January Review

Performance Review
While December was Our Man’s most disappointing month as the investor (with Mrs. OM) in the portfolio, January was Our Man’s most disappointing month as a portfolio manager despite the portfolio producing a modest gain of +0.45%. 

Why disappointing? 
The reasoning is simple; as you’ll no doubt remember, Our Man has regularly expressed his negative sentiment towards equities and this is reflected in the portfolio’s setup.  As such, we would expect the portfolio to have non-descript performance should the market’s rise but to be profitable should they stumble.  So it proved, with the portfolio up over 1% going into the final day of the month, before seeing its month’s return largely wiped away by a 100bip+ loss from the THRX position.

THRX; What happened?
 Let’s first talk (very briefly) about why THRX (a biotech company) fell; the company had applied (for the drug telavancin, to be used in nosocomial pneumonia) to the FDA to request that they be allowed to pool survival data from 2 studies.  They unexpectedly received a response from the FDA, saying that even if the FDA accepted the pooled data, the existing studies would equate to only 1 appropriate trial.  As such, THRX would need to conduct a second trial meaning a delay of at least 2-years (before the drug could be approved) and much additional cost.  Obviously, for a drug development/biotech company, this is pretty bad news.  The stock suffered heavily both from the fundamental impact (estimated at $1-1.50 per share by analysts) and especially from the change in sentiment (e.g. investors could reasonably conclude that THRX has higher execution risk than they had previously considered) that this type of news engenders.  Fortunately, while Telavancin is a very important drug to THRX (and the only one in it has in Phase III Trials, currently) they have more important drugs coming through the pipeline (most notably Horizon, in Phase II Trials).

THRX; why this was bad portfolio management?
Let us go back to what Our Man wrote, when he was delighted to inherit the THRX position -- “The sizing is a little large (6.5% of total assets, estimated), but OM is comfortable with the downside given the heavy equity put-hedge that he intends to apply”.  The sad truth is that the sizing was too large, with Our Man’s over-focus on the potential return meaning that he was reluctant to sell some immediately in order to bring the position down to an appropriate size (3.25-4.00%) given the risks involved.  This over-sizing directly resulted in an extra 50-60bips of the negative impact to the portfolio in January.

As Our Man has been discussing portfolio management recently, it seems to be a good time to highlight the secondary (and potentially tertiary) impacts of the initial error.  The side effect of it is that it leads to numerous different decision paths, which are all defensive in nature and fraught with various behavioural biases that can help compound the initial error.  A small sample of possible questions Our Man now has to deal with; should the position be reduced immediately?  Should the entire position be held, given the seeming over-reaction, and partially disposed of later?  How much should be sold down?  How much later – how much more pain should Our Man risk the position inflicting?  

By contrast if Our Man had thought more thoroughly about the risk beforehand and right-sized the position, the decision-making process now would be far easier and likely more productive.  In essence, it would boil down to is now the right time to add, and if so, to the initial level of risk (3.5-4.0%) or should the position now be oversized?
For what it’s worth, Our Man has decided to retain the full THRX position for the moment, given the severe reaction.  However, it would be better to view the existing position as two; a long-term investment position (3.5-4.0%) and a short-term tactical position (1.5%-2%).  The tactical position has a ‘stop loss’ at a strike price of $10 linked to it, with a rolling ‘take profit’ at $12.50.


Given all of the above, the breakdown of performance should be unsurprising; the stand-out contributors being the Long Treasuries positions (100bips+) and the long Put positions (25bips+), with their good work largely undone by the Long THRX position (-100bips+).

Portfolio
42.14% -- Long Long-term Treasuries (via L TLT and L Aug-29 Treasury Bond)
8.77% -- Long GLD
7.61% -- Long Intermediate Bond Fund (via L VBIIX)
5.39% -- Long THRX
4.61% -- Long Restricted equity positions (via L NWS, L CMTL, L CRDN, L SOAP)

(4.53%) – Delta-Adjusted Short position in the SPY (via L Dec-10 puts, with strikes at 100 & 85; 1.02% premium at risk)
(3.18%) – Delta-Adjusted Short position in GS (via L Dec-10 puts, strike 120; 0.85% premium at risk)

29.59% -- Cash