Investment Lessons Learnt This Past Year (2004)

d.o.g. posted on 1-1-2005 at 13:26


As we begin a new year, perhaps we can all take a moment to look back at how our own investment skills have been enhanced over the past year. Doubtless there were many surprising developments in our respective portfolios, both pleasant and unpleasant. UOL and CAO are obvious examples of such unexpected developments.

While it's tempting to engage in mine-is-bigger-than-yours comparisons, I think it will be more meaningful for each of us to share what we learnt this past year, in investment terms, rather than relate our respective gains or losses for 2004.

Sharing knowledge enriches us all, while comparing portfolio returns will merely generate envy and resentment. I'm not ashamed of my 2004 returns, but putting up the numbers won't help anyone learn anything. (FWIW I ended 2004 in the black, though my returns were far behind what I got in 2003.)

Back to investment lessons:
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1. When fundamentals deteriorate, sell NOW.

I had several holdings whose fundamental operations deteriorated significantly during the past year i.e. the negative events were not one-off in nature. That made their current prices unattractive from an investment viewpoint. Some holdings I sold as soon as I could, the others I held for a while before deciding to sell. In each case, I realized a net loss, but where I hesitated to sell, my eventual loss (in percentage terms) was larger.

So I've learnt, in a rather expensive way, that it's better to sell too early than too late.

2. The market leader is not always a good investment.

One of my holdings was the dominant player in its domestic market. However, the management expressed reluctance at the AGM to either gun for more market share at home, or to expand aggressively overseas. It preferred instead to maintain its market share while waiting for cheap overseas investment opportunities to come along.

Yet it seemed to me that it would only be a matter of time before foreign rivals would muscle in on its home turf. Without overseas operations to either counter-attack its rivals, or cross-subsidize a price war at home, there didn't seem to be much promise in its future.

(Building a castle and defending it with a big moat is all well and good, but without an army out there attacking rivals and capturing other castles, it's inevitable that eventually a big enough invasion force is going to show up, and then either destroy the castle utterly, or force it to surrender.)

Indeed, a foreign challenger had recently come ashore, and the management didn't seem to have any good answers at the AGM as to how they were going to fight it off.

The company was (and still is) well-capitalized, but I felt that its current conservative strategy did not augur for a prosperous long-term future. So I walked away. After factoring in dividends, I had eked out a small gain.

The lesson? Management at a leading company can get too comfortable.

3. AGMs and EGMs are a valuable source of information.

Though material information such as profit forecasts cannot be disclosed, it is possible to obtain an update on operations, especially with regards to seasonal trends and whether the outlook is good or difficult.

It is also the only time when investors will be able to ask the management questions face-to-face. There is a lot of difference between off-the-record answers given on the spot, and answers carefully prepared and sent via email.

In addition, one has the opportunity to listen to other investors who can also put forward questions that one has not thought of. There is no monopoly on investor intelligence; other investors can and do ask good questions. Of course, one must be patient - most of the questions asked are either irrelevant (share price) or redundant (already in the annual report).

The meetings I attended provided me with enough information to change my analysis of the companies. In most cases, I opted to change the level of my holdings, either selling out or buying more.

The bottomline: Take every opportunity given to talk directly to the management.

4. The margin of safety must be sufficient.

I learnt the hard way that the margin of safety can only be sufficient when there are multiple criteria for investment. An excellent profit margin, an efficient management, stupendous growth potential, a good dividend policy and a low price are individually insufficient to justify an investment decision. They should all be present to some degree, but more importantly, strength in one area cannot offset weakness in another.

It is difficult to make a good investment out of paying a high price for growth. Nor can efficient management replace a sound dividend policy, and certainly a low price is no panacea for a weak profit margin. Each investment criterion must in itself be satisfactory, and several should be more than satisfactory, before one can invest with the confidence that one's principal is appropriately protected, with a good potential for satisfactory returns.

I invested in a few holdings this year on the basis that cheap valuations, stable businesses and good dividend policies could offset low profit margins; this proved to be unsound, with each of these companies subsequently running into problems which severely eroded their earnings. Going forward, I no longer think it worthwhile to invest into a company that has a red flag or black mark in one or more investment criteria. There are many companies that do not exhibit these problems; why knowingly buy a flawed company?

(I must however acknowledge that "vulture investment" into distressed securities can be extremely profitable for the expert. But these constitute "special situations" and are not a part of normal investment activity.)

Key point: The margin of safety must be provided by multiple criteria.