Michael Burry, best known for predicting the 2008 market crash and immortalised in “The Big Short”, has once again predicted a bubble: index funds. Whether or not index funds are a bubble – or contributors to a bubble – is a matter of debate. Nonetheless, the opinion of a man who predicted the 2008 financial crisis carries quite a bit of weight. I have written about Burry and index funds before, but this time I’ll look at it from another angle: which stocks does he own? The popular adoption of passive investing via index funds created a way for trillions of dollars to be indexed to certain stocks. In many cases the daily traded value of index funds is tenfold the trading value of the very stocks which they index – i.e. the value linked to the stocks is way greater than the value these stocks trade daily. The rise of passive investing causes an overcrowding effect in stocks favoured by index funds. Should the crisis pan out, Burry likens it to a theatre that is overcrowded with a small exit door. He argues that passive investing has resulted in many investors foregoing fundamental security-level analysis. Investors buying index funds rather than looking at individual stocks has caused a value disparity.
“Why don’t you explain this to me like I’m 5 year old?”
In the past, investors and fund managers would buy individual stocks to create their portfolio. They did research on individual companies’ current finances, future outlook and then bought or sold the stock based on how good or bad the company’s determined fair value seemed when compared to the current share price.
Stock prices represent a lot of information: company financial outlook, investor sentiment, potential risks, etc. The advent of technology that allowed billions of shares to be traded meant that any new information is quickly represented (or “traded in”) to the stock price. Any rational investor buys or sells stick based on the information at their disposal.
Today, investors tend to buy index funds instead of individual stocks. The companies that are tracked by the index fund benefit from the capital flows and their stock price goes up in value. The argument is that this is an “artificial” value increase meaning that markets are less efficient at discovering prices.
Inevitably, markets will go down. Panic will cause many to sell their index fund holdings, and consequently companies represented in the index will see rapid capital outflows. This will
punish both good and bad companies as well as increase volatility. Hence the theatre door analogy.
What would someone who feels compelled by this argument do? Fortunately, due to US legal requirements, the public is free to view the holdings of Scion Asset Management (the fund managed by Michael Burry). Interestingly, his portfolio contains only 7 stocks. It’s fair to postulate that for various reasons, Burry may see significant value in these stocks that are not reflected by their stock price. It’s also important to note that any short positions of Scion are not published – it’s very likely that the most vital part of Burry’s investment strategy lies in his short positions. Some of the holdings below may just be hedges to cover his shorts – so to speak.
- GameStop (27.78%): The largest holding is a perplexing one. GameStop is a holding company for different gaming and electronic stores. While gaming is a booming industry, GameStop uses an outdated model by selling games in physical stores. Online shopping and internet gaming platforms such as Steams has essentially relegated GameStop to Blockbuster redundancy. In 2015 GameStop traded as high as $46.80 and is currently trading at 10% of this at $4.61. Burry maintains that its balance sheet is in good shape and that its future cashflow justifies a much higher price. GameStop is sitting with a dividend yield of 39.18%.
- Tailored Brands (21.22%): Specialised in men’s apparel with more than 1400 locations in the US. Like GameStop, Tailored Brands has also fallen more than 90% since 2015 – down from $65 to $4.25. Burry is not a momentum investor and is notorious for seeing value in cheap stocks – which is very apparent from his 2 largest holdings.4 Alphabet (16.36%): Also known as Google, Alphabet owns many different companies under this umbrella. It seems that his 16% holding in Alphabet may be a more long-term view due to the businesses that Alphabet may be set to take over in the future.
- Sportsman’s Warehouse (14.12%): Not the same as the South African version, Sportman’s focuses largely on outdoor goods. It is yet another small cap stock which Burry has scooped up – supporting his hypothesis that passive investing has led to value not being represented in small stocks.4 Bed Bath & Beyond (13.39%): This is yet another stock that has been hit hard over several years. Currently trading at $15.57, it has recovered greatly from a 2019 low at $7.40 (where Burry is likely to have first entered the position). With a dividend yield of 4.42% and an intact balance sheet, it is clear why the stock seems attractive to Scion.
- Canadian Natural (6.70%): CNQ is one of the largest oil and gas companies with diverse operations across the globe. It’s unclear whether this holding is covering a short position, or whether Burry sees hidden value. It’s certainly an interesting pick given political conditions, and unlike his other stock picks, it’s not trading at or close to lows.
- Nuvectra (0.44%): A measly and enigmatic holding of less than 1%. It is a risky play as the share is illiquid and trading at a mere $0.16. I’m struggling to find any justification for owning the stock other than Burry may have speculated that for such a small holding at risk, there may be a significant reward.
As mentioned, a bubble in index funds is a matter that is up for debate. Burry seems convinced of a bubble and his significant holdings in small cap stocks that have been hit hard affirms this. Investors simply buying index funds mean that they do not know the value of stocks that they (indirectly) own. Small cap stocks are a minefield – in many cases there is a reason why a stock is trading at a low price. However, with fundamental security analysis and some scrutiny of company financials, a savvy investor may see significant returns or alternatively protect returns should a crash come to fruition.