Investors overestimated how deep the Covid crisis was gonna be...

Interview w/ Tony Yoseloff of Davidson Kempner on distressed investing in Covid, market froth, Robinhood, etc. "The market is a very powerful force itself... What is speculative remains to be seen."

Jun 14, 2021

Our most recent interview features Tony Yoseloff –– the Executive Managing Member of Davidson Kempner Capital Management, one of the world’s largest alternative asset managers with $37 billion in assets under management and a variety of strategies including distressed credit and risk arbitrage.

The last time Tony had a public appearance seems to be in 2015 at a Milken Institute panel with other executives discussing firm management topics. He and his hedge fund have kept a very low profile over the years, so we were quite thrilled and honored to have this “major scoop” –– sitting down with Tony for 2 hours talking about a wide range of market issues from event-driven investing in Covid to market froth, from democratization of finance to forecasting under radical uncertainty…

Some punchlines:

A common mistake that investors made during the Covid crisis is they overestimated how deep the financial crisis was going to be caused by the pandemic, and massively underestimated their probabilities of success. And the market caught up to that much quicker than a lot of smart investors. There were still investors in June last year who were saying to sell the stocks. The market is a very powerful force itself, so the collective wisdom was actually very, very smart in that in that era.
Though the regulators in 2020 had not lived through a pandemic, they did have the benefit of seeing what worked and what didn't in 2008. The lesson of 2008 was probably the Fed support didn’t come soon enough, so it wasn’t shocking to me with the aggressive Fed support last March because I had lived through 2008.
What is speculative in any different era remains to be seen, but if an investor can find the right quality asset, one can still do very well over a long period of time even if initially paying a high price in a speculative market environment.
We’ve printed a lot of money, and it sounds like we're planning on printing a lot more money. That's very untested over time at the rate in which we’re doing it. The history of fiat currencies is that they generally fail, so that part worries me.
There was an old risk line at Bear Stearns that “no one ever wants to exceed their risk limits for things they don't like.” That means if one exceeds their risk limits, by definition they really like it, but that is precisely the moment one has to stay very disciplined to the risk limits because that's when investors can really get into trouble.
It is ironic to me that you have people saying that that “STONKS only go up” because it was literally only a little over a year ago that they went way down.

Some highlights from the interview…

(All quotes are lightly edited for clarity).

Q: There has been quite a bit of event-driven movement in the market over the past year. How did you see market evolve? What are some of your overall takes investing through Covid?

A: There was a massive overestimation of how deep the financial crisis was going to be caused by the pandemic.
A portion of the reason might have been geographic. The major centers of finance –– especially New York and California –– were regions that were particularly hit hard by the financial crisis and locked down more than most of the rest of the U.S.
By May 2020, it started to become more clear that the crisis was not going to be nearly as deep or as evenly distributed as people thought it was going to be, and that's when we really started to see wide-scale buying in the markets.
People invested in assets that are related to work from home and Covid recovery, but there was a massive amount of speculation that returned to the financial markets, as exemplified by the growing demand for baseball cards and NFTs.
We found the past year has been an incredibly fruitful environment for event-driven investing, which is what we specialize in. So in each of our different areas that we invest in, we look for events and catalysts in terms of how we're going to get from point A to point B in making our investing return. And this is an incredibly fruitful environment for event-driven investing.

Q: How would you define an event? A lot of people might group the Covid pandemic as one big, broad event. But perhaps from your perspective, there were multiple specific things you look for within that broader event?

A: There are many events that are buried within the bigger event of the pandemic. For example, there's now an absolute boom in the residential housing market. Even in New York City, where people thought that real estate was going to be left for dead, it's actually pretty busy in residential real estate.
If you look back, you can make an argument that the U.S. has been under-building houses for a decade. If you look at the rate of production of new single-family homes in the U.S., it was far greater pre-2008 financial crisis than it was post-2008. We were probably over-building homes in the middle of the 2000s era, but the rate at which we were over-building homes was much less than the rate at which we under-built homes for a decade since then.
That's just like one tiny thing, and there's a lot of things that are left to play out. Shutting down the country during Covid was very messy, but it was also very quick, and reopening the country is likely to take far longer with many ebbs and flows that yield fruitful investment opportunities.
There are a lot of things people don't really know the answer to yet, but are speculating on. For example, are movie theaters going to look exactly the same post Covid? It will just take time to figure those things out. So for our business, that's very powerful.
Another example is how M&A activities were put on hold for a year, and it would make sense to see them roaring back soon. A portion of that is because boards weren't interested in doing deals during Covid. Also a lot of times before deals get struck, management teams spend time with each other to figure out whether there’s a good cultural fit between the companies, which was very difficult to happen for most of Covid. My understanding is a lot of that has returned as well.
You had a very busy merger wave from 2015/16 through 2019 that basically came to a grinding halt in 2020. So it makes sense that mergers have picked up again quite a bit.

Q: How exactly did you feel watching the stock market crash last March? Was it at all clear to you that we were going to get out of this just fine after the Fed announced that they would support the markets? Was there a chance that things would really go bad?

A: I was less concerned about the decline being as deep as it was. It wasn’t shocking to me with the Fed support because I had lived through 2008. I think the lesson of 2008 was probably the Fed support didn’t come soon enough in that era.
I would say that Lehman Brothers was allowed to fail; it didn't necessarily have to fail. There was this belief that there would almost be deterrents from Lehman Brothers failing in that era. And then when AIG almost fell the week afterwards, people realized “OK, we have to actually finally step in and solve things.”
Though the regulators in 2020 had not lived through a pandemic, they did have the benefit of seeing what worked and what didn't in 2008. So they stepped in, and they stepped in very aggressively. Whether they needed to or not is a question for later, but it's unquestionable that the Fed’s intervention was very effective.
From my perspective as an investor, I wasn't relying upon that for success, but I always knew that it was a possibility that we would get Fed’s support and that we would get it sooner than one would think.
People were massively overestimating the amount of damage fairly early, and the initial price drop in the securities was so dramatic and quick that it just felt like a great buying opportunity.
As a distressed debt investor, you have to be willing to buy things when no one else wants to (that’s the whole point). And one often has to be willing to be a little bit contrarian than the rest, which Davidson Kempner seized the opportunity to be.

Q: Today is also a time when many investors are concerned with market froth. Do you think markets have become more detached from fundamentals because of the Federal Reserve’s liquidity support and so on?

A: Well, you have to take a step back –– there is really not a single “right” price for stocks to trade at, right? One often uses discounted series of cash flows to value stocks, but what's the right rate of return on that discount? A portion of that might be your assumption on interest rates, but a portion of that is the spread above what you’re willing to pay for that.
When I got to Princeton in the 1990s, there was the big boom in the mutual fund industry and the first democratization of buying stocks. It was a big deal – you could go online and buy a stock. Fast forward to 2020, you can download Robinhood and quickly own a fractional share of stock. These are some dramatic long-term changes. With more people engaging in the market, it might not be crazy to see the expected yield go lower [and push up the prices].
What is speculative in any different era remains to be seen, but if an investor can find the right quality asset, one can still do very well over a long period of time even if initially paying a high price in a speculative market environment.
The 1999/2000 was an incredibly speculative time. I looked, out of curiosity, that if you bought Amazon at the most expensive price in 1999, you paid about $100/share for it. If you bought it at the cheapest price, you would’ve paid close to $1/share. Now Amazon is a $3,500/share stock! So you would’ve done pretty well regardless, right?

Q: There was a common sentiment during the pandemic that “STONKS only go up.” Do you think we're in a structurally different era today because of secular trends such as structurally lower interest rates and the global savings glut – there’s so much savings and money floating around that they have to end up somewhere, like baseball cards or NFTs.

A: We’ve printed a lot of money, and it sounds like we're planning on printing a lot more money. That's very untested over time at the rate in which we’re doing it. The history of fiat currencies is that they generally fail, so that part worries me.
For stocks –– if you're buying into a company that's paying out dividends over time (let’s say a more traditional cash flow generating company), you may not like the yield that you earn on that over time. But if your savings is earning 0.1% in your bank account, that may not be a crazy strategy for some people.
It is ironic to me that you have people saying that that “STONKS only go up” because it was literally only a little over a year ago that they went way down.
Stocks themselves can be speculative. And when you own something with leverage or through the option form, which seems to have become popular these days, you're compounding that leverage. But if you buy something without leverage, and it's got cash flow attached to it, that's reasonable. Especially if you own it for a long period of time, generations of wealth have been created in the U.S. by doing that.
Going back to the democratization of stock investing, I think it's generally a good thing for society and would like many more of that. It shouldn't have been as hard to buy stocks as in the 1990s.

Q: What are some of the things you’re more nervous about going forward?

A: There are still many unknowns ahead, such as what travel might look like and how the current administration will continue to respond to the pandemic.
Distressed investors like Davidson Kempner have typically dealt with businesses more on the margin versus dealing with businesses that are in their sweet spot. The pandemic did a lot of damage to businesses like traditional retailers, but it doesn't mean it's going to be better or worse when we get out of the pandemic, so we still have much to figure out.

Q: How do you deal with the “unknown unknown?” How do you forecast the future or make decisions when moments seem extremely unknown? Especially when there are events such as the pandemic or the GameStop situation that don’t seem to fit very perfectly into traditional risk models?

A: As a firm with a large risk arbitrage business, I still have this risk arbitrage mentality, which is you take every investment and try to narrow it down to: 1) what are you going to make if it's successful, 2) what are you going to lose if it's not successful, and 3) what's the probability of success?
If you can figure out those three things over time (and each of them requires calculations and a lot of guesswork), then you can forecast how you're going to do in your investments over time.
A common mistake that investors made during the Covid crisis, with the benefit of hindsight, is they massively underestimated their probabilities of success. And the market caught up to that much quicker than a lot of smart investors. There were still investors in June last year who were saying to sell the stocks. The market is a very powerful force itself, so the collective wisdom was actually very, very smart in that in that era.
Also, you still need to adhere to basic risk management rules like the maximum percentage that you want of any one investment in your portfolio or how much money you are willing to lose in any one place. Weird things can happen outside of investors’ control, and risks can become compounded when leverage is used.
There is the old Bear Stearns in the DNA of Davidson Kempner. Marvin Davidson, our firm’s original founder, was one of the senior executives at Bear Stearns. There was an old risk line at Bear Stearns that “no one ever wants to exceed their risk limits for things they don't like.”
That means if one exceeds their risk limits, by definition they really like it, but that is precisely the moment one has to stay very disciplined to the risk limits because that's when investors can really get into trouble.

Q: How do you filter out all the noises? There's so much information bombarding everybody these days. Especially in financial journalism, everybody has a story every day about whether markets go up or down.

A: There's definitely a multitasking element to this that's helpful. You want to block out and reach your conclusion. On the other hand, you have to consistently absorb new information as well because things change.
If you buy a private company and you realize you made a bad investment, you're in salvage mode at that point.
If you buy a public stock and you realize you’re wrong, you can click two buttons and sell it. But you have to have the mental state to do that. Especially if you’re doing public markets investing, one of the important parts is to understand when you're wrong and do something about it.
There's an old saying that “investors keep their losers too long and don’t ride their winners.” You obviously want to do the opposite of that. For me, keeping an open mind matters, so even when you've made your mind up, you have to be willing to to change it.

A bit more background about Tony & Davidson Kempner…

Tony graduated from Princeton University in 1996 with a B.A. from the School of Public and International Affairs. He then received a JD and MBA from Columbia University where he was awarded the John M. Olin Fellowship in Law and Economics. He had interned with the American Enterprise Institute, one of the largest think tanks in D.C., and had also gotten offers from regulatory law firms in D.C. He eventually went down the path of corporate law in New York but realized fairly quickly that he didn't want to be an attorney full time. That was when he decided to enter the MBA program at Columbia and shifted his focus back towards money management.

Tony joined Davidson Kempner in 1999. At the time, it was a firm of 15 people at most, managing over a billion dollars. While most graduates at the time pursued opportunities in technology given the dot-com boom, the early career in investment management had enabled Tony to use both his finance and legal skills, which really appealed to his intellectual curiosity. Over the next two decades, Davidson Kempner would grow to be a powerhouse – building out additional investment strategies such as long-short credit, as well launching a new distressed debt hedge fund in 2005 and a private equity style distressed fund in 2011, just to name a few inflection points.

Tony explains that Davidson Kempner is 100% owned by its working partners, and the firm has made a lot of effort to be a really nice place to work to make sure “we treat everybody the way we would want to be treated ourselves.” Tony says that it’s not just about finding a career that's intellectually stimulating and satisfying; one also needs to find the people that one likes, respects, and wants to spend time with. Davidson Kempner has always strived to maintain a teamwork-based culture no matter how big it’s grown.

Tony became a Managing Member in 2004 and the Co-Head of the firm alongside Tom Kempner in 2018, so it was a transition process long in the making that allowed the leadership to be passed down. However, when Tony took over as the sole Executive Managing Member and Chief Investment Officer of the firm in January 2020, he wasn’t left with a playbook as to how to deal with a global pandemic.

“There was a model in my head for how to deal with a financial crisis, but the Covid-19 pandemic was just something nobody had a playbook for” – Tony had guided a large portfolio through the global financial crisis in 2008, the European crisis in 2011, and the Euro debt crisis in 2015; he had also been at the firm during the Long Term Capital Management crisis in 1998, as well as the Enron scandal and U.S. stock market crashes between 2000 and 2002.

In the interview, Tony also talks about how he guided the firm through the pandemic crisis, their success of bringing people back to the office after work from home, how to give more people downtime and improve mental health when there is a growing mix between work and life in 2021, and how to sustain a culture of excellence over the years.

Disclaimer: Needless to say, my emails are just casual commentaries. I try my best to write them thoughtfully and with care to provide some alternative perspectives on various issues, but please do not treat them in any way as financial advice for your own investment.

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