George Soros: How he broke the Bank of England

George Soros is legendary because he has had at least 3 billion dollar months. Months where he has earned more than a billion dollars for his hedge fund. The first time he did so, he broke the Bank of England. But it wasn’t even his original idea that led to the feat.

Stanley Druckenmiller – who worked with Soros – came up with the thesis.

  • The British pound was pegged to the German mark as part of ERM (precursor to Euro.)
  • The reunification of East and West Germany was leading to inflation in Germany and pressure to increase interest rates.
  • Britain however was in a recession and needed to reduce their interest rates.

When Germany increased their interest rates, Druckenmiller thought it would be a wise idea to bet on the British pound peg breaking away from the German mark. He shorted $1.5 billion worth of the British pound.

But Soros thought that wasn’t enough. Soros’s genius was not in thinking up the trade. But understanding the risk of the trade, and betting accordingly.

Understanding the risks of the trade

Soros realized:

  • Trading the British pound is a liquid market. He could exit quickly at a loss of just half a percent.
  • But if the thesis were correct and the peg would break, they could earn 15-20% of the bet.
  • The Bank of England was the only one buying the British pound to maintain the peg. But looking at their balance sheet, they only had $44 billion worth of firepower.

In this case, increasing the bet size would deplete the Bank of England’s coffers quicker. It was less risky to increase the bet size! And so Soros made the call to leverage and borrow money to short a cool $10 billion worth of the British pound!

Most amateur investors would caution against borrowing money to make a bet. They would caution against making one single huge bet – it’s better to diversify and reduce your risks. 

But Soros understood risk / reward better than anyone else. Soros’s fund was up 12% in that year. By making a concentrated bet with a low downside, all he was risking was wiping out the profits they had made that year. 

But by making such a huge bet, he signalled to the other hedge funds in the market that there was an anomaly. They all jumped in after Soros. And forced the hands of the Bank of England to throw in the towel.

On 16th September 1992, Britain announced their exit from ERM. The Bank of England suffered huge losses. And Soros enjoyed his first billion dollar profit month!

Soros has repeated the same feat two more times. Once with the Thai Baht during the Asian financial crisis in 1997. And again with the Japanese yen when Prime Minister Shinzo Abe started a program of extensive monetary easing to jumpstart the stagnant Japanese economy.

The Soros Strategy

Soros has shown that his strategy is repeatable. And it consists of recognizing two things:

  1. Finding the moment of change
  2. Understanding the risk and betting accordingly

While it was Duckenmiller who understood the moment of change and came up with the thesis, Soros’s fund would not have made the insane profits if it did if it weren’t for Soros’s concentrated bet. While every investment book tells us about diversifying our portfolio, time and again, history has shown that the investors who understand the risk and make concentrated bets make out like bandits.

Warren Buffet’s bet on Amex

In 1964, Warren Buffet bet 40% of his portfolio on one company. American Express. This was after Amex had posted a loss of $58 million!

Anthony De Angelis had figured out a scam. He could get loans by showing food products as collateral. His ships would dock, inspectors would audit the cargo, and certify it’s salad oil. Based on that certificate, he would get bank loans from companies like Amex. 

De Angelis figured that he could trick the inspectors. His tankers contained mostly water, with a few feet of salad oil floating on the top! He showed 1.8 billion pounds of salad oil and borrowed $180 million for it. When in reality, he only had 110 million pounds of salad oil!

When the ruse was found out, Amex had lost $58 million! And people were selling its stock left right and center.

At such a time, Buffett and his partners actually went and staked out restaurants and hotels. They found that the same number of customers were still using Amex cards in restaurants and malls!

While there was a change in Amex’s balance sheet, there was no change in the amount of money they would continue to bring in! And so, Buffett went on a buying spree of the Amex stock when everyone else was selling it!

This strategy of observing for change and then making concentrated bets is not applicable to the world of trading alone. 

 How underdogs Sri Lanka win the Cricket World Cup

During the 1996 Cricket World Cup, Sri Lanka was considered an underdog. Their team was just ok on paper. And before then, they had won just 4 of their 20 games in previous World Cups! No one expected them to even reach the Quarter finals – let alone win the cup.

So how did Sri Lanka pull the impossible?

They understood a change of rules. And bet according to the risk / reward ratio.

In 1995, to make the game more interesting, rules were changed. Only two fielders were allowed out of the 30 yard circle for the first 15 overs of the game! This meant that there were less chances of getting caught out in the deep if you took the aerial route and hit the ball high up in the air.

All the teams adjusted their game according to the new rules. India sent in Sachin Tendulkar to play at a faster pace. Australia groomed Mark Waugh. And South Africa had Gary Kirsten. But when these class players got out playing aggressive shots, their teams tumbled.

Sri Lanka understood this: if teams did play aggressively and lose early wickets, their batting order could collapse. And they wouldn’t post a good total on the board.

So they modified their strategy. They bet two of their players who were not that great with the bat as it is to go higher up the order and hit the ball. If they got out, they still had good batsmen behind them to avoid a collapse.

And so, wicket keeper Romesh Kaluwitharana and off spin bowler Sanath Jayasuriya – two players who usually batted way down the order – were sent to open Sri Lanka’s batting. Their only mandate was: hit a 100 runs in the first 15 overs. (This was during the era when 60 runs in the first 15 overs was considered a lot!)

The strategy worked out and Kaluwitharana hit an average of 140 runs in 100 balls, while Jayasuriya hit an average of 131 runs in 100 balls during the tournament!

And Sri Lanka went on to win the World Cup!

Action Summary:

  • Observe for moments of change. Ask what will be forced to happen because of that change.
  • Make your bet with conviction. Concentrated bets make fortunes. Diversification is a good strategy for people who don’t understand the risks completely.
  • Manage your downside. Understand that your thesis can be wrong. So make bets based on how much you are willing to lose.