Top 5 of 2024: #1: Scott Bessent - EP.415

29:16You should have it in your center book or let me do an SPV for you. So at the end of your first run at Zoros, there was a lot of change, Stan left, and you go and launch what I think was the largest hedge fund at the time, a billion dollars at Besson Capital. What was your initial thoughts of your investment style after all of that experience? I think one of the mistakes that I made, and over time caused a big philosophical change, was never do what the investors tell you to do, do what you're good at. So when I started in 2000, I was able to raise a billion dollars because I told investors I wouldn't do macro.

29:56Macro had become a bad word. Long-term capital had blown up in 1998. And that wasn't really macro. It was more RV gone amok. And then I think some macro positions had hurt Tiger, that Soros had had a big drawdown. It was just long, short equities. How did you feel that that inhibited you from being able to express investing the way you'd learned? I think it was just the loss of asymmetry. If I had a bullish view on oil, okay, I'd probably be better off owning crude because I remember at a point I did have a bullish view on oil and the oil stocks didn't move because they were looking more at the mid curve or analysts were waiting for a price, whereas the oil price was going up.

30:46So what happened was I went back to the investors and said, look, we're going to do macro. If you want, I'll take the lock off and you can have your money back. We had a good run after that. But at that point, I'd been working since I was nine years old. I was 42. I had been financially successful and I was just tired. There are two components to a hedge fund. There's managing the portfolio, running the business. I thought I had an A team on the portfolio side. I didn't have an A team on the business side. So there's always this anxiety. So I thought I wanted to retire. I might have been a professor right out of Yale if I hadn't had a lot of student loans.

31:29I wanted to go back and teach. I remember having dinner with Stan and his wife, and he said, F you, you'll be back in a year. You can't not do this. And he was right. That was my to come and work with you at Protege. I thought I could be halfway back in with the fund of funds model, with the best ideas model, because for me, a lot of it, it's a competition of making money, but also what we do keeps you stimulated. A lot of people do crosswords. A lot of people play bridge. I find this just so stimulating. One of my mentors, Byron Wayne, said, I'm going to work until I die. And Byron kept work until 10 days before he died.

32:16So after that run, I know you were going to go launch a fund again, and then George calls to take the big seat. By that time, Soros had gotten big. And I'm curious how you thought differently about a large scale asset pool. I went back and I really wanted to see if rather than size being the enemy of performance, whether you could turn size, free form capital, so no mandate, and the ability to make quick decisions into an asset. And I think we were able to. How'd you go about doing that? Brought in a good team, revamped the outside manager portfolio, made it known that we were open for business, that you bring us an idea, we will not bigfoot you and go around you.

33:06I can give you an answer in three days, whereas Blackstone or somebody might have to take you to an investment committee with five memos in three weeks and build it. And they came. We had a good internal team. And then the hub and spoke system for the external managers was very successful. How did you spend your time when you had so much more capital, so many different teams, George hovering as he was known to do? I arrived September 2011, and the bond market in general just melted down. European bond markets, especially the Italian bonds, were still in melt mode. The idea was for me to reacquaint myself with the firm.

33:49It was 320 people to manage, 120 investment professionals, and many of them not happy to see me there. So I was supposed to have 90 days to get in the seat, get to know people, the firm. I ended up doing, I think five days in, the biggest trade I'd ever done was John Corzine's firm got liquidated out of their Italian bond position. And it was a$3.5 billion trade. I still had the index card that I worked it out on. And JP Morgan called us and I was able to say, we'll take the whole trade with the repo right now. When you're in a seat like that, that's as big as it gets in the financial world, how do you decide when it's time to move on?

34:39A couple of things. You have to think, what's the level of administration you're doing? Is that impacting your returns? My telos in my career has been, I want to do things I'm interested in. I want to keep learning. And I don't want to be bogged down. I don't want my day to be things that I don't like. Every day is not a good day. Every week's not a good week. But you want to have good months and years. So if you're on the wrong trajectory, there's that. Then I think that I had some differentiated views that maybe one other person at the firm didn't have. I think it's a real challenge as we get older to not become more negative all the time.

35:26So you go to start key square. What does key square mean? Key square is a chess move. So it's at the end of the game where there are two kings, a couple of pawns, and there is one square that the king can go to. And I think about that in investing a lot. There is one thing you can do. It's a simple move. It could be at the beginning of the game. It could be at the end of the game. The funny thing, I'm fine at chess. I'm not great. I don't love it. And I don't think that chess is the liquid markets game. The liquid markets game are cards and backgammon. It is luck and how are you going to manage the hand you're dealt.

36:09You don't know what's going to happen in Israel. You don't know when the Chinese Navy is circling Taiwan. on. Is that a drill or is that the real thing? What you're going to be handed every day, you can have good luck, you can have bad luck, but you've got to manage these things that have been thrown at you, whereas private equity is much more chess. All the moves are on the board. What is the move you're going to do? It was quite humbling. We had the highest ranked female player in the world come in. And I think she played 12 or 13 of us at once. And I was very happy. I was a penultimate person still standing.

36:53She unfortunately didn't do it blindfolded. But afterwards, she did this tutorial and she was showing us famous chess moves. Like she knows chess moves from 1913 from a Cuban grandmaster. You could probably go back and look at some of the things JP Morgan had done or some of the great industrialists, if you're looking at Mellon or Phipps or Rockefeller, they're doing the same things in a lot of ways that the private equity people are doing. And that's chess. In this cards backgammon analogy, when you're investing, now you're taking on the full macro strategy. From everything you've been through, everything you've learned, how did you set out of what you were trying to do at KeySquare?

37:40On the investment side, we just wanted to have a couple of big positions, manage them well, and pick out the big themes, try to keep the noise out. We had a small, tight-knit team, and then we had 30 consultants around that. Those were people some I'd worked with since the mid-'80s. We probably had three new ones, three out every year, and the idea would be, okay, we don't need a Latin American specialist in the office. We have a great consultant in Latin America. We don't need a Tokyo office. We have a great Tokyo specialist. The other thing, having been on the allocator side, was to be an asset to the partners.

38:22So a lot of times we would have a major endowment come to us and say, we're going in on this private equity deal in Brazil. what do you think we should do with the currency? I'd love to walk through how you distill your investment process. You're looking for a couple of big ideas. Where do you find them? I think it goes back to my dad in the science fiction. What could you imagine could happen? I remember one of our consultants telling me, there's this guy in Tokyo, used to be a prime minister. His name's Abe. He's going to run for office and break Japan out of disinflation. Since the Fukushima tragedy, which it's easy to remember, unfortunately, is 31111, the Japanese yen had strengthened significantly.

39:11There was a series of prime ministers. I'd started going there, I think, in 1989 or 1990 during the bubble. And it'd really been more of a trading chop malaise with a general downward trend. The yen had become the most expensive purchasing power parity currency in the world. And when this fellow said, well, Abe is going to break the deflation cycle and here's how he's going to do it. The three arrow program and it's two, two, two, two percent inflation, two percent growth in two years. I went and met him and I believed he could probably do it. It was also a great setup. Back to your question of conviction, the Bank of Japan, the way the board runoff was working, he was going to be able to reconstitute the Bank of Japan.

40:03Without the prime minister being able to appoint new governors, he would not have been able to get the reflationary mindset. So he was able to reconstitute the board in his image. So there's a lot of connecting dots to make a big move like that. You can imagine that it could change, but you also have bonds that would make our trade of people shorting the JGBs for years. That's a great segue. I had no interest in being short JGBs. When I thought about the macro panoply of potential instruments, okay, what are stocks going to do? What's the currency going to do. And everybody, because they had so much scar tissue on JGBs, he goes, well, doesn't this mean JGBs are finally going to go?

40:47I said, I don't know. It might mean JGB yields go lower before they go higher. But it was very clear to me that the yen was the ultimate expression and that equities would be a good derivative of that. What's the research process to connect all these dots to get to the point where you can have that kind of conviction in a macro trade? Just like with a stock trade, we set up the fundamental picture. So this is what could happen to the current account. This is how cheap the currency is if it just got back to the historical level. So you actually have a framework and reference points for where it could go.

41:28And then there are technicals involved, which can be very different than stocks. What would happen if the yen started weakening? Could there be a cascade effect because exporters have a certain position? When you get one of these big, major changes, a lot of times there's been a lot of position buildup over time. I think it was Nassim Taleb who says that lack of volatility leads to volatility. So you're also trying to figure out, okay, where's the market? And not unlike with the subprime trade, we had started putting on a short yen position. one of the brokers had seen us doing it and called and said, oh, well, we have this vol fund that will sell you all the yen puts you want.

42:21Great. And I think this vol fund thought they were picking us off because the yen had been very stable. So vol was low. Maybe the vol on the screen was four. And they thought, well, if these guys would pay six, we'll sell them as much as they want. So I think they thought we were crazy to buy these things at a six ball. Like with a stock, the yen was bouncing around between 78 and 82. I thought maybe it could go to 95. And then when this thing got in motion, maybe it could go to 105, maybe it could go to 115. I remember George and I went up to New Haven. This was a proprietary piece of research that I thought we had, one of the architects of Abenomics was a Japanese professor emeritus in the Yale Econ Department who had been a student of Tobin's, complete Keynesian.

43:13And I think Professor Hamada, he was old when I was there. He was in his 80s now. And we went up and had lunch with him and he just mapped the whole thing out. And at one point, George asked me, do you think this is going to work? And I said, I have no idea whether it's going to work, but it's going to be the market ride of the lifetime. That's the thing. The policy decision doesn't have to work, but it can cause a lot of price gyration. How do you think about position sizing and trading around something like that? I tend to trade in thirds. And a lot of the position sizing is what's the market giving you in terms of this ball fund wanted to sell us these digital options.

43:54They move very quickly. Is there asymmetry in the ball market? What is the market giving you? and where's your P &L in the year? Then a lot of times we'll keep adding if the P &L is good. So that's a very different notion than a lot of people think about, say, fundamental investing, which is that the size of your P &L in a given year will determine your position. Talk me through how that portfolio management methodology works. One of the world's greatest stock picker, Warren Buffett, rule number one, don't lose money. rule number two, don't forget rule number one. It's really this idea you earn the right to take a risk, whether it's backgammon or you're at a poker table or playing bridge.

44:40How's your chip stack? If you walk in and say, all right, I'm bringing$10 ,000 to the poker table and that's it, then you're going to bet differently. If you've got 20 ,000, you're going to bet differently than it's$30 ,000. It's really anti-Duke thinking of bets. I'm curious about the relationship between the duration of the trades and that betting chip stack. You mentioned if you're up on the year, what does that imply about the types of positions you'd take on so that you'd say, okay, it's January 1, we're starting it, we're resetting our chip stacks? I do that as a discipline, reset the chip stack.

45:21And when I'm doing it in December, especially currencies, you can be making a lot of money in December. You're like really whipping them and driving them. And whether it's the traders or the risk team or other people say, well, you know, it's December 15th, we got to start taking this down. It's like, God, boy, this could really go in January. When I look back, almost every time that I've taken it down, it's been the right thing to do because there's always a counter trend. How do you think about just the process of risk management so that if you're wrong on a big position, it doesn't blow you up?

45:57That's exactly it. I don't know because of my dad's poor risk management, whether I'd have a lot more money because I'd be less risk averse or I've gotten to where I am because of the risk management. Like the wolf's always at the door. But I'm a big believer in Nassim Taleb's definition of risk, probability and severity. When we think about investing in China now, what's the probability that you're going to lose all your money one day? That you're going to have a Russia-Ukraine kind of day, which seemed unimaginable, that Russian equities would go down 95 % in a day. So it's always probability, severity.

46:40How are you measuring liquidity? Because correlations go to zero when you may think you're hedged. One of my risk management techniques have been you can be one thing, but not many. You can't be concentrated, illiquid, and leveraged. I prefer to be liquid and then to use leverage. I try to stick with a set of rules. I want to be able to get out within 24, 72 hours on part of the portfolio. One of the most fascinating things I've always found about your career is you launched two of what were the largest hedge fund launches at the time, best in capital at a billion and then key square four or five.

47:25and that macro hedge funds in particular are notoriously difficult to sustain as a business. I'm curious why that's the case. Ted, that's a great observation. So it really goes back to the Ted Williams and the Babe Ruth comparison. Ted Williams, 400 batting average, and he could see the seams on the ball season after great season. Babe Ruth was a home run hitter, but very low batting average. But the home run came for, I think, five or six decades, the sultan of SWAT. And a lot of macro tends to be more Babe Ruth than Ted Williams. And the investors grow impatient. They pull out. You have a big year, big two years.

48:16The money comes back in. Rents and repeat. I think that we have created a business model that works well for us. We have the general hedge fund, which is family, friends, long-term investors, those who judge us more on a three-year average. There was a very good study from the Common Fund that said one of the most successful strategies for allocators that when you believe in the manager, and I always tried to do this when I was at Soros or any investment committee that I'm on. When a manager has one, two, three, blow it out of the park years, you pull in some capital, pull it back. And when they are in a slump, you add.

49:03And I've found that over the years, the best results that I've given to investors are those who add when we're down. The other thing that we've done in our business is we have a relationship with a lot of larger funds where we will go to them with episodic once a year, maybe once every three years, big ideas. We create an SPV and can leverage up into the situation. And then when that opportunity passes, we give the money back. One of the things I've always appreciated about our conversations that I like to tell people is, more than anyone I've ever known, it strikes me you know how to read the newspaper six months ahead of time.

49:44And I'd love to hear what you're thinking now about what could happen six, 12 months from now. Well, I will also compliment you because back to having great colleagues, you were very good. And I got my nose out of joint a couple of times. It's like, you're getting it exactly right. What's going to happen in six months? you don't have the positions. And that was super helpful. And the other thing too is I often think that if I'd had the real newspaper, would it have been obvious what the trade is? If you had said, okay, there's going to be this war in Israel, it is going to go on for a year, but oil prices are going to be lower.

50:25That's not obvious. If you were going to say that we're going to have a 7 % budget deficit, that rates would go way up, but there'd be a mag 7, that there'd be a tech bubble. So thinking about what's going to be in the newspaper and then the right investment vehicles, I think the big challenges for the next couple of months are going to be very path dependent on the election. If Republicans, which I'm pulling for, get the trifecta, I think there could be a growth shock and animal spirits are back. And maybe the Fed's jumbo rig cut was a mistake. I hope that they don't have to reverse and start hiking, which I think would be a big loss of credibility for the Fed.

51:13Then on the other side, if Vice President Harris were to win, likely going to have divided government. Republicans will probably have the Senate. And we're going to have to figure out what happens here with a 7 % budget deficit that's likely continuing to go up. My strong feeling is that Chinese have moved tactically to stabilize the economy, but that Xi Jinping is a different kind of cat. That what we saw in the aughts up until 2012 or 2013 with capitalism with Chinese characteristics or communism with capitalist characteristics. He's a Leninist. So he's not going to allow a clearing function in the market that would allow for a sustainable Chinese economy.

52:06Then I think we are in a long-term bull market in gold. I think we're seeing reserve accumulation by central banks. I follow it closely. It's my biggest position. And even I was surprised the other day when the Central Bank of Poland came out and said that they want to take their gold reserve to 20%. And you know, Ted, over my career, some of my best investments have been when a policy, when a government, when a management is driving 90 miles an hour at a brick wall, you assume that they are going to hit the brakes. So that's how you get the big policy changes. a couple of times I've been in the car when they've hit the wall.

52:50That's less fun. But I think that many of my best investments have been detecting when you're going to get the policy change. And as I said with President Xi, one thing in the Reagan White House used to say, policy is personnel and personnel is policy. So you always look at whether it's the management or the policymakers, at the end of the day, they're human. They want to be judged. Some of them are elected. They want to think about how history is going to remember them. So they are very susceptible to external pressure. And many times, if you have an ongoing dialogue with them, if you observe them for a long time, it's easy to detect when they are going to slam on the brakes, which is also a very good risk control metric because many times something has gone so far out of equilibrium, you get a very good entry point.

53:46Are there anywhere else in the world that you're keeping close eye on? Japan. I believe that this could be a secular bull market, one of the few in the world. Abe had great policies, but he also had great stability. And then he was assassinated, unfortunately. He was out of office when he was assassinated. I believe he would have come back. So now the Japanese are maybe back into this game of musical chairs with prime ministers. And then I think Europe is a big question mark in terms of policy and deindustrialization, and especially politics. I would predict that in the next 18 or 24 months, Marine Le Pen, the bet noire of European politics, is going to be president of France.

54:36And she's going to be president of France because the alternative on the left is worse than she is. So these populist politics that are a backlash to trade and immigration, and also just some very bad choices that have been made by the Europeans. German industrial policy. We're going to sell into China. We're going to use Russian energy to fuel us. We're going to keep a cheap currency because the Southern European states, which are now doing much better than Germany, we're going to turn off our nukes and make ourselves more reliant on German energy. I'm very interested to see what the German mighty industrial export machine does over the coming years.

55:24I know for many, many years you've been a very private person and recently you've been named as potential roles should Trump win. I'm curious to first ask, how do you distinguish your political views from your financial views and responsibilities? That's a great question for the fund. I always do that there shouldn't be zealots in the market. And a lot of what I'm doing now is just a continuation of what I've done for 35 years. It's the geopolitical analysis, it's macroeconomic analysis, it's following trends. And I decided to come out from behind my desk because I do believe this election, there's a big choice.

56:07and we are going to decide whether we are going to grow our way out of this debt burden. And I think we can through deregulation, energy, independence and dominance in the U.S. and a growth mindset. We can get back to growth. I feel very strongly that this is the last chance to grow our way out of this. I also felt very strongly that we're in the midst of a great realignment and of a Bretton Woods realignments coming in terms of global policy, global trade. There's a lot of what I taught at Yale. I've been studying it my whole life. I'd like to be part of it, either on the inside or the out. And then three, I think that this new Republican Party that's been reconstituted with these new constituencies is the party of the future.

56:59It's a melding of working class and business class people. I'm determined that these new constituencies get treated well. I started out, our family was very affluent. My dad saw to it that we weren't. And now that I've made it back. So I've known economic anxiety and I want to see for these constituencies and for working people that things go well. So one of two things is going to happen when this comes out. I guess most likely one of these two parties is going to win. If Donald Trump wins, regains the presidency, where do you think that brings you? I'm just working to make sure he wins. There's nothing beyond November 5th if he loses.

57:41Scott, I want to make sure I get a chance to ask you a couple of fun closing questions. What is your favorite hobby or activity outside of work and family? That's been modified as I got older. I remember when we worked together, I was doing triathlons. I will tell everyone, if you have a middle age crisis, don't do triathlons because I have two new hips. I am rebooting my favorite outside of work. So trying to do more lifetime sports, whether it's hiking and walking or golf. What's one fact that most people don't know about you? I might have gone into politics or the military 20 years ago. I just think I was gay 20 years too early.

58:17How have you felt that being gay has influenced your life and career? It had a big influence. I had an appointment to the Naval Academy that I decided not to take in 1980, and we were broke. And so it was free, but Yale was very good to me. I worked three jobs in summers, and things worked out. And I think maybe subconsciously, one of the reasons I was attracted to money management, the numbers are the numbers. It's not a sales job. You don't live next to clients in Greenwich and they're going to give you commissions because you're at the country club together. I always thought your P &L protected you.

58:56And if I could add one more thing, I am probably the most quantitative person you'll ever meet who's also very religious and very superstitious. I don't think they're mutually exclusive, but a lot of people do. I pray and have a rabbit's foot that my quant analysis is right. What's your biggest pet peeve? Entitlement. I think plenty of people are privileged, but anyone who acts entitled really bothers me. Which two people have had the biggest impact on your professional life? Stan Druckenmore. Probably the greatest investor of all time. It's humbling. Never a down year. But also wonderful mentor, human, family man, the charities.

59:42And then Byron Wayne. Byron never had children. And as a result, he had a group of us who he doted on, he counseled, he criticized. It was incredible because his mental flexibility was he never got rigid. I remember after the 2016 election, 10 days later, when Trump won, he and I were having lunch. I said, so Byron, what do you think? He said, Scott, just to know, you know where I am on politics. I cried when Trump won. I think the market's going straight up. Who can do that? What's the best advice you've ever received? You have to believe that anything can happen. You never know how things are going to change.

1:00:26You've got to be ready when they change. and you have to be prepared to get lucky. So if you've done a lot of prep and the big event comes along, you're prepared for it. And then the other thing is I've never done anything for short-term money. I always try to think over the long-term, is it going to keep me engaged? And there's probably a bigger pot of gold further out. All right, Scott, last one. What life lesson have you learned that you wish you knew a lot earlier in life? Long-term relationships are the most important. One of my college roommates, we've been friends since we were 17. We've been there for divorces, marriages, children's births, and it's just these relationships over your life that are so important.

1:01:20When you talk about what was it like going back to Soros, I was the most popular person in the 212. Even when I retired in 05, the great people like Ed Hyman at ISI, you know, Scott, we're just going to leave you on the mailing list because smart people never go away. And I'm still speaking to Stan Druckenmore every day. I'm still speaking to Nick Rodini every day. So all of a sudden, when I'm the most popular person on 57th Street, it doesn't really mean a lot when somebody disappeared. These long-term friends are the same people who pick you up when you're down and rein you in when you're getting too euphoric.

1:01:59You did a good job of it when we worked together. I hope I did the same for you. And that's really the key is to stay balanced and have people who keep you in a good equilibrium. Absolutely. Well, Scott, thanks so much for sharing your insights and good luck with wherever this thing brings you. Great. Thanks, Ted. Thanks for listening to the show. To learn more, hop on our website at capitalallocators.com, where you can join our mailing list, access past shows, learn about our gatherings, and sign up for premium content, including podcast transcripts, my investment portfolio, and a lot more. Have a good one and see you next time.

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