Separating process from outcome

In any activity involving a process that leads to an uncertain outcome, humans tend to dwell on the outcome and judge the quality of the process based on the attractiveness of the outcome. The same is true for investors, who as a group tend to attribute skill to good outcomes and bad luck to bad outcomes, without due consideration of the process.

This fixation on outcomes is understandable. After all, investment outcomes are returns, and returns are what ultimately matter. However, in any probabilistic undertaking—and sound investing is all about probabilities, confusing good outcomes for good process is a recipe for poor results. Take table games for example – in blackjack, the casino faces maybe a 47 per cent chance of a bad outcome on each individual hand played. But behind the scenes, a good process is in place (the game rules) which ensures that over many hands, the house always wins.

A sharp focus on good process is important because, like casinos, successful investors hope to play many hands, and that is only possible by playing hands where the odds are in the investors’ favour. Yet, having a good process is only half the battle; the other half is sticking to it, especially when the process calls for cutting your losses.

As many readers will know, Twitter was the subject of much takeover speculation towards the end of September and early October, which drove the share price up 30 per cent. At the time, the Montaka fund was short Twitter, and after extensive internal discussion, it was decided that the position should be covered. A few days later, the rumour mill for another short also ramped up, so following the same process (in addition to our weak conviction heading into September quarter results), we also covered that short position. In the following week, all suitor interest for Twitter disappeared and the stock crashed back down 30%. So was the decision to cover the Twitter short at an ex-post high point bad process or bad outcome?

To answer the question broadly, one needs to consider one’s investment philosophy, which should ultimately shape the investment process. At Montaka, one of the key tenets of our investment philosophy is capital preservation, which means not risking capital when likely outcomes are not asymmetrically in our favour. Given the imminence of the potential takeover (Twitter was due to receive bids in early October), coupled with a combination of cheap debt and high equity valuations (cheap scrip), the fact that the stock was already up 30 per cent did not preclude the possibility of a bid with an even higher premium (e.g. 50 per cent, but unknowable in reality).

The investment committee faced a decision where there was perhaps up to 30 per cent upside from maintaining the short position and hoping the bids fell through (which they did), versus an unknowable downside, with even odds at best. Therefore, based on the information available at the time and without the benefit of hindsight, covering the Twitter short was good process that resulted in a sub-optimal outcome. Had a bid been submitted, the process would have led to a good outcome, i.e. capital preservation from having already covered the short. Needless to say, trying to anticipate or second guess the intentions of an acquisitive CEO in hopes of recovering lost ground never makes for a good investment process.

Finally, our decision to cover the other short position following the same process resulted in a good outcome, as the stock rallied more than 20 per cent over the following month, albeit for a mix of reasons.

Montaka is no longer short the shares of Twitter (NYSE: TWTR).

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