I am a fan of the Coffee Can Portfolio, an “Active Passive” approach to investing. The idea is simple: Try to buy a basket of the best stocks you can and let them sit for years. You incur no costs with such a portfolio, and it is simple to manage.
You can follow and track my stock baskets here, on my Performance Scorecard.
I was reading Jack Schwager’s Hedge Fund Market Wizards: How Winning Traders Win, and was delighted to see a chapter on Jamie Mai. Mai is the founder of Cornwall Capital, which I first learned about from the movie The Big Short. In ~2012, Cornwall had realized returns of 40 percent/yr (52 percent gross) over 9 years.
That’s 40X before fees!
How did Jamie Mai manage to do this?
Mai has a very unique investment approach: He seeks to identify asymmetric trades that arise because of mis-priced derivatives. For those unfamiliar, a derivative is simply an asset that “derives” its value from some other asset. For example, Options, which we discussed here and here, are derivatives.
We Live in a Theoretically Priced World
Mai believes that we live in a theoretically priced world. That is, derivative prices are based on a number of theoretical assumptions. One important assumption is that future stock prices are likely to follow a normal distribution. This assumption can be entirely inappropriate in specific circumstances. When that’s the case, we get mispricings. Mai takes advantage of these by creating trades where the expected probability-weighted gain is asymmetric compared to the probability-weighted loss.
This line of thinking really resonates with me because when Investing in Mavericks, we are doing the same thing. We expect our probability-weighted gains to be much higher than our probability-weighted losses. How? Remember that when we buy a stock, the most we can lose is 100%, which is also rather unlikely, but we can make multiples from a winning stock.
Mai looks for situations where price dislocations have occurred because the market has identified some idiosyncratic risk in a company or a market, and assigned to it an uncertainty discount.
Let’s look at a couple of examples.
Capital One in 2002, An Example
During his interview, when asked to share an example, Mai spoke about Capital One (Ticker: COF).
The Setup:
In 2002, Capital One dropped from $50 to $30 in one day because they announced an agreement with regulators to sharply increase their reserves against their subprime-laden loan portfolio.
This put into question the company’s reputation. Investors now doubted whether Capital One’s strong past performance was fraudulent.
Let’s not forget that Enron filed for bankruptcy in December 2001! That was fresh in everyone’s minds.
Mai’s Insight:
Mai felt that the odds that the stock would still be near $30 in two years were tiny. He felt that either the company would be vindicated or it would go under, a bimodal outcome. Recall from the above that option prices tend to price-in a normal distribution of outcomes. This created the opportunity for mispriced derivatives.
The Trade:
Cornwall conducted research by talking to people at the company. They did background checks on management and even tried to get in touch with people who had gone to college with the CEO! Eventually they became convinced that COF was unlikely to be a fraud.
As a result, they believed that a large price move was much more likely than usual for the stock, and hence they bought out-of-the-money calls to express the trade. (In-the-money calls could also have been bought, albeit with less embedded leverage).
The Outcome:
As the uncertainty discount dissipated, and price rose, Cornwall made 6 times their money on those calls in just over a year!
Altria in 2003, Another Example
Mai also spoke about another similar opportunity with Altria (Ticker: MO), the cigarette maker.
The Setup:
In 2003, Altria’s market cap had been cut in half in response to several rating agency downgrades due to a few large class action lawsuits underway at the time.
Each case had the potential for 9- or even 10-figure settlements, not to mention the risk of setting a precedent favorable to future plaintiffs.
As a result, the contingent liability for the tobacco companies was massive and therefore insolvency was a real risk.
Mai’s Insight:
Mai once again felt that this situation would result in a bimodal outcome. He felt that substantial new information was likely to come out that would either validate the rating agencies’ concerns about the litigation, in which case, the stock price would sell off substantially, or the reverse, in which case, the stock would appreciate substantially.
Mai heard a couple of smart investors argue that the ratings agencies were wrong. In their view, structural industry changes would protect the tobacco companies. Specifically, they noticed that U.S. taxpayers had gained a controlling economic interest in tobacco companies and the majority of revenues from cigarette sales were going to various federal, state, and local government agencies.
The Trade:
As a result, Mai felt there was an above-average probability of a large price move in one direction or the other. Since his research suggested a greater likelihood for a bullish outcome, he once again bought the out-of-the-money calls. The calls appreciated sharply when one of the key cases supporting the rating downgrades was thrown out on appeal soon after.
The Outcome:
When new information came out, Cornwall made 2.5 times their money quite quickly. Although, Mai felt he sold too soon.
So, How did Jamie Mai generate 40X returns in 9 years?
Mai recognized the following:
First, events that create the perception of going concern risk can create options mispricings.
Second, markets can be poor at evaluating outcomes probabilistically. In the examples above, the normal probability distribution assumption implicit in option pricing models was inconsistent with market realities.
Third, markets tend to over-discount uncertainty from identified risks. Conversely, they under-discount risks that have not yet been identified. Whenever the market is pointing at something and saying this is a risk to be concerned about, in Mai’s experience, many times, the risk ends up being not as bad as the market anticipated.
As a result, Mai repeatedly placed trades, where the expected probability-weighted gain was asymmetric compared to the probability-weighted loss: Heads, You Win Big, Tails You Lose Little.
And that's how Mai generated 40X returns in 9 years.
Next Week: A Present Day Altria
Next week, we will look at a present-day opportunity that looks very similar to the Altria setup above. Subscribe here so you don’t miss out.
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If you’re New to Playing For Doubles
Read more about my Investment Philosophy here:
The Three Stages of a Maverick: Stage 1 The Disruptors
The Three Stages of a Maverick: Stage 2 The Contenders
The Three Stages of a Maverick: Stage 3 The Leaders