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..
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.
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.
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.
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.
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.
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.