Saturday, May 12, 2012

Where's the risk?

I've been thinking a lot about risk lately someone in conjunction with my last post, and otherwise related to reminiscing on some of my investment failures.  I want to use this post to walk through some of my past failures as well as look at changes in how I evaluate investments, and how my portfolio is ordered.  In a way this post will probably be a digital rubber necking for most readers, gawking at some things I've invested in and thinking "really, how? why?"  No one is a perfect investor and I'd rather make mistakes I can learn from than repeat the same mistakes over and over.

Where I failed to see risks

I heard the expression somewhere "You haven't really invested until you've lost a significant amount of money."  If this quote is true, I surely qualify as an investor, losses hurt, let the bleeding begin..

Morgan Stanley

I invested in Morgan Stanley back in 2006 with the idea that they were a decent investment bank with a new CEO who was going to leverage their Chinese relationship into gold.  They were also doing shareholder friendly things like spinning off Discover and MSCI to focus on their core operations.

All was well and good with Morgan Stanley until this little hiccup called the subprime crisis started to appear in 2007.  I kept reading about it, but also read that we'd have a soft landing so I ignored the issue.  I purchased in the $60s and ended up selling out in the $40s sometime in 2008.  I realize I was lucky to not ride it all the way down, but it was still painful.

Seahawk Drilling

I loaded up on Seahawk shares in 2010 with the thesis that the Mocondo spill was a temporary downturn, drilling would be back soon and Seahawk was selling for less than the scrap value of their oil rigs.  I purchased shares all over the place from $7 to $10 and ended up selling in the $3-4 range after they declared bankruptcy.  My hit would have been even worse if I didn't buy a large chunk of shares on the day they declared bankruptcy and sell them for a 50% gain, a lucky trading gain.

What did I miss?  The company was bleeding cash and it was a battle against the clock.  Drilling didn't start back up quick enough and the company was called on a outside liability which they didn't have the ability to pay and forced them to seek bankruptcy protection.

E*Trade

Sometime in 2007 E*Trade started to run into problems with their home equity portfolio and the stock was punished.  Citadel ended up buying a large stake, and the company brought in a new CEO.  At this point I felt that their core franchise was good, and the home equity problems were behind them (see minimizing the subprime above, ugh) so I loaded up on LEAPs.  In the end my LEAPs expired before E*Trade's problems did and I probably ended up with a 80% loss or more.

Discover Financial

I purchased Mastercard back in 2006 and did very well as Mastercard's IPO liability overhang wasn't as severe as many people thought.  The company started to operate for a profit and shareholders were rewarded.  I foolishly thought the same would happen with Discover once it was spun out from Morgan Stanley.  I ended up with some Discover shares through my Morgan Stanley holding, and I believe I purchased more on the open market.

When I read the filing on the spinoff I shrugged off Discover's failed Goldfish card in the UK.  I also minimized the slowly rising default rates the company was seeing, I only saw gains ahead.  I ended up selling Discover at a loss when the financial crisis took a bigger bite out of the company than anyone thought.

Myrexis

A spinoff, and a company selling for less than net cash, what could go wrong?  It was a biotech!!  Myrexis was spun out of Myriad Genetics and given a wad of cash to develop a few new drugs.  I thought the net cash, and spin off situation made this the type of deep value stock investors dream of.  Unfortunately the company worked to squander their cash pile, abandon the drugs they were working on and tried to acquire another development stage company in a massively dilutive merger.

To add insult to injury the company Myrexis was going to merge with (Javlin) fell far below the merger price because the market doubted that the merger would compete.  Another company came in and bid far higher for Javlin giving shareholders a double and leaving Myrexis paying a breakup fee to end up with nothing but ill-will from shareholders.  Not only did I lose money on Myrexis, I could have doubled my money on Javlin.  I even pointed this out to a few other investors but never followed through myself.

What's the common thread?

So in the four examples above what is the common thread?  I either misunderstood, or misjudged the company's liabilities.  In some cases I thought time would heal problems, but when a company is burning cash time is the enemy not a healer.  In other cases a seemingly small liability was actually a bit of a death blow.  In my excitement over the investment I minimized these factors.

It's also worth noting that outside of Myrexis none of my mistakes were in Graham & Dodd deep value stocks.  I invested in two bio-tech stocks for less than net cash thinking these were Graham stocks, but I was deluding myself, a cash heavy biotech with massive negative cash flow doesn't have a margin of safety.  In all of the situations I've been disciplined in applying a margin of safety I've done ok, at the worst I've broken even.

What changed?

The combination of all of the above failures forced me to reconsider my strategies and how I look at investments.  I would previously look at something, and look for where the gain was and how was I going to make money.  I've changed and look at how I can lose money on any given investment.  Right away I look to see how I can poke holes in a company, and if I poke enough holes I walk away.  This makes it easy to look at a lot of companies, most companies I eliminate quickly.  Of course I don't always follow this perfectly, at times I've been prone to put a bit of money towards speculation (see CECO post), but for any substantial holding this is how I approach an investment.

The second change is I won't invest in any company that's not cash flow positive.  I know there are plenty of net-net or value investors who will invest in turnarounds, but that's not for me.  I've been burned a few times by companies that have negative cash flow.  If a company is reporting losses but is cash flow positive I won't exclude them.  In almost all cases if a company is cash flow negative they won't fit in my portfolio.  As of the beginning of last week I had no companies in my portfolio that were cash flow negative, this changed when Titon Holdings released their result, so now I have one.  I need to re-evaluate Titon soon.

How does this affect my portfolio?

I think some of the discussion above is hard to follow if you don't have the context of my portfolio to understand it in.  I don't run my portfolio in any sort of style, I'm not a Buffett investor, I'm not a Greenblatt investor, I don't concentrate like Berkowitz etc.  I will generally invest in anything that appears cheap, safe and has a margin of safety.  I also won't initiate a position bigger than 5%, I will let positions naturally grow bigger than 5%, but I'll never initiate anything higher than 5%.  I usually will start at 1-2% and scale in slowly.  I also like cash, I never let my cash fall below 5%, but I usually have around 10-20% in cash at any given time.  Maybe this is foolish and I sacrifice returns, but I always want to have the ability to buy something no matter the market condition.

Sometimes a 1% or 2% position stays that size, other times I've kept investing until I get to 5%.  I don't have a hard and fast rule as to how I do this.

So currently I have 38 positions not including mutual funds.  I hold a number of index funds and two mutual funds in a 401k and IRA, I don't count these as positions, they rarely change and are a 70/30 stocks/bonds allocation equally divided by US and international.

Of the 38 positions:

  • 12 are net-net's.
  • 3 are community banks trading below book value.
  • 4 are tiny positions in unlisted stocks so I could receive the annual report.
  • 2 are options positions, one a hedge, one a speculation.
  • 2 are spinoffs, one I'm looking for margin expansion, and the second one I hope falls into the below category eventually.
  • The rest are companies that have high ROIC that I'm content to hold while they grow earnings, book value and generally compound at nice rates.  These companies include things like Mastercard, America Movil, Installux, Precia Molen, Goodheart-Willcox and others.
I try to keep my portfolio balanced, I'm not concentrated in any one type of stock, any one sector, or any one country.  The idea is by staying somewhat diversified when I make mistakes in the future (which I will) the losses will be limited.  I've changed my mindset from looking for gains to focusing on how I can avoid losing money.  I've found that when I focus on a strong margin of safety in cash flows and a discount to actual earning power or assets I've done my best.  It's when I deviate from this that I start to notice losses creep into my portfolio.

I'm not even sure if this post will be useful to anyone other than to gawk at myself, but I've found it has been cathartic to write this down.  Thinking about my losses helps me focus on what I know, and what I can control, mainly ensuring a strong margin of safety before I click buy.


Disclosure: Long the good stocks mentioned, no positions in any of the junk.

15 comments:

  1. I just want to say that this post has been useful to me. I've been doing a lot of learning, reading and experimenting with investing over the past 2 years, and I'm just now coming to a point where I can feel confident about my choices when I decide to buy a stock. I've finally started evaluating stocks in terms of their fundamentals instead of their technicals or price history. If I disregard all my previous stock purchases as silly decisions or learning experiences, I've only made one truly informed purchase so far, and I would call it a Buffett-style purchase, investing in a franchise that can compound value. What I've been considering lately is whether to start learning about turnaround situations so that I could try my hand at those, but some little voice in the back of my head kept telling me that it wouldn't be something I'd be comfortable with.

    After reading through your post, that voice has come to the forefront and I've decided that turnaround investing is not for me. Thank you for helping me realize that without having to take any losses by learning the hard way. As for your description of your investing process, it sounds like you give more and more recognition to what you are or aren't comfortable with, so congrats. That's one of the most important parts of choosing an investing strategy that fits yourself.

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    1. Thanks for the comment, as you state knowing yourself is probably the most important part of the investment process. Only invest when you're comfortable, you'll do very well.

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  2. Hi Nate,

    interesting to see how your portfolio managment style exactly mirrors what i try to do.

    For some reasonwhen selecting stocks I always start with the downside which sometimes makes it hard to really to see and appreciate the upside.

    On the other hand, a stronger focus on the downside sometimes results in identifying potential short ideas as well.

    mmi

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    1. MMI,

      I think looking at the downside is the easiest and quickest way to approach a company. If you look at anything long enough you'll eventually convince yourself it's decent. More information doesn't always make better decisions!

      Since I found your blog I had sort of figured we invested similarly, it's good to have actual confirmation.

      I've done my worst when trying to short sell. I've only done options a few times, every time has been a miserable mistake. I decided it's not for me, I'm long only.

      Nate

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  3. Terrific post Nate. I'm curious out of all your 38 positions, what would you say are your highest conviction holdings?

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    1. Good question! I don't really have a highest conviction that I pile into. I of course like most of what I hold, otherwise I'd sell it.

      Given that I really like Precia Molen, Installux, Corticeira Amorim, Mastercard. I'm not happy with some of the recent developments for America Movil, but I'm still holding. As for net-net's I think my highest conviction is probably Hanover Foods, followed by some of the Japanese companies I have.

      Hope this helps, I believe I've written about most of the companies I've mentioned.

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    2. Hanover Foods looks interesting, although their EPS has been steadily declining. How concerned are you by this trend?

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    3. LC,

      I'm not overly focused on the last year or two's earnings. If you take the longer view the company has been growing earnings and book value solidly for the last decade. I think this is a longer term investment (a few years) so being patient is important.

      Nate

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  4. So to be clear, do you think they were bad investmennts because you estimated the probabilities (or the magnitude) of something bad happening wrong?

    Or did you think they were bad investments because something bad happened?

    There is quite big difference between the two.

    Do you have any situations where something bad happened to the investment but you still think the orginal idea of bet was good (ie. you estimated the probabilities correctly but "the coin just didn't land as you had hoped")?

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    1. Really insightful question. I think the answer is they were bad because I underestimated the probability of something bad happening, and it did. In all the cases the potential liability that eventually sunk the investment was there from the start, it's just I overlooked it.

      Seahawk was a strange beast in that my actual thesis was proved correct. A competitor purchased the company's assets and liquidated them for scrap. I listened to the competitor's conf call a few months later and they realized close to the estimated value. So the thesis was right, it's just the company didn't have enough liquidity to get there.

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  5. Nate,

    You are doing what most investors won't do-- confront their own mistakes. That puts you at least a step ahead.

    I am wondering if the subprime/MoStan debacle taught you anything about your macro econ circle of competence? And have you since taken a gander at the Austrian school?

    Most value investors poo-poo the value of understanding the macro picture because they're "buying businesses, not economies." But these investors also seem to be captured by the ignorant, fallacious economic viewpoint of Keynes. And then they step in Keynesian messes like the 2008-09 crash and wonder why they got their faces ripped off.

    So far, I haven't found a ton of explicit, direct ways to MAKE money by understanding the macro situation. But I have found numerous ways to avoid LOSING money by understanding it. Many value traps are connected to changing macro economic paradigms.

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  6. Great post Nate - publicly admitting mistakes is tough to do, but I'm sure you'll be a better investor by doing it.

    Tom L

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  7. Some of what you say about analyzing your "mistakes" is right -- sometimes you are wrong and there are things you missed. However, in other cases -- you just make a calculated bet and things go against you. For example, if someone offered to flip coins with you 10 times and were willing to pay you $1k every time it landed on heads, and you'd have to pay $500 every time it landed on tails you'd take that bet right? It's possible that after 10 flips you lose money, but it doesn't mean you made a bad bet.

    This is especially true if some investments are special situation investments involving legal outcomes such as GYRO or TIVO.

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  8. Oh and I forgot to mention sometimes you hit big winners when your thesis is completely incorrect as well.

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  9. Nate, great post. I think this is very helpful as a lot of analysts and bloggers either arm-chair quarterback or suffer serious survivorship bias in presenting outcomes. Understanding the thinking and process that go into an investment are vital. Ex ante analysis of outcomes is golden. Thanks for putting this up there. Studied mistakes are the seeds of true learning.

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