Michael Burry's value investing philosophy and 2008 market predictions

Money Manager: Michael Burry Background
Michael Burry rose to fame as a money manager thanks to Michael Lewis’s The Big Short—a history of the subprime crisis and the men who foresaw and capitalized on the market crash in 2008 by essentially shorting the subprime mortgage industry. Burry is a non-practicing but licensed doctor whose interest in financial markets and insights into the industry led to attention from investors like Joel Greenblatt and firms like Vanguard.
Burry founded Scion Capital in 2000 with his own money and funds contributed by family members. Scion Capital enjoyed phenomenal returns throughout the early 2000s. Burry began looking into subprime and saw the potential for a massive short to pay huge returns. He built up a large position in credit default swaps, which served as insurance against the collateralized debt obligations being sold to other investors. The other investors were soaking up subprime mortgage-backed securities (MBS) filled with subprime loans that Burry was confident would soon default and trigger a cascading effect of defaults. Credit default swaps were his idea of hedge against that triggering. But he went beyond the idea of hedging: he bought the swaps as a way to short the MBS market. In the wake of the housing bubble implosion, Burry’s fund saw returns of nearly 500%: he himself netted $100 million and his clients netted $700 million in returns (Lewis, 2010).
Burry still manages the fund though now it is called Scion Asset Management. He has recently identified passive investing as being responsible for creating a bubble similar to the MBS bubble leading up to the 2008 crisis. As Fabozzi and Mann (2005) point out, “The securities issued by the U.S. Department of the Treasury are backed by the full faith and credit of the U.S. government. Consequently, market participants throughout the world view them as having no credit risk.” Burry is of the opinion that there is no such thing as a risk-free asset class. That thought makes him seek a margin of safety in all investments today. Market Philosophy Burry’s market philosophy is based on Ben Graham and David Dood’s book “Security Analysis”—the idea of value investing. Burry operates from the standpoint of the idea of margin of safety—the notion that market price and a stock’s intrinsic value may differ giving investors the opportunity to capitalize on that difference either through buying or shorting the stock (Panda Agriculture and Water Fund, 2018). For the record, his philosophy is not strictly that of Graham’s. Rather he views value investment “as a broader concept -- he usually picks technological stocks, made a spectacular bet against mortgages’ ‘fake value’ and now also invests in water and agriculture” (Panda Agriculture and Water Fund, 2018, p. 2).
Burry is also known as a contrarian investor, meaning he adopts perspectives that run contrary to what others are doing to see if he can find the flaw in their thinking and leverage that flaw to his advantage—as he did when he shorted the MBS market by buying credit default swaps when no one else was. It was his view that the MBS represented fake value and the swap was a way to short it.
Burry is also motivated by conviction—the knowledge that he knows something other investors do not. That is why when his fund was down in 2006 he wrote to investors without any worry that the main reason for the fund's underperformance was because of its big position in credit default swaps. Burry held the position until 2008 when he liquidated it entirely for a massive profit. It was his sense of value investing and contrarian investing that allowed him to build such a big contrarian position and maintain even when the market seemed to be suggesting he was wrong. Investment Theories Burry’s investment theories are based on the concept of margin of safety. The idea of margin of safety investing is that one should only pick investments when it can be determined that their value is above their market price. In other words, the market has inefficiently priced the asset to a point where it is being offered in the market at a price that is below its intrinsic value. This means that Burry must find a way to approximate a company’s intrinsic value more efficiently than other market participants.
This also means being able to exploit inefficiencies in the market, and today Burry finds many, particularly when it comes to passive investing and the amount of money being funneled into a handful of equities by passive investing and ETFs. According to Burry, passive investing destroys the opportunity for price discovery. There is no analysis; instead, the indexes focus on momentum and trends. As Burry has noted numerous times, “This is very much like the bubble in synthetic asset-backed CDOs before the great financial crisis in that price-setting in that market was not done by fundamental security-level analysis, but by massive capital flows” (US News & World Report, 2019).  Burry’s strategic approach to investing is a bit different than it was in the lead-up to the housing bubble subprime crisis. In that situation, Burry had been instrumental in creating an investment vehicle that the market did not even know it would need but that it would soon want—the credit default swap (Lewis, 2010). It was not a matter of finding an asset to buy or short but rather a matter of seeing an alarming trend in the MBS market and realizing there was no way to bet against it. Thus, he turned convinced others to create that way by selling credit default swaps on the MBS instruments. Today, that is not his approach and he simply looks for value where others are not seeing it—i.e., his approach is 100% based on the margin of safety. Performance Record Burry’s performance record is quite phenomenal. In his first year managing Scion Capital, his fund returned 55% vs. the S&P 500, which fell 12%. As the market continued to fall over the course of the next two years, Burry’s fund returned 16% and 50%. (Szramiakje, 2017).
When the housing bubble burst, Burry’s fund had returned nearly 500% to investors in 2008 thanks to his large position in credit default swaps, which he purchased cheaply in the years leading up to the crash and which suddenly became very expensive to everyone else as their portfolios full of MBS now looked less and less valuable—or safe.
Burry currently manages approximately $340 under Scion Asset Management (Li, 2019). The long portion of the fund’s portfolio is up 28.8% year-to-date vs 10.1% for the S&P 500 Total Return Index (Gaffney, 2019). Position on Market Efficiency and Non-Market Efficiency Burry neither believes in market efficiency or in market inefficiency (Panda Agriculture and Water Fund, 2018). His position is that the market can be both and neither. There are myriad factors at play for one to adopt a position as infallible at any given point in time. One has to look at each investment opportunity uniquely, as its own special situation: “Insiders leak information. Analysts distribute illegal tidbits to a select few. And the stock price can sometimes reflect the latest information before I, as a fundamental analyst, catch on” (Panda Agriculture and Water Fund, 2018, p. 8). The problem with today’s markets is that price discovery just does not appear to be happening and so efficiency is a major issue.
And yet Burry’s contention is that for long-term investors like himself it is also not a big issue for eventually price discovery occurs and in today’s world of fast-moving algorithms it can happen quickly—especially with passive funds and ETFs investing so much into a handful of stocks that could plummet in price if there is a run on the market. With central banks pumping liquidity into markets, however, that liquidity inevitably winds up driving the price of equities higher. It is as though the markets would be efficient if the central banks would let them—but if that were to happen, many companies would go to zero and so would everyone’s economy because so many funds are tied to the markets’ return—sovereign wealth funds, mutual funds, pension funds, and insurance funds. All of society would suffer the world over if price discovery were permitted. Thus, for Burry, there is no way to exploit the system’s inefficiencies like there was prior to 2008. In the wake of the subprime crisis, the Federal Reserve launched quantitative easing (QE), and QE changed the way in which markets work fundamentally. Risk Mitigation Methods Yet with central banks quick to plug cracks in the plumbing with liquidity injections, the risk is not of a market crash but rather of inflation and the debasement of the currency. Crashes may occur at year-end like what happened in December 2018, but they are caused by a lack of liquidity and the Federal Reserve has already entered the Repo market to help prevent another problem like what occurred year-end 2018. However, unless the Federal Reserve is buying coupons, the situation could get out of hand as liquidity dries up anyway and the Federal Reserve is forced to launch QE4. That would, in turn, lead to billions in new money entering the market and the prices of safety assets rising right alongside risk assets.
In Burry’s view, safety comes first. Thus, Burry’s risk mitigation methods are to look for stores of value, which is why he has been investing in land, water, and gold—traditional hedges in times of high risk (Panda Agriculture and Water Fund, 2018).