equilibrium price, it could also
undershoot.We still loved our short.
Furthermore,we were confident that the huge rise in the price that
had already occurred would eventually cause conservation and the substitution
of alternative sources of energy.
From the beginning, our practice had been to write a detailed
monthly letter to our investor partners to keep them fully informed of
our thinking and performance. Unfortunately, despite our pleas for confidentiality,
the letter got passed around via e-mail, so our performance
and positions became known. In our July letter, we stressed that we
were value, not momentum, investors. In our process, when the price of
an investment goes against bias by more than 15% in the case of a commodity,
it triggers an automatic review of the fundamentals. Following
that review we either have to add to the position or close it.As value investors,
if the fundamentals have not changed, our inclination is to add
to the position in question, not close it, because the price change has
actually made it more attractive, not less. Investing on the basis of value,
not price momentum, is our religion.
Warren Buffett articulated this philosophy best with his manicpartner
analogy. At a talk I attended, in one of his musings, he expressed
it something like this:
Suppose you are an equal partner in a good business with a manicdepressive
partner named Mr. Market. From time to time,Mr. Market
will only see the favorable factors affecting your business and will then
become so euphoric about the prospects of the business that he will come
to you and offer to buy your half at a ridiculously high price. So, of
course, you should sell it to him.
At other times, seeing only trouble ahead for your firm, he becomes
deeply depressed and in his despair offers to sell you his share
at an outrageous discount to its intrinsic value.Then, you should buy
it from him.
Buffett went on to say that it was irrational, the height of foolishness,
to sell an asset you were confident was undervalued just because its
price was falling. In other words, Mr. Market can be an old fool (or
maybe a young fool) who, from time to time, becomes hysterical.
Sometimes, in his madness, he sees ghosts. At others, he imagines the
good fairy touching him with her long golden fingers.
You are perfectly free to ignore Mr.Market or to take advantage of him,
but it will be disastrous if you fall under his influence. Suppose the
price you could sell your home at was quoted every day. For several
months the quotation steadily declined.Would you then sell your home,
the home you were comfortable in and satisfied with, just because its
price was declining? Of course not! In this sense, an attractive investment
is similar to a home you are happy to inhabit.
Mr. Buffett’s value philosophizing sounds eminently sensible, but it
doesn’t work when you are trafficking in commodities and you have
short-term-performance sensitive clients. On August 19, the price of
oil hit 48, equity markets were reeling, and we were down 7% for the
year.The next day the New York Times ran a story, complete with a picture
of me looking bedraggled, that reported Traxis was suffering substantial
losses from its oil short. Furthermore, the tone of the piece was
that I was a loser, which, because everybody I know reads the Times, did
not exactly lift my spirits.That weekend when I went out to dinner at
the country club, I sensed people watching me, but when I tried to
meet their eyes, they looked away.
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