I’ve been debating in my mind how I would write this piece. In the end, I just decided that I would tell it plain. Part of investing is losing money. There is a connection between willingness to lose money in the short run, and ability to make money in the long run. My experience has been that if you don’t take the risk of losing significant money, you don’t make significant money. Another way of saying it is that if you don’t blow one up every now and then, you’re not taking enough risk.
With that introduction, let me present my 10 worst losses since starting this strategy 7.7 years ago, beginning with the worst, and moving to progressively lesser losses. These ten losses comprise 55% of the total dollar value of losses since I started this strategy.
What can I say? My original thesis was that Deerfield was a mortgage REIT that did it right. In spite of my negative real estate views, I did not think that the risk would extend all of the way to prime mortgage and Alt-A (no stated income) collateral. Alas, my training as an actuary should have told me to avoid companies dependent on market confidence to maintain financing. As the repo haircuts rose, free assets diminished, aand they had to collapse their balance sheet. My main mistake was thinking that repo haircuts couldn’t get that high. I was wrong. I finally sold when I thought the likelihood of insolvency was significant.
I got in this one too early. My industry models sometimes flash “cheap” when things will get cheaper. Sometimes I have the sense to remember that. This time I didn’t. YRC has more debt than I would like, but it has a huge amount of upside when the economy turns. Waiting for that turn could be fatal, but I continue to do so. One other note: for the remainder of this piece — where my graphs say exit, it does not mean sale. For companies that I still owned at 4/30/2008, I market them down as “exited” because that is where my calculations end.
The jury is out on this one. As with all of my investments, I try to analyze a company versus its likely future prospects. I don’t care a lot about the past, I just try to analyze current price versus future prospects. My estimate of future value warrants continued inclusion in the portfolio.
Catch a falling knife? When there is fraud, I give other investors a pass. As for me, I should have known better. Cash flow was light relative to earnings — not a good sign. Another warning sign ignored: avoid managements that are self-absorbed. Dynegy and their investment banks had to kick in to fund a settlement. (Note: it is only worth going through the settlement process when a deep third pocket gets tagged. Most fraud cases are broke, and only the lawyers do well.)
I’m afraid that friends influenced me here; a number of people in my investment department owned Dynegy, and when I bought, e comment was “Welcome to the Dark Side.” Dark? — better to say red ink. I can’t prevent being taken in by fraud, but I can minimize it if I focus on companies with strong cash generation. It’s hard to fake free cash flow.
Jones Apparel Group
Again, my industry models flashed “Cheap” too soon. Everything depends on whether Jones can turn their operating businesses around. I think they have a chance, and given the recent sale of one of their subsidiaries, there is enough cash. That said, I tend to worry when debt levels verge on high, and the debt maturities are near. There is a new CEO, who was the old CFO. At present, I still think there is value here, but I will take my loss before the end of 2008 if earnings results don’t turn.
Cable & Wireless plc
One of my ways of trying to make money is to buy strongly capitalized companies in an industry that is having troubles. Well, the strength of C&W’s balance sheet was overstated; there was a bit of a fraud issue there. And, I should have listened to Cody Willard, who e-mailed me before we really knew me, and said something to the effect of, “Yeah, they have a balance sheet, but no good businesses. Can’t make money with that.”
Part I Summary
Every loss is stupid in hindsight. We all get tempted to say “woulda, coulda, shoulda.” But the same principles that led to my losses also led to my greatest gains. Two articles from now in this series, I’ll go over those. But it is best to lead with failure… we learn far more from our failures than our successes. What are my lessons here?
- Don’t play with companies that have moderate credit quality during times of economic stress.
- Measure credit quality not only by the balance sheet, but by the ability to generate free cash.
- Spend more time trying to see whether management teams are competent or not.
I’ll see if I can’t do better on these concepts in the future.
Full disclosure: long YRCW and JNY