Tails, You Win; Essential Wisdom From America's Best-Performing Stocks; Let Your Winners Run; My Netflix story; When the Stock Market Doesn't Need the Economy

By Whitney Tilson

Friday, September 18, 2020

1) I just finished listening to the new book by blogger and venture capitalist Morgan Housel, The Psychology of Money: Timeless Lessons on Wealth, Greed, and Happiness (I shared Wall Street Journal columnist Jason Zweig’s review of the book in my August 17 e-mail).

I found it fascinating… especially the chapter about tail events, which is taken from Housel’s June 2018 blog post entitled Tails, You Win. Excerpt:

Long tails drive everything. They dominate business, investing, sports, politics, products, careers, everything. Rule of thumb: Anything that is huge, profitable, famous, or influential is the result of a tail event. Another rule of thumb: Most of our attention goes to things that are huge, profitable, famous, or influential. And when most of what you pay attention to is the result of a tail, you underestimate how rare and powerful they really are…

It’s easy to measure how important tail returns are to public markets. Spoiler alert: It’s not much different than VC [venture capital]…

The S&P 500 rose 22% in 2017. But a quarter of that return came from five companies – Amazon, Apple, Facebook, Boeing, and Microsoft. Ten companies made up 35% of the return. Twenty-three accounted for half the return. Apple alone was responsible for more of the index’s total returns than the bottom 321 companies combined.

The S&P 500 gained 108% over the last five years. Twenty-two companies are responsible for half that gain. Ninety-two companies made up three-quarters of the returns.

The Nasdaq 100 skews even more. The index gained 32% last year. Five companies made up 51% of that return. Twenty-five companies were responsible for 75% of the overall return.

It’s always like this. J.P. Morgan Asset Management published the distribution of returns for the Russell 3000 from 1980 to 2014. Forty percent of all Russell 3000 stock components lost at least 70% of their value and never recovered. Effectively all of the index’s overall returns came from 7% of components. That’s the kind of thing you’d associate [with] venture capital. But it’s what happened inside your grandmother’s index fund…

Extreme winners and losers emerge faster in VC than other investment styles. But extremes are the norm, everywhere. Great ideas and great execution are rare. Most competitive fields have strong feedback loops: Losers keep losing because no one wants to be associated with losers, and winners keep winning because winning opens doors, and open doors beget more open doors. Amazon is successful in part because it has cheap capital, and it has cheap capital because it’s successful. Sears, on the other hand, has virtually no shot at redemption. In many industries, customers do not want the fifth-best product. Talented employees don’t want the fifth-best employer. They want the best. So winning accrues to just a few. It’s as true for large companies as it is for startups, even if the latter happens faster.

A takeaway from that is that no matter what you’re doing, you should be comfortable with a lot of stuff not working. It’s normal. This is true for companies, which need to learn how to fail well. It’s true for investors, who need to understand both the normal tail mechanics of diversification and the importance of time horizon, since long-term returns accrue in bunches. And it’s important to realize that jobs and even entire careers might take a few attempts before you find a winning groove That’s how these things work.

2) Research by Professor Hendrik Bessembinder of Arizona State University reinforces what Housel says about the tail effects in stock markets. Here’s an interview from Institutional Investor’s RIA Intel: Essential Wisdom From America’s Best-Performing Stocks. Excerpt:

You published a report in 2018 that made quite a splash. You said that since 1926 four out of seven common stocks had lifetime buy-and-hold returns less than one-month Treasuries. You also noted that the best-performing four percent of listed companies accounted for all of the U.S. stock market’s gains in that time. This would appear to be an indirect endorsement for an S&P 500 index fund. Is that a takeaway from this? Or is there something else you would emphasize?

I actually think that my 2018 paper provides some evidence for each side of the great active vs. passive debate. There was already a strong argument for low-cost index funds, and then my paper added to that argument the insight that the majority of undiversified portfolios will end up underperforming the index benchmark.

Bessembinder also highlights that even the greatest stocks in the long run almost always have severe declines, so investors need to be prepared so they won’t panic and sell at the bottom:

In your new report you wrote that “even within the highly successful decade, shareholders experienced drawdowns that lasted an average of 10 months and involved an average loss of 32.5%.” More remarkably, you wrote: “During the immediately preceding decade, drawdowns for these highly successful stocks lasted an average of 22 months and involved an average cumulative loss of 51.6%.” This suggests that even for the most successful stocks, great pain continues to be part of the package. Given these numbers, are there any stocks that are trading in a way that suggests they could be the next great wealth generators? Or is it impossible to extrapolate anything from mere price performance?

I guess no one will be too surprised that even the big winners deliver something of a bumpy ride – what surprised me was the extent. Apple has delivered drawdowns over 70% three separate times! Even if one today purchased a stock that will turn out to be the big winner over the next decade or two, most likely there would be periods where the value drops 50% or more. And, as the fourth report in the series shows, it is very hard to identify tomorrow’s winners based on characteristics that are objectively observable today.

In terms of their capacity to endure pain, how common is it find investors who have the fortitude to sit tight and endure brutal periods of extended underperformance?

I don’t have a data-based answer, but my guess is that many investors would be tempted to bail out during a 50% or 70% drawdown. So, one place where I hope the new report can contribute value is in showing that such big drawdowns are the norm, even for stocks that turn out to be great investments. That knowledge may help an investor ride it out.

3) A clear implication of the tail effects that Housel and Bessembinder talk about is that you have to let your winners run.

How I wish I’d better understood this earlier in my career! I still get a knot in my stomach every time I think about Netflix (NFLX) because it was both my best investment – but, because I didn’t let it run, also my worst mistake.

Here’s an excerpt from my forthcoming book, The Rise and Fall of Kase Capital, explaining why…

Let Your Winners Run

It’s so painful to know that had I only done one thing when I relaunched my fund in 2013: simply held Netflix, the stock of the decade, which I owned in size at the absolute bottom in October 2012. It would have made up for all of my other mistakes… and then some.

But instead of sitting back and profiting from correctly identifying one of the greatest moonshot stocks of all time, I focused on short-term traditional valuation metrics and began trimming (and eventually sold) the position far too soon.

I took some profits when it went up 50%. When it doubled, I trimmed some more. I kept trimming as it went higher and higher, always keeping it a 3% to 5% position. By the time I sold my last shares, it was up 600% from its lows. I was so proud of myself for this super-successful investment…

But then the stock rose an additional 600% from where I exited. I should’ve made more than $100 million on Netflix for myself and my investors. Instead, I made less than $10 million. Of course, that’s not terrible… But it was a costly mistake that still haunts me to this day…

What was I thinking?

It wasn’t that the stock had reached my estimate of its intrinsic value. In fact, my analysis revealed that, at the bottom, Netflix was trading at an unheard of 90% discount to its intrinsic value. I was buying a dollar bill for a dime!

(I based this estimate on 30 million paying streaming subscribers at the time, when the company had a $3 billion market cap. In other words, the company was valued at $100 per subscriber – at a time when 10% of Hulu, a far inferior business, was valued at $1,000 per subscriber.)

Thus, even after the stock doubled, the market was only valuing Netflix at $200 per subscriber. The business was going gangbusters, yet the stock was still a 20-cent dollar, so why was I selling?

In part, the answer is that I thought I was conservatively managing risk. But mostly it was that I let emotions get in the way of my analysis. I’d never had a stock move so far, so fast – it just felt risky and overpriced.

If there’s one portfolio-management lesson I want to leave you with, it’s this: You must let your winners run.

There’s an old saying on Wall Street, “Pigs get fat, hogs get slaughtered,” which cautions against being greedy.

I disagree.

If you’re looking in the right places for the right kind of high-quality businesses whose stocks are attractively priced, every once in a while, you’re going to invest in a stock that doesn’t just double, but goes up five, 10, 50, or even 100 times.

To build a successful long-term track record, you must be greedy when opportunities like this arise! Investing in a moonshot stock like Netflix only happens maybe once a decade – or even once in a lifetime. So it’s critical that you make the maximum amount of money on them.

I owned a handful of them in my nearly two-decade career, including Amazon, Apple, and Netflix.

Hanging onto them might seem easy in hindsight, but it’s actually really hard. Allow me to explain why…

Imagine that you bought the stock of an incredible company that grows and grows for a decade or more. Think one of the tech giants, Costco Wholesale (COST), Visa (V), or Nike (NKE).

To make a fortune, all you have to do is hold on to it and do nothing.

But the markets are open for trading 252 days each year. Over 10 years, that’s 2,520 trading days – and each day presents an opportunity for you to do something dumb: Sell the wonderful stock you own.

Let’s say you’re really smart and disciplined, however, and you only have one dumb day out of every thousand. In other words, you’re smart 99.9% of the time.

The odds that you sell the stock at some point over those 2,520 trading days over a decade are 92%!

It’s especially hard to patiently just hold on, year in and year out, if you’re a professional hedge-fund manager. As one for almost two decades, I can tell you that these folks don’t have the luxury of patience. Even though I had great clients who weren’t putting short-term pressure on me, I still felt it. It affected my judgment and contributed to my terrible decisions to sell some of my best-performing stocks far too early.

If you aren’t managing other people’s money, you don’t need to worry about short-term performance pressure. This is your biggest advantage over the big money on Wall Street: You can look many years into the future and, as long as your investment thesis is playing out, you can ignore stocks’ inevitable short-term gyrations and let your winners run…

To be clear, I’m not saying never sell any stocks. You have to watch out for a changing story – like a 97% decline in Valeant Pharmaceuticals, for example – as well as extreme valuations – like Cisco (CSCO) at the peak of the tech stock bubble in 2000… nearly two decades later, the stock was still trading below its dot-com peak. And you need to manage the position size, as I’ve discussed elsewhere in this book, so you can sleep well at night.

I never had an issue identifying and buying some of the greatest companies of all time. But one of the biggest mistakes of my career is that I was rarely patient enough to hold them and let their gains compound over the long term. Remember, you only need to find a few of these multi-baggers to do well over your investing lifetime.

4) I got a kick out of this funny two-minute spoof video about the disconnect between the economy and the stock market: When the Stock Market Doesn’t Need the Economy.

Best regards,


Whitney Tilson
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About Whitney Tilson

Prior to creating Empire Financial Research, Whitney Tilson founded and ran Kase Capital Management, which managed three value-oriented hedge funds and two mutual funds. Starting out of his bedroom with only $1 million, Tilson grew assets under management to more than $200 million.

Tilson graduated magna cum laude from Harvard College with a bachelor’s degree in government in 1989. After college, he helped Wendy Kopp launch Teach for America and then spent two years as a consultant at the Boston Consulting Group. He earned his MBA from Harvard Business School in 1994, where he graduated in the top 5% of his class and was named a Baker Scholar.

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