Hedge funders are in the news. Carl Icahn tweets about his dinner with Apple's Tim Cook. Dan Loeb tussles with George Clooney. Bill Ackman says Herbalife is a pyramid and shorts the stock; George Soros goes long. If you want to understand the guys who run hedge funds, you first have to realize that they—we—are a little nuts.
The trick to running a hedge fund is to drink from the fire hose of information, take it all in, figure out what everyone else knows and then position your portfolio to benefit when everyone else is inevitably wrong. This is no simple feat. Sleepless nights, second guessing, minds racing, almost a split personality working out both sides of all arguments.
You force yourself to think like a contrarian. Actually, you become like George Costanza in the "Opposite" episode, listening when Jerry Seinfeld suggests "if every instinct you have is wrong, then the opposite would have to be right."
Famed investor Julian Robertson climbed mountains because, I'm convinced, at the summit, when the air is thinnest, you become euphoric. Great hedge funders bottle that feeling—because once you invest, you're at the whim of markets that no one can forecast day to day. You are floating, drifting—your gut knows you're right but you tumble violently until the market catches up with your way of thinking. Stay sane? No gain.
Stanley Druckenmiller loaded up George Soros's funds with dot-coms late in the game; he resigned in 2000 after the investments blew up. Last fall, hedge funds piled into Apple on the way to a share price of $700, which is probably why it hit $700.
Being crazy can be lucrative. But in every market cycle there are moments when hedgies run out of ideas. We're in just such a time. Zero interest rates make it hard to read others' sentiment, commodities have rolled over, bonds are backing up, and the Federal Reserve may or may not be tapering. No longer trusting their Costanza mindset, or maybe because of a loss of patience, they grab onto handholds—trying to tether themselves to more sure things.
With mixed results at best. In 1985, Carl Icahn bought a controlling interest in airline TWA, took it private in 1988, saddled it with debt and left as it filed under Chapter 11 in 1992. Eddie Lampert's ESL Investments bought Kmart and Sears and still operates them as they shrink. Bill Ackman's Pershing Square bought a huge interest in J.C. Penney at $25, installed new management, and watched the company wither only to leave the board and dump all his stock Monday for under $13.
A famous 1980s tactic for tethering became known as greenmail. Greenmailers buy a chunk of a company, threaten to take it over or shake up management, and then sell their stake back to the company at a premium. With junk bonds from Michael Milken's Drexel Burnham Lambert, Saul Steinberg's Reliance Holdings bought 11% of Disney's stock around March 1984. In June, Disney paid Reliance $77.50 per share to go away. At the time, the stock was trading just over $65.
They're ba-ack. In the summer of 2011, Dan Loeb bought 5.8% of Yahoo paying $13-$15. His Third Point fund then installed three empty suits on Yahoo's board, helped hire CEO Marissa Meyer, and said nothing when Yahoo paid $1 billion for the $13 million-in-revenue blog company Tumblr. In July, Third Point sold back two thirds of its shares to Yahoo at $29.11 per share in exchange for getting off the board. The stock is now $27, and the company is arguably no better off. The runup in Yahoo is based on the increased value of its holdings in two Asian Web companies.
Third Point has also bought 7% of Sony and is agitating for the company to sell a piece of its film and TV business—prompting actor George Clooney to call Dan Loeb "a carpetbagger" and "the single least qualified person to be making these kinds of judgments." Wait until Mr. Loeb asks for a board seat and a role in Paul Blart: Mall Cop 2.
Carl Icahn bought $1.5 billion in Apple shares and tweeted, "We believe the company to be extremely undervalued. Spoke to Tim Cook today. More to come." This is known in the business as talking your book and, predictably, the stock popped to $500. (It's now $488.) Mr. Icahn apparently wants Apple to borrow $150 billion to finance more share buybacks, figuring the stock will go to $625. Maybe, but new products and earnings growth are the only long-term drivers of value, not an impatient investor with a few billion to throw around. Apple should ignore him.
When hedge-fund managers grab onto "sure things" rather than float, it's usually a sign they've lost their touch. Stay thirsty, my friends.
And what's an individual investor to do? Teach yourself how to think ahead of those who are scrambling for ideas. When everyone else is thinking short term, start thinking long term. Embrace ideas when everyone else hates them. Out-Costanza the hedgies.