Whitney Tilson Explains LECG Position (XPRT) ~ market folly

Tuesday, March 15, 2011

Whitney Tilson Explains LECG Position (XPRT)

Back in late February, we highlighted that Whitney Tilson's hedge fund T2 Partners had gone activist on LECG Corp (XPRT). Since then, shares have fallen dramatically and they sold their entire position. In his February letter to investors, Tilson explains their thought process behind the investment and lessons learned:

"It was a historic day for us on the last day of February – but not in the way we like: one of our positions declined by 80% in a single day. You might think that such a decline is, ipso facto, proof of a mistake, but we’re not so sure (and that’s not just because we had a good day and month). Allow us to explain…

LECG is a specialized consulting firm that “conducts economic and financial analyses to provide objective opinions and advice that help resolve complex disputes and inform legislative, judicial, regulatory and business decision makers.” Our investment was based on the belief that LECG could successfully integrate recent acquisitions into a profitable business structure. Given the company's market capitalization of approximately $40 million, we felt that we had a reasonable margin of safety imbedded in the company's $109 million in Accounts Receivable, offset by $26 million of net debt.

The company's distressed stock price, under $1, was due to a default on the existing debt. Given the quantity and quality of the receivables, we believed that the default was a short-term issue and that LECG would be able to refinance debt on a secured basis, supported by the Accounts Receivable, in which case the stock could easily be a multi-bagger.

Much to our surprise and dismay, however, LECG instead announced what is effectively a plan of liquidation. We don’t know why the company pursued this path, though it is possible that this route preserved compensation agreements for employees at the expense of existing shareholders. Given the rapid execution of the liquidation, we believe the equity will end up being worthless so we sold our entire position.

In light of this permanent loss of capital, why aren’t we certain that this was a mistake, as Netflix clearly was? Because it’s possible that we made a high-expected-value bet, but just got unlucky. Investing is a probabilistic business so it does not necessarily follow that every time you lose money, you made a mistake (and, conversely, every time you make money, you made a good investment). This is very simple and, to us, obvious, but is very poorly understood.

Mispriced Options

LECG was a classic mispriced option, a type of investment that violates the rules of classic value investing, but with which we’ve had extraordinary success over time.

Warren Buffett is reported to have said that there are two fundamental rules of value investing: 1) Don’t lose money; 2) See Rule #1. We disagree. While it’s certainly true that investors should focus primarily on avoiding losses, we happily make investments in which we know there’s a decent chance – even a likelihood – that we’ll lose most or all of our money, as long as the upside is great enough to offset this risk. For example, if you could invest $100 in something that had a 70% chance of being worthless, but a 30% chance of being worth $1,000, would you invest? Of course, because the expected value is $300, or a 3x return.

But how much of your portfolio would you invest in this type of mispriced option, given that there’s a 70% of losing all of your money and looking (and feeling) like a fool? There’s no easy answer, but for us, in this situation, the answer is maybe 1% of our capital – and we’d look hard to find other similar investments so we could have a portfolio approach.

This is what we did, for instance, when we invested in the warrants of a handful of SPACs in late 2008 and early 2009 (and even created a side fund called the T2 SPAC Fund). By carefully selecting only a handful of the SPACs with the best sponsors and structure, we thought that each SPAC had a 50/50 chance of getting a deal done, in which case the warrants were almost certain to rise 5-10x. As it turns out, all but one SPAC got a deal done and we profited handsomely.

Outside of SPACs, other mispriced options that have worked out very well for us include our biggest winner ever, General Growth Properties shortly after it filed for bankruptcy, when the stock was around $1, TravelCenters of America, which rose 96.2% last month, Border’s bouncing from $1 to $3 in each of the past two years, and (many years ago) Denny’s.

But some percentage of these investments will be wipeouts like LECG, the Trian SPAC, and Sirva. That’s okay – it comes with the territory."

So, it's interesting to see one fund manager's approach to position sizing with these types of investments. Risk management is obviously a prime tenet of investing and this is a great case study. In other recent posts on this hedge fund, we detailed how T2 covered their Netflix (NFLX) short position. Be sure to also check out other hedge fund letters we've posted up.

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