Investment lessons learnt year 2005 - D.O.G.

d.o.g. posted on 30-12-2005 at 19:31

1. When fundamentals deteriorate, sell NOW.

I hadn't actually learnt this one properly *sigh*. It happened again 4 times(!) before I got it right the 5th time and sold quickly. I must be a slow learner...

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

I have owned (and still own) stock in companies which were (and still are) market leaders. So far the record is mixed - some did well, some went nowhere and others went south. So current market share is not necessarily a good indicator of future investment returns.

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

This is absolutely true. However you not only have to acquire the information. You also have to ACT on it. Failure to act on the information cost me dearly 4 times (see: deterioration of fundamentals) though fortunately I saw the light the 5th time and quit in time. No insider information was involved - just conclusions reached from executives' choice of words and their body language. Not just AGMs and EGMs too - any meeting with company executives should be pursued.

4. The margin of safety must be sufficient.

I learnt that numbers alone are not sufficient - information gleaned at AGMs, EGMs and other meetings with management can change the gut feel enough that action should be taken. If I'd included gut feel in the margin of safety, I would have avoided losses on 4 occasions where I had a change in gut feel but didn't act.

5. Beware companies in cyclical industries.

The rise and fall of HG Metal was pretty scary even from the outside, enough that I won't go into cyclical companies without first having a clear exit point. Definitely no "buy and hold forever" attitude for these type of companies.

So that's it - my 10 cents (5 lessons @ $0.02 each) from 2005. May everyone's 2006 be better!

posted on 1-1-2006 at 08:55

I was fatally optimistic that the near future would look like the recent past. I forgot that the recent past is only a starting template, and that the final analysis must depend on current inputs - inputs which I sought and received, but failed to use properly.

Oh yes. One more thing I learnt:

6. Dividends are important.

Some value investors may remember that in the US, from 1802 to 1992, 80% of the total real return of stocks was generated by the reinvestment of dividend income. For me, the lesson was learnt a lot closer to home, "up close and personal" in my own portfolio.

This year, my 4 biggest mistakes cost me, on average, 29% of my invested capital. Unfortunately the biggest mistake, a relative loss of negative 48% on a cost-to-cost basis (excluding dividends), was also the biggest absolute loss. It was the 3rd largest holding, representing about 12% of my portfolio just before the bad news broke and the price crashed.

The saving grace was that my dividends (from the entire portfolio, including the mistakes) were more than enough to cover all the capital losses and put me comfortably into positive territory. So... dividends are cool. For me, 2005 was definitely the Year of the Dividend, not the Year of the Rooster.

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CAVEAT: don't be blinded by dividends either. My biggest mistake was also one of my "best" dividend payers. Financially, it seemed sound: pristine balance sheet, good profit margin, high ROE etc. Investment-wise, it had a seemingly reasonable price and a good dividend yield. And so I foolishly dismissed the warning signs:

Warning 1. At the AGM, the CEO was roundabout in answering questions about how business was going.

The company executives can't discuss anything materially related to profits. However, they can (and often do) reveal useful information regarding the level of sales, order backlogs, inventory levels, cost of materials, manpower costs, freight costs and so on. All these can be used to deduce what the amount and sustainability of earnings is likely to be.

In this case, the CEO was very circumspect, saying only that they were "having difficulty finding clients who can pay us in the way we want" (yes, what a mouthful!). In hindsight, I realize that his choice of words indicated that business was not good - clients were either paying too little or too slowly, or both. He also noted that there was global overcapacity in the industry. I blithely ignored this and assumed the company's niche (#2 in its niche markets) would protect it from price erosion. WRONG.

Warning 2. Senior executives were no longer big shareholders (vanished from the top 20 shareholders list).

I asked the executives this, and they said it was to diversify their personal portfolios for the purpose of financial planning. This sounded at first like it made sense, but I was not satisfied because they could have sold 1/2 or even 2/3 of their holdings, and they would still have been in the top 20 list. So they either sold most of their holdings, or moved them into a nominee account to hide future changes. Either way, this was no good.

Looking back, I now consider this a red flag, similar in some ways to how some of United Foods' shareholders sold a large part of their holdings around the same time. I would also be careful of companies where the controlling shareholder sells a big bunch of his own shares to "improve liquidity." This is obviously just cashing out when the price is good.

If the company is going to do very well in the future, why would the controlling shareholder (or any senior executive) sell? Only if he thinks the company will not perform up to expectations reflected in the share price, will he sell. Otherwise he can just wait a while for the results to come out, and then sell at an even higher price.

Warning 3. Succession plan was not in place.

The CEO was an outstanding executive, and well-respected in the industry. A really all-round good guy. Problem was, the company had no clue who would take over if he got hit by a truck. The trusted lieutenant is not always the best person to take over. In this case, there were 2 senior executives who could have taken over, except that neither was willing to do so - both were content to play their supporting roles. So, if something happened, the void could not be filled. As it turned out, the CEO quit, and nobody was available to take over. Oops.

Since everyone dies or quits eventually, I think this is an important question that companies must answer. In my case, it seems to come up quite often, perhaps because I have a bias for companies with experienced management, preferably with decades in the industry. This means that the management is often quite old... and while they are usually highly capable, they are also usually uncomfortably near to (or even beyond) retirement age.

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There is a silver lining to the expensive mistake: I learnt to be more suspicious. And so, at a subsequent AGM at a different company, when I got answers from management that made me less than completely comfortable, I said to myself "no you won't get me again" and bailed out, giving up the upcoming dividend. It was going to go XD only after the first quarter results announcement, but I was quite sure the results would not be pretty, so I gave up the dividend and sold out with only a small profit.

Epilogue: the first-quarter results were poor, as I expected, and the price went downhill. Then the second-quarter results came out even worse - abysmal, in fact - and the price went into serious freefall. Fortunately, I was not part of the carnage, having already exited a few months back.

So as the markets open for 2006, I'd like to encourage everyone to share on what they've learnt in the past year.

There is no shame in making mistakes, only in failing to learn from them.

Happy New Year!