A Few Words on GameStop and Risk Management

These past few weeks, as the world watched some investment funds get the rug pulled out from under them, we received a powerful and necessary reminder: We are in the business of investing, not gambling. And although a large number of market participants treat the stock market like a casino, sooner or later those firms will be faced with the unfortunate reality every gambler must contend with: that flipping coins—and taking outsized risks—do not create sustainable outperformance or long-term wealth.

At the age of 12, I was reading Buffett’s annual letters and becoming enamored with investing. As I soaked up every word of his letters, I knew I had found my calling. In addition to his investing acumen, Buffett has a unique ability to make complex matters simple in regard to the market:

I always wanted to make a career in the stock market, but I come from a pretty successful family that made the bulk of its wealth through an operating business and then, secondarily, through real estate expansion. By the time I turned 37, I wanted out of the family business to pursue my lifelong passion.
My family did not want me to leave the business, for the compelling reasons that (a) we were doing exceptionally well, and (b) they saw Wall Street as a place for gamblers and irrational gains and losses that weren’t based on rhyme or reason.

I understood why they felt this way. If you look at the world of day-trading and the short-term mentality of many Wall Street players, irrationality is undeniably rampant. But my reasoning told me that was precisely where the opportunities existed. The more irrationality in the market—the more people who treat the market like a roulette wheel, on both the retail and institutional side—the greater the opportunities to generate long-term, outsized returns.

I certainly didn’t need to leave the family business, and in many ways I would have had an easy life staying put. But I believed that if you can approach the investment process with strong, pre-defined risk management practices that don’t allow the market to whipsaw you, there is nowhere you can make more money, with less risk, than in the equities market.

The “magic formula” comes down to a combination of solid risk management and a strong conceptual ability to analyze operating businesses. Put differently, it is our ability to act patiently and think long term, guided by our real-world business vision, that has allowed us to deliver such strong returns to our investors.

Toward that end, Prime maintains risk management parameters that are considerably more conservative than those adopted by a large number of hedge funds in the marketplace. In order for Prime to avoid the market gyrations that make many funds vulnerable to closure or dramatic setbacks, our investment process rests, as it always has, on a foundation of well-designed risk management practices, including but not limited to:

• No options or derivatives
• Invest only in highly liquid, publicly traded companies
• Currently have approximately 30 long and 35 short positions
• Invest only in well-established companies (currently have a weighted average market cap of over $50 billion on both the long and short book)
• Strict position-size limits
• Pre-defined leverage ratios that we adhere to by rebalancing on at least a monthly basis Maintain a long-term-value-based approach to each investment
• Diversify by investing in several different sectors on both the long and short side of the portfolio
• Finally—and perhaps most importantly as relates to GameStop—for every $2 billion in market cap, allow ourselves to take only a 1% short position

Each risk management parameter laid out above, and the final one in particular as it relates to the current fiasco, help prevent us from falling into the high-risk hole that other funds have had to claw their way out of. Yes, these parameters are conservative and may leave money on the table. But as we said before, the core reasoning behind each of these guidelines is to ensure that we can maintain our long-term mindset and continue to capitalize on our ability to understand operating businesses and identify mispriced investment opportunities well into the future.

Interestingly enough, we were short GameStop in the past. But even though we believed the company would eventually go bankrupt, we exited our short position years ago based on the parameters above, precisely because we did not want to be nailed by this irrational short-term mindset and the inevitable “dead cat bounce” and “short squeeze” outcomes that can result from investing large portions of a portfolio in relatively small companies. In fact, this parameter was put in place exactly because we know that as these companies get smaller and smaller, increasingly irrational behavior can and does take place in the market. It is a game of bandits, and you’d better have your risk management in place if you wish to survive.

We have survived, and thrived, for over 12 years now—combining substantial outperformance with strong risk management.

We want our performance and our portfolio offerings to be sustainable and attractive to our investors. We do not want to gamble, we want to invest. The restrictions we place on ourselves, if you will, create a lot more value in the long term—and keep our fund out of trouble on a fundamental level. And we love that.

Good risk management combined with long-term performance—that’s been our goal since inception.

Over the past twelve years, our portfolios have averaged the following returns on an annualized basis:

• Long Only: 48.5% gross, 40.3% net
• Traditional Long/Short: 34.7% gross, 29.3% net
• Ultra Hedged Unlevered: 22.6% gross, 19.0% net

Since inception, on a gross basis, our Long Only portfolio is outperforming the S&P 500 by 33.1% per year, our Traditional Long/Short portfolio is outperforming the HFRX Equity Hedge Index by 32.4% per year, and our Ultra Hedged Unlevered portfolio is outperforming the HFRX Market Neutral Index by 23.5% per year.

The fact that we’ve been able to generate such returns in the presence of the strong, transparent risk management parameters outlined above, says a great deal about both our sustainability and our long-term vision—which is to truly understand the core potential of the companies we invest in and then be patient enough to see our fundamental premises unfold. As we look ahead, we will continue to focus on our investment process, with the goal of delivering sustainable long-term outperformance to our investors for many years ahead. We look forward to updating you again soon.