On Making Investment Mistakes and Getting Lucky
Unscheduled maintenance: Apologies to those of you who tried to access StudentOfValue.com in the past week and failed. Last Friday, there was some unscheduled downtime due to issues with Amazon's cloud, where this blog was hosted. Coupled with other issues I had with the service, I once again moved the site to a new hosting provider. Now, I am with DigitalOceal.com and so far, so good.
While I was working on this post, Howard Marks’s latest memo came out (read it). There I learned that Twitter founder Jack Dorsey claimed, “Success is never accidental.” Coming from the founder of a hugely successful, internet, 140-character-limited SMS service, it makes you wonder what luck is.
Twitter started as a side project at a failed podcasting company. It has been mentioned dozens of times under the What Were the Most Ridiculous Startup Ideas that Eventually Became Successful question on Quora. If Twitter’s success wasn’t luck, then what is, really?
From Marks’s memo, quoting Ed Smith’s article In Defense of Luck, we learn that:
Denying the existence of luck appeals to a fundamental human urge: to understand, and ultimately control, everything in our path.
Last week, I reminisced about the past 5 years. By default, such overviews smooth out the kinks that mark the true historical record, unless your name is Madoff and it was smooth all along.
I admitted that the timing of my first investments was very lucky and somewhat reckless. Yet, 2009 was my best of all five in the markets. Take this as an illustration of the adage that it’s better to be lucky than good. And in the short term, it is. But luck turns. On a longer time scale, you eventually run out of luck. This is why value investors emphasize process. Good results don’t necessarily follow from a good process. But, process is persistent and can be improved. There is nothing you can do about luck. Making your own luck is improving your process and living long enough to pick the fruit or, as some have put it more succinctly, it is where preparation meets opportunity.
The best way to improve – be it in investing or other areas of life – is to, first and foremost, learn from the mistakes of others. Save your precious time and avoid discovering the wheel. By best I mean the most painless and cheap.
However, if I take best to mean the most lasting and impactful, then nothing beats your personal experience. As Mark Twain put it in his wonderfully jocular way:
A man who carries a cat by the tail learns something he can learn in no other way.
I, for one, have dragged a whole bunch of cats by the tails in my 5 short years of practice. One was not enough. I like to make sure I got the lesson right.
A Huge Non-Lethal Investment Mistake
You may find this very boring and predictable, but my worst mistakes were in retail – value investors’ graveyard.
Retail is a hugely competitive sector. A successful retailer has to serve a very specific customer need, in the right location and store format, offering the right merchandize selection and in-store experience. As an investor, you have to have a good grasp on these dynamics. Judging by JCP, even activist investor legends like Bill Ackman slip up on retailers.
Here is what I was looking at in late 2010.
What I saw was a mature retailer with relatively stable revenues and decreasing profitability, still throwing off $200-250m cash annually, selling for 8-10x that. Not exactly a screaming buy, but the price was falling – soon to reach 6-7x. Interested? I know I was.
In reality, I was looking at a dying, crummy electronics retailer by the name of RadioShack (RSH). What followed was a landslide of bad news: earnings plunges, margin declines, dividend cuts, and executive turnover, accompanied with steep, steep price declines. Of course, as a value investor, the last item just piqued my interest.
People blamed Amazon, except, at the time, Amazon had been around in a big way for a decade. Maybe customers were still just getting comfortable with the idea of shopping online and the financial crisis provided the necessary nudge for them to look for better deals, even without first seeing and trying the merchandise or alternatively, using BestBuy and RadioShack just as showrooms. This is more believable. Yet, it doesn’t accommodate for BBY’s 250% gain last year, or HGG’s 100%.
Other plausible reasons are the lousy locations, poor selection, and bad customer experience offered at RadioShack’s stores. As I said, a retailer has innumerate ways to go wrong. All the factors above were at play simultaneously, making it hard to tell which had the most weight in the company’s decline.
As far as I am concerned, the worst problem with RSH is its lack of focus. The company doesn’t have a reason for its existence. At some point in the early 2000s, with the rosy dotcom goggles shattered, RSH had a choice to make – whether it would shrink considerably and fill a much smaller, hobbyist electronics retailer niche or pursue a bold, new growth strategy. Not much of a choice, when you look at it from the distance of time.
However, few CEOs are keen on shrinking their kingdom, even when it’s a question of shrinking or losing the kingdom. RSH’s management decided to pursue growth through a mobile platform – selling mobile contracts and prepaid cards, along with mobile phones and accessories for them.
What special could RSH offer to the customer shopping for a mobile phone? Not much apart from convenience maybe, due to its 4,000+ locations. Why else would anyone buy an iPhone at RadioShack instead of at the iStore or at their operator’s store. Besides, what are the margins on mobile phones and plans? Although sales dropped only 11% in the past 15 years, gross margins came down from 50% to 40% to 30% in the last reported quarter. Obviously, the bunch of overpriced trinkets you sell together with a new phone don’t justify making this your main focus.
Instead, scaling back and targeting a small hobbyist niche could have been sustainably profitable, though painful to do. If RadioShack focused on being to electronics hobbyists what Danier (DL:CN) is to leather hobbyists, it would have fared much better. Of course, instead of $4b in sales new RSH would be happy to reach $400m, but gross margins would never drop under 50%. RSH was doing great at 50% gross. The much reduced scale could have been handled by a capable management team.
At the time of my purchase, I considered this the logical path. What I didn’t consider was that the logical path doesn’t necessarily have to be the one taken. There was no evidence, no hint, in the letters to shareholders or the MD&A section of the annual report that RSH may shrink its business and focus on the hobbyist niche. There was just evidence of declining sales and margins, and inventory build-up. Evidence I chose to ignore – a completely unforced mistake.
Another mistake related to my unfortunate RSH investment was that I anchored my view of the company to the 12-year period between 1998-2009. During that time, RSH did splendidly: nearly $5b in operating income; $3.5b free cash flow with $2.7b net income. Apart from the peak of the Dotcom Bubble and the trough of the Great Recession, the stock price was constantly in the $20-30 range. I mistook this for stability.
However, I didn’t buy immediately after I had done my research. Back then, in late 2010, I was still not happy with a price around $20. But, as it started declining in 2011, I took a small position at $14.50 – just to keep my attention.
The story could have ended here – much less intricate and costly than it eventually turned. But I could do better. I had more foolishness in me. The 2010 annual report came out and the bottom line wasn’t much changed from the previous year.
Moreover, at some point in the second-half of 2011, I listened to a lecture from one of my favorite value guys, Francis Chou, or maybe read his letter. You can find his lectures at The Ben Graham Centre for Value Investing at the Ivey School of Business. Chou likes making fun of himself by saying he invests in CRAP companies, meaning cannot realize a profit. So, subject to more confirmation bias and whatever the bias of following your favorite investors is called (herding?), I decided to increase my position.
The only problem was that the price was still not low enough. It was under my $14.50 entry, but I wanted a larger margin of safety if it were to turn into a full position. Torn between buying and waiting, I went for the middle road and sold puts expiring in January 2013 with a $5 strike. Why sell puts? Because I really wanted to increase my position in RSH and $5 seemed like a steal back then. The cherry on top was that I collected the premium immediately. What could possibly go wrong?
No need to stretch this already long post. Time went by and things went wrong. I started 2013 with a decent position in RSH at an average cost a little over $5 when the market price was a little over $2.
In a final fit of loss aversion, I didn’t sell when the price breached $4 during the year.
Having run the whole gamut of behavioral biases, I start 2014 with this legacy, as they like to call them, problem. I am using this post to retrace my path into the trap, draw some lessons, and decide on my next step.
Do I sell immediately or do I wait for a change in perception? It worked for BBY and HGG.