Monday, November 10, 2008

Congratulations (again) to Allied Capital shorts.

Those of you who still have your allied puts are having another big day today. The market is shocked to learn that maybe Allied can't continue to pay a 55% dividend yield after all. I love that something like that can surprise people. Efficient market theory? I think not.

Allied Capital is collapsing yet again -- down 38% on the morning so far. Folks who followed me into a series of Allied shorts are up around 400% or so in the last six months depending on which puts you bought and at which strike price. I wrote in a post one month ago that I was exiting most of my position after the 55% collapse due to my uncertainty over whether the government would come in, bail them out, and nullify my investment thesis. I thought the move was unlikely, but I was uncomfortable keeping such a large position in what amounted to a bet on the actions of a Congress in dire straights before an election. After the company's first collapse, my investment grew to represent roughly 95% of my net worth. I sold off most of that for obvious reasons, but I still believed in the investment and decided to keep my $15 puts that expire in January, 2009.

I now face a dilemma. This is where short-term trading gets you into trouble, because you want to pretend you know which way a stock (or the market) will move over the next two months when the truth is you do not. Ordinarily, this would be no decision at all -- you stick by your long-term thesis that the company will go to $0 per share and you remain in your investment. The problem is, the options expire a few days before inauguration day, and who knows what a lame-duck session of Congress will do.

I still feel it is unlikely that Congress will bail out Allied. The company isn't of much consequence. For this reason, I will continue to hold my options until either the company declares bankruptcy, is purchased by someone else, or my options expire in January. Whichever comes first will decide when I leave. I purchased these options for around $2 or so last year. They give me the right to sell Allied at $15 per share. As of this post, Allied has fallen to $4.40 per share, so my puts are already in-the-money by $10.60 per share. So far we're up around 400% or so, and this is one of the worst performers (I owned puts at $20, $15, 10$ and $7.50). It is a fantastic return, but to get there we had to buy them when the stock was trading at $35 per share, and we had to put up with all sorts of nonsense as the company continually lied to investors to send the stock up over the summer.

This is what strength in your convictions buys you. You can hold on when things take off in the opposite direction, knowing that you are correct in the long term. As Warren says, you are right because your facts and your reasoning are right -- not because other people agree with you!

On a related front, MBI continues to collapse. I had a similarly large short position in them going back to October, 2007. It had a similar performance to Allied, but with MBI - as I wrote on October 26 - I exited 100% of my position because I felt they had a much greater chance of being bailed out by the government. I still believe firmly that if the government does not bail them out they will fall to $0, and they are worth far less than that with their enormous debts.

For those of you who have followed me into SDS, EEV, EFU, etc, I hope a day like today can help you understand that having a proper long-term view and understanding the investment thesis will keep you from making emotional decisions which cause you to buy high and sell low. Over time, I am 99% positive I am correct on the emerging market collapse followed by a collapse of Europe, as Europe financed the emerging markets. We can have short-term rallies in the interim, but they mean nothing. Just like with Allied and MBIA, eventually the underlying fundamentals will win out.

No comments: