Investing mistakes - I've had my share this year. I'm a relatively novice investor (I bought my first individual share in September last year) so I expect to have my fair share of errors as I go along, the key thing as I see it is to learn from my mistakes to prevent their repetition as far as possible. So, without further ado, here's a tally of my investing cock ups:
1) Elektron Technology - EKT
Technically this is a mistake of 2011, my only action in 2012 was to sell my remaining shares in January at 23.3p. Given the market price is now 17.3p this was arguably a successful decision! However it's worth a look at because I think the mistake I made here is an easy one to do and one I anticipate I'll inevitably make again - trusting in management who aren't operating in shareholder's best interests.
The Chairman, Keith Daley, currently owns 13% of the company, which is normally a very good sign. Management who are owners overcome the principal-agent problem and tend to act in the better interests of shareholders. Key word - tend to. The incident in question that led me to selling out here was this statement:
Wow - management awarding themselves bundles of shares - giving away almost 10% of the company in one fell stroke! Now I'm all for management being well incentivised, but this was beyond ridiculous. Such an action is effectively a big middle finger to all non-management shareholders. The business may be selling well below the intrinsic value right now but with management having shown they are in this to maximise wealth for themselves at the expense of other shareholders, who'll be the end recipient in the long run of this value? Given there's cheap companies out there which have shareholder-friendly management why take the chance?
There's plenty of ire on the ADVFN company board about the management even before the JSOP announcement. My mistake was not investigating this further before I bought at 32.3p - d'oh! One last piece of irony is that one of the board members has written a book entitled Angels, Dragons and Vultures: How to Tame Your Investors... And Not Lose Your Company. The writing really was on the wall... or rather, in the book.
2) RSM Tenon - TNO
Oh dear, oh dear, another 2011 hangover. I bought at 20.6p back in October 2011 and sold in February at 5.8p. The price is essentially the same today but is highly volatile as the equity is now essentially just a stub - the business is bordering on insolvency. There's a good number of mistakes I made here so it's good to go through them all.
a) Read the bloody cash flow statement & be skeptical of accounting profits!
TNO showed operating profits of £30m in 2011, which put the share price on a very attractive "adjusted" P/E of just over 3 at the time of purchase. I say adjusted because actual net profit was only £7.5m due to all the exceptionals, which is another warning sign. The really big warning sign here though was in the cash flow statement. Since 2008, the business was cash flow negative every year despite showing increasing "profits". Accounts receivable were building up, and up, and up...
It all came crashing down in February 2012 after the company reported a loss of £70.5m. Ouch.
b) Balance sheet strength
TNO had significant amounts of net debt, ~£65m, at the time I invested. Whilst a bit of gearing, used wisely, can be a useful way to boost ROEs in this case it meant that the downside here was huge as the equity could easily be wiped out (as I found!) which dramatically changes the risk/reward profit of the shares. I now strongly prefer strong balance sheets when investing as it means that, even if the company has a few rough years, they're able to ride it out and come through the other side if the business is one that's long term viable.
c) Relying on other investors to do the research for me
This was just pure laziness on my behalf. I actually spotted the previous two warning signs before buying the shares and bought them anyway. Why? I saw that Odey Asset Management had taken up a long position in the shares. I assumed they knew better and had done their research - Crispin Odey has a good reputation as an asset manager and is certainly a far better investor than I am. The lesson? Even experienced hedge fund managers get it wrong from time to time - DYOR.
d) Be skeptical of roll ups
I've recently read a book entitled Billion Dollar Lessons - a fantastic read by the way - which analyses corporate failures over the years to look for patterns to learn from. One of these is the high failure rate of roll ups. The story is simple, acquire loads of similar businesses to benefit from synergies. Great idea, right? Sadly, often not. I recommend reading the book to learn why - most of the lessons I think apply to RSM Tenon.
3) Playtech - PTEC
Ah, Playtech. I love the company. It's in an industry that I know well (I used to work in it) and I have a strong admiration for the market position Playtech have in it. The business will do well over time, however I'm not touching the shares. I actually made a profit on this purchase (I bought at 337p in 2011 and sold at 354p in May this year) but I still consider it a mistake, and not because the share price is now much higher at 427p. The company is arguably still very cheap even after the rise at which I sold them at a forward P/E of 10 and a near 4% dividend yield. So why did I sell?
Two words - Teddy Sagi. The founder of Playtech and owner of a large percentage of the shares. This is a man who knows how to play the capital market games in his favour very well - especially at the expense of other shareholders. He has a history of getting Playtech to buy his other companies at, shall we say, fairly generous prices. Of course, the Playtech board say they each purchase is at a fair price and their nominated advisors, Collins Stewart, are happy to put their names to it for an independent assessment but when you get an acquisition at seven times "adjusted EBITDA" you should suspect things to be a bit up. Adjusted EBITDA, as Charlie Munger would call it, translates to "bullshit earnings".
The truth came out in the final results where more details of the acquisition were revealed. The balance sheet was essentially full of nothing but intangibles (tangible book value was negative) and PTTS generated just €3.5m of profits in 2011. Given the acquisition price was €140m with an earn out of another €140m shareholders paid between 40x to 80x 2011 profits for this acquisition! No surprises also that the full earn out was paid in the end.
Let's also not forget the placing that was done at the bottom of the market, underwritten by Teddy Sagi, allowing him to increase his holding at a dirt cheap price.
Playtech will make a lot of money over time - it's very well placed in its market to do that. Sadly, I get the feeling that most of that money will end up in the pockets of Teddy Sagi and not the other shareholders. €280m is 3.6x the total profit that Playtech made in 2011 - that's many year's previous profits that the shareholders won't ever see, because they are now Teddy's profits. Oh well, at least they have a nice new business making €3.5m in annual profit...
4) French Connection - FCCN
I first bought FCCN in 2011 at 86p, then again in April 2012 at 43.4p (Ouch), then once more in August at 20p (Ouch!). So, what went wrong? Simply, FCCN was a turn-around story that didn't turn around. The company has buried within it a very profitable wholesale division but is burdened by the loss-making retail division. When I first bought, profits at the wholesale division were growing nicely and the retail side looked to be under control. Then, things just stopped getting better. The company announced sales weren't going as well as hoped and then they announced double digit sales declines as well as a whole host of 'measures' they were taking to remedy the situation - most of which looked like things they really should have been doing all along. The price crashed down to 20p.
I'm actually now only down 25% overall on FCCN ('only'!) as the price has since recovered slightly to 29p. The earnings story has disappeared for the mean time, replaced by losses, but the balance sheet is still very strong and the company is trading at 43% of tangible book value. I think the risk reward balance is in my favour at the current price, and the company sounded cautiously optimistic at the end of the most recent trading update.
So if I'm still long term positive (at least at the current price), what do I consider to be the mistake? My original investment case was built entirely on earnings - specifically, earnings growth. I had no real basis on which to place this - I have next to zero understanding of fashion and for a retailer like this tastes can change on a whim, something I didn't pay enough consideration to in my original investment case. For a company that is operationally geared this leads to disaster. The earnings history alone would have told me that unpredictability was high here and I should have been more cautious. Contrast this with my investment in Debenhams, another retailer, but one that doesn't sell one particular line of clothes for which fashion could swing wildly. The earnings history of DEB is far more stable which can give an investor far more confidence in their valuation on an earnings basis.
However, another good lesson here is to contrast this case with TNO. In TNO, balance sheet weakness lead to my error in guessing future earnings to cause a virtual wipeout of my investment. With FCCN, the investment case has simply changed to an assets-based valuation whereby I have time to wait for the company to try and fix things because of the balance sheet strength. Maybe they will, maybe they won't, but it takes a lot of losses to wipe out the remaining £65m of tangible equity. If they do manage to turn things around there's the potential for significant multi-bagging as the previous expectations of decline in to oblivion get re-assessed. Fingers crossed for next year!
5) Software Radio Technology - SRT
Ah, SRT. This is the classic share I normally avoid like the plague. Few hard assets, no proven earnings and a punchy market cap that expects a lot. The CEO, Simon Tucker, gave a presentation at a Mello event and the story seemed (and still is, kind of) incredibly compelling. Huge market, mandated purchases, little competition etc etc. However a string of missed targets now calls in to question the whole investment case. Orders have always been a bit lumpy, but it feels like every results the next big order is just around the corner. Just not this particular corner.
I allowed myself a little punt on SRT because the story seemed so compelling and so likely to happen (don't they all?) but thankfully I at least had the sense to realise that an investment here was inherently high risk and speculative so limited myself to a small percentage of my portfolio. I topped up at 20p shortly before the shares got tipped by Midas and banked a decent profit before the shares continued their decline. I still hold some shares although it's still a small position for me. I'm a patient person and I'm curious to see how this case turns out so I'll probably hold on to the remainder regardless of what happens. Currently, I think of it as paying a low price for a good lesson - stick to value investing!
P.S. It's interesting to note that, as mcturra points out, the share qualifies for James Montier's Holy Trinity of short selling. D'oh!
6) Chemring - CHG
I outlined my original thesis on CHG at TMF. Presciently, I included the one following line:
"To be honest I don't know the defense sector well at all..."
Which was largely to prove my downfall. Earnings collapsed in a way I didn't expect and the share price fell with it. Thankfully, SaintGermain stepped in and sounded a cautious note in the thread which put me off stepping up my position size. He basically hit the nail on the head with statements like these:
"Industry slowdowns always start with order delays, then cancellations, then earnings downgrades."
"Given the current environment, I think there is downside risk here."
This is a general problem I think I'll encounter a lot - I'm a novice to a great many industries and hence won't have the experience that investors like SG do (He also runs an excellent blog that is well worth following - it's taught me a lot about his investment approach). The lesson here then is to stay within my circle of competence and be fearful when trying to value companies in industries I don't really understand, especially when the valuation is based predominately on earnings.
7) The Real Good Food Company - RGD
Lots of debt. Terrible long term average ROEs. A CEO a patchy corporate history. Low quality of earnings. Why did I buy here? Well, the forecasts for the future look good. If they are achieved the company will probably be cheap. Being completely honest I only bought a small position largely because other private investors I know whose opinions I value a lot like it, so I bought in spite of my reservations from the warning signs. Because that's my main reason, it's a mistake regardless of the eventual outcome. I'm still waiting to see if the forecasts will be achieved - management seem confident they will - but I'll probably be out if the share price reflects any positive results. I don't really know why I'm in this share at all.
Wow, that took a long time to go through, but it's a really useful (if somewhat painful) exercise. It's easy to put mistakes down to bad luck or external factors (I'm a big fan of learning about behavioural psychology - there's a multitude of ways for us to achieve denial) but in reality most will stem from some underlying error of judgement rather than some black swan killing the investment case.
Amazingly, in spite of this catalog of errors I've actually had a pretty good 2012 in investing. I'll do a blog post in the near future on the investments that actually went well, then my overall portfolio results (after the last trading day of 2012) and finally my selections for 2013.
Disclosure: I own shares in FCCN, SRT, CHG & RGD