After looking at the crash of 1987 through the lens of a macro trader, I thought it would be interesting to examine how a bottom-up stock picker navigated the same environment. Who would be a better example than legendary hedge fund manager Julian Robertson. The Outstanding Investor Digest published excerpts from his letters in 1987, allowing us to follow him through the stormy year.
Robertson started working at Kidder Peabody in 1957 and left for a sabbatical in 1978. He started Tiger in 1980. By early 1987, he had created a remarkable track record. He entered the year bullish and invested in small caps. He believed Japanese market was in a bubble, which he expected to fuel the U.S. market in the near term. Japanese investors would recognize the valuation discrepancy and divert some of their funds to the U.S. The lower dollar was also a key reason for his bullishness. The year started off well and the fund was up about 20% by March.
“We own a high percentage of small capitalization stocks.”
“We have attached a great deal of importance to potential Japanese investment in American equities.”
“The lower dollar is working its magic among manufacturing companies. Earnings of the forest products companies are exploding with actual results coming in far ahead of expectations. Jefferson Smurfit …our second largest holding… sells at only 10 times 1988 earnings.”
Robertson illustrated the excess of the Japanese bubble to his investors. Nippon Telephone & Telegraph, for example, “sells at about 250 times earnings” and exceeded the stock markets of nations like Germany and France in value.
The bubble was not just visible in valuation, but also in behavior. Japanese corporate treasurers were buying stocks and even borrowing to do so:
“This means that the Japanese treasurer is now placing his available funds in the market on margin.”
Robertson was certain the bubble would burst eventually:
“The same irrefutable logic that developed into Holland’s tulip mania in the late 1600’s and the 1982 bust in Kuwait.”
Tiger was short Japanese stocks with the expectation that the violent burst of the bubble would precede a bear market in the U.S.:
“We should get some warning signs before the inevitable downturn. That warning should come … in the form of a severe crack in the Japanese market.”
In the summer of 1987, Robertson further bolstered his shorts exposure by making a strategic investment in The Polar fund, a short fund run by his friend Gilchrist Berg. Through the investment, Robertson gained both direct short exposure and early access to short ideas for his own fund.
September and October of 1987
As of the end of the third quarter, Tiger was up 13.9% as compared to the S&P 500 at 6.5%. Robertson was pleased as the fund was only about 80-85% net long on average. He believed that the market would continue to benefit from foreign buyers, Private Equity buyouts, and greater equity allocations by pensions. He noted growing bearish sentiment and hinted at the use of portfolio insurance by investors who were afraid of a severe decline. His own investors seemed to share this negative sentiment as they reacted very positively to the investment in the Polar short fund.
“There is a great hue and cry around the investment community about how high stock prices have gone. Investors seem to have the feeling that because things have been so good they cannot continue to be as good. Almost everyone is looking for an excuse to sell stocks or for a device which would help ameliorate losses in the event of a severe break.”
“I do not see great danger of a drastic market decline until we all get a great deal more complacent.”
At the same time, he continued to find good investments:
Metropolitan Financial: “Sells at 44% discount to book value and at less than 4x earnings. Recently … authorized purchase of 10% of shares.”
West Fraser Timber: “…picked up saw mills at distress prices and modified to their very efficient standards. Selling at CAD$28 ½, should earn $4.00 with cash flow above $8.00.”
“The point of all this is that there are still excellent values available in today’s market.”
However, he did suggest that his LPs maintain a “doomsday” fund:
“This is your disaster fund and your total interest should be in protecting the principal.”
We know what happened next. On October 19, the Dow Industrial fell 508 points, or 22.6%. The combined losses of Monday and the preceding Friday were 30%. By market close on Monday, the market had erased all of the year’s gains and showed a year to date loss of 8.3%.
After the crash
A few weeks later, in his November 10 letter, Robertson broke the bad news: the fund had declined 30% from September 30 to October 31.
“Probably none of have ever lost so much money so fast in our lives. We are shocked and wonder what to do.”
He continued with a more detailed explanation:
“While we freely admitted that we might not do as well as the market in a run-away upside rally, we certainly expected to better in any decline. In actuality, we did do better than the market on the days of the decline; our problem was that we did not do nearly as well during the rallies in the middle of the decline.”
Robertson outlined three key factors that led to Tiger’s poor performance:
The fund was concentrated in small caps when the market experienced a flight to quality.
Tiger was short the Japanese market, expecting it to break first. But Japanese stocks performed better than U.S. stocks.
The fund was leveraged which was costly to unwind in the chaotic market environment. Tiger cut back its gross exposure from around 250% before the crash to 162% (115% long, 47% short).
“When we tried to unwind our hedges, we were hurt by the illiquidity of the market. Premiums paid to unwind shorts or puts, as well as the discounts we had to take to sell longs, hurt us badly.”
Robertson believed that the crash mainly affected Wall Street, not Main Street (the U.S. consumer and corporations). Market sentiment had turned very bearish: “that the collapse of the stock market will lead to recession or worse.” But he believed that lower interest rates and a cheaper dollar would positively impact the economy:
“What about the other 80% of America? Their main asset is their home.”
His bullishness was based on the fundamentals of his portfolio companies:
“I am not quite sure what will happen next… But I know that Ford Motor Co. is a value at four times earnings and twice cash flow.”
“I know that West Fraser Timber is a value. It is family owned but sells at only fractionally over four times earnings, three times free cash flow.”
“No matter what, companies will continue needing insurance and Marsh & McLennan is the best purveyor of insurance.”
Moreover, he warned his investors not to abandon the market:
“In my last correspondence I suggested the creation of a ‘doomsday’ fund. For those of you who have such funds, the tendency will be to increase their size. I urge you to try and resist that temptation.”
“There are great values around – we should do well.”
“Things are setting themselves up for one of the major buying opportunities of our time. Industrial America has not been this competitive with the rest of the world in years.”
“We look forward to the great opportunities which lie ahead. Nevertheless, for the time being, we will keep a conservative posture.”
In December of 1987, Robertson sat down with Barron’s for a rare interview. He reiterated his mea culpa:
“I would love to say we did as well as we thought would have. We did not. We thought the break would come in Japan first. And we were in a lot of smaller companies and our leverage hurt us, too.”
And maintained his bullish outlook:
“We are more stock pickers than market judges. We don’t make big market bets. Having said that, I’m having a very difficult time finding shorts at the present time.”
“There are so few bulls that I can’t imagine who’s going to impregnate the cows.”
His view was based on his conversations with corporate America:
“I don’t talk to anybody in industrial America who isn’t absolutely tonning it. I’m talking about smokestack America. They are making a fortune.”
Robertson continued to be bearish Japan, which he called “absurdly overvalued.” A bursting of the Japanese bubble was the key risk he saw for global markets.
“I can’t see how a crash in Japan can be anything but very bearish for markets all over the world. Japan is practically the only place where we can find good shorts now.”
“It just doesn’t make sense to me. There’s never been one of these things that’s succeeded.”
Intellectually Honest and Calm
Robertson did not try to make excuses for the poor performance. He examined and explained what went wrong. He reduced leverage. Then he focused on what to do going forward.
No Style Drift
Robertson took a defensive stance and lowered his fund’s leverage. But there was no change in strategy, no new big macro bet. He talked to his contacts in Corporate America for an update on the economy. Then he carried on with his bottom-up approach of investing in the stocks that he thought offered the best risk-reward.
Only a couple of months after the most dramatic loss of his career, Robertson talked about “one of the major buying opportunities of our time.” There was a lot of blood in the streets and he was ready to buy. He told his investors that raising more cash was exactly the wrong thing to do in a world awash with bargains.
What we should ask ourselves:
I think the single most important question is: would you have redeemed from Tiger?
Imagine the market crashing tomorrow. Your favorite hedge fund manager tells you he was ill-positioned and underperformed, despite being short. This is the guy who was supposed to protect your capital. And while plenty of people are turning bearish around you, he wants to double down. Would you stick with him? And why (or why not)?
Julian Robertson created an exceptional track record. But not without experiencing vicious drawdowns. Could you maintain conviction through that kind of volatility?
Tiger Management Net Performance per the book The New Investment Superstars by Lois Peltz:
Tiger Management 1987 investor letters as reprinted in Outstanding Investor’s Digest.
Julian Robertson, A Tiger in the Land of Bulls and Bears by Daniel A. Strachman
Barron’s “By American And Short Japan Is Julian Robertson’s Strategy,” December 21, 1987
The New Investment Superstars by Lois Peltz