Tiburon Tenets (Part 1): Capitalizing On The Random Walk

When asked how he had become so rich?  He replied, "I sold too early."
– JP Morgan, famous financier

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In an article by Peter Lupoff, CEO of Tiburon Capital and formerly of Millennium and Third Avenue, he discusses how Tiburon actively trades around core positions as a way to increase returns and decrease risk (TabbFORUM article) – you'll have to sign up for TabbFORUM if you are not already a member but it is free. These are concepts that we have articulated through our explanations of "Capitalizing on the Random Walk" and the "Good Stock Paradox". The point being that if you have a sense of intrinsic value and the stock trades around that value, then the market is providing dislocations in value that should be traded upon. For instance, Microsoft's stock has ranged between $17 and $31 over the past 52 weeks. That would suggest that the company has created or destroyed over $100 billion dollars of value which seems a bit excessive to me. I'm guessing that within that period there were deviations from intrinsic value that would suggest a core position should be trimmed or added to.
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In a more illustrative example, let's assume we have a $30 stock which currently represents 3% of our portfolio and we currently calculate a 30% probability-weighted return. Now let's move forward to a point where the stock has gained 10% and trades at $33. Assuming we do not sell any shares as the stock accretes, we now have a 3.3% position in a stock with less potential upside and more potential downside. Increasing our exposure to assets with lower probability-weighted return sounds like flawed portfolio management to me. Let's extrapolate the example and assume two funds. Both own 3% of the same $30 stock. The first fund owns the same number of shares as the stock goes from $30 to $33 to $27 then back to $30 for a total gain of $0. The second fund cuts the position in half as the stock rises to $33 and then adds back to the position as the stock falls to $27 and then trims again when stock rises back to $30. The second fund would hold the same 3% position at the beginning and the end of the move as the previous firm that made $0, but would have generated 50 basis points of portfolio alpha net of $0.03 commission.

Buy and Hold is a flawed strategy in a market where the probability-weighted return of portfolio assets are constantly changing. If, at the end of the day, you are trying to construct a portfolio where the best probability-weighted return are your largest positions and the worst are culled out of the portfolio then you must have an active trading mentality. If the market were more efficient and less volatile, then you could buy and hold, but thank goodness for thoughtful investors, it is not.