In his 2001 Scion Capital Letter, Michael Burry cited one extraordinary example of market inefficiency in which he profited greatly. Here’s an excerpt from the letter:

An Illustrative Situation

The repercussions of the late 1990’s asset bubble continued to resonate through the markets during 2001, creating tremendous volatility as well as tremendous opportunity. Those with a clear idea as to valuation likely did not find their portfolios terribly troubled this past year.

Those stock market players who respond to other inputs likely had some difficulty finding their bearings. As for the Fund portfolio, one situation in particular provides insight into the character of your investment here.

Within the 3rd quarter letter, I explained that the “Fund has been averaging down in a stock, purchased during the quarter, which has fallen tremendously out of favor over the past couple of months.” I further explained:

The future performance of this position will have absolutely no correlation with either the performance of the general market or further terrorist attacks. At quarter end, however, the position sat at a low point, trading at a valuation of just 3/4 the free cash flow of the trailing twelve months. And unlike many businesses that have faded rapidly during 2001, this business achieved record free cash flow yet again during the first half of 2001… I will note that the prospects for a recovery in this position during the fourth quarter are wholly in question.

However, over the next year or two, and especially over the next five years, there is a very high probability of substantial gains as a result of this investment. Such gains would be largely irrespective of the status of any economic recovery, or lack thereof.

The Fund continued to purchase this security during the first days of October, while the security remained downtrodden. As it turns out, we did not have to wait five years, or even a year or two.

The stock tripled off its quarter-end lows by late October. Moreover, during early December, a competitor agreed to buy all of the stock of the company at a price that amounts to nearly seven times its price as of September 30th 2001.

Indeed, while this stock traded down and around its lows, allowing the Fund to take advantage of a truly tremendous sale on free cash flow, a secret bidding process was in the works.

Two strategic buyers and one financial buyer submitted three separate bids for the company at valuations six to seven times the then-current market price.

This extraordinary example of market inefficiency surely increased the reported volatility of your investment in the Fund — but without added risk, and ultimately much to your benefit.

There are many in the investment world that believe the sentence you just read describes an impossibility.

Not so coincidentally, both the CEO of the winning bidder and your portfolio manager independently responded to the same July event when finalizing our rather bullish investment thesis — even as the market proceeded to punish the stock on news of the very same event.

Owing to our different professions, we went about our investments in different ways. I committed the Fund to a substantial investment in the common stock.

He called the target and began to bid for the entire company. You should recognize, however, that this is not such a coincidence precisely because I buy common stocks for the portfolio as if I were buying pieces of businesses.

In fact, at all times I strive to buy stock at prices per share that no acquirer could ever pay for the whole company — not because the prices are too high, but because the prices are so low that a potential acquirer proposing them would be laughed out of the boardroom. Such is the opportunity afforded by the very human market for common stocks.

You can read some of the Scion Capital Shareholder Letters here:

Michael Burry: Scion Capital Shareholder Letters.

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