Managing Mistakes

A reader recently asked me to talk about my sell discipline and past mistakes. It’s a good subject so I thought I’d do a quick post.

As I’ve stated many times, limiting mistakes is very important for absolute return investors. While we can’t eliminate them, I believe mistakes can be minimized by following some basic guidelines. Rules that have helped me limit mistakes include: refuse to overpay; understand and normalize profit cycles; use realistic valuation assumptions; avoid businesses that can’t be valued (i.e. unpredictable cash flows or unmeasurable liabilities); separate operating and financial risk; ignore benchmarks and peers; embrace patience; and finally, focus on established businesses with sufficient operating histories (necessary for accurate valuations).

While I believe these guidelines have improved my batting average considerably, I have and will continue to make mistakes. One of my favorite presentation slides listed all of my winners and losers since 1998 (defined as realized gains and losses). It was an interesting and unique slide, as it included every mistake I’ve made over the past 18 years. Fortunately all of my losers (highlighted in red) fit in one column. I found this slide very useful when communicating with clients and potential clients. A popular question or request for portfolio managers is, “Tell me about a mistake you made and what you learned from it.” I’d respond, “Turn to page 18. They’re all there. Which one would you like to discuss?” Wouldn’t this be an informative slide for all active managers?

One of my first and largest mistakes of my career was The York Group (YRKG). If my memory serves me correctly, it was a -50% realized loss. It was a meaningful loss on a full position and it hit me when I was already having a tough year (1999).

The York Group was a market-leading manufacturer of caskets, behind Hillenbrand. When I bought their stock it appeared to be the perfect stable business and industry – death care. How could I mess this one up? While growth was slow, revenues and cash flows were very predictable. Assuming you could get over the uncomfortable nature of the business, the death care industry had many attractive attributes of a high quality business. And Wall Street seemed to agree.

In the mid-90s, Wall Street was busy helping the market-leading death care companies (mainly funeral homes) consolidate. Wall Street was racking up investment banking fees and placed strong buy recommendations on almost every death care stock. Death care quickly went from a pile of boring low-growth private businesses to an exciting publicly traded growth industry! However, in the end, it was just another roll-up scheme that ultimately ended badly for many of the funeral home consolidators and investors.

I wanted to learn more about the industry, so I decided to attend one of the death care conferences in New York. I’ve never been to an investor conference quite like it. This was a group of companies rooting for a bad flu season. It was strange and a little uneasy, but ultimately I accepted that these were simply businesses providing society with necessary products and services.

I eventually became quite knowledgeable of many of the companies in the industry. After getting to know the industry better, I decided I didn’t want to own the funeral homes. They were expensive and I’d been investing long enough to know the risks associated with roll-ups and aggressive acquirers. Instead of buying the funeral homes and cemeteries, I focused on the companies that sold to them, like the York Group and Mathews International (caskets and bronze memorial plates).

So how did I lose money on what appeared to be a relatively low risk investment? To put it simply, things went wrong. First, the company lost a large contract to its largest competitor, Hillenbrand. While I knew this was a risk, I didn’t properly discount for the revenue concentration and contract risk (I should have used a higher discount rate in my valuation model). Furthermore, the negative operating leverage from the lost contract was greater than I expected (I should have used a lower worse case cash flow assumption in my scenario analysis).

In addition to the drop in revenues and earnings, the lost contract caused management to panic. To replace the lost revenues, York made a large acquisition of a bronze plate manufacturer.  The company took on debt and paid a healthy price. To make the acquisition work and improve profitability, management consolidated the bronze plate manufacturing facilities. The strategy backfired and caused bottlenecks and delivery issues. To make matters worse, York’s balance sheet was now leveraged with debt from the acquisition, limiting their financial flexibility.

My “sure thing” low-risk investment quickly transformed into a large unrealized loss with operating risk and financial risk. And this is when my sell discipline kicked in. When I purchased The York Group they had a strong balance sheet (low debt to cash flow) and low operating risk (very consistent business). After I purchased their stock, they eventually took on both forms of risk.

I’m comfortable assuming financial risk or operating risk, but never both. When investors assume both forms of risk, the probability of a business operating under distress or the threat of bankruptcy is elevated (leveraged energy stocks in 2015-2016 are great examples). As an absolute return investor, I never want to position myself to have a stock go to zero. Stocks can recover from a lot of things, but zero is not one of them. Avoiding and selling businesses with operating and financial risk has allowed me to keep goose eggs off the scoreboard and limit large losses.

Another reason I’ll sell is if I feel I can no longer value the business accurately. If something occurs while I own the business that creates too much uncertainty in cash flows, assets, or liabilities, I will sell the stock.

Lastly, I will sell a stock when it trades above my valuation and I’m no longer being adequately paid to assume risk. Fortunately, this has been the reason for most of my sells over the past 18 years.

Before I conclude, I want to touch briefly on averaging down on positions with unrealized losses. I will average down assuming I remain confident in my valuation AND my valuation is stable. If my valuation is in decline, I will not add to the position. If I’m forced to reduce the valuation of a business, I clearly got something wrong. Either my discount rate was too low or my cash flow and growth rates were too high. To protect myself from myself, I like to wait for my valuation to stabilize before adding to a position (I update my valuations quarterly).  I don’t want to be stubborn and buy a company all the way to zero (I call it pulling an Enron). My valuation in decline rule, helps me avoid emotional buying driven by my ego (yes, we all have them and they can be very dangerous!).

I hope my sell discipline and guidelines help you think of ways to reduce meaningful losses and mistakes. What’s that famous Buffett quote? Rule #1 don’t lose money. Rule #2, don’t forget rule #1. I really like that one as it fits the absolute return mindset perfectly!

I’m looking forward to the end of the current market cycle when we discover who has been following all of the rules of successful investing. During periods of inflated asset prices and extended market cycles, rules on minimizing mistakes aren’t very popular. Thanks to the reader for requesting and reminding me of its importance.