Some lessons from a value investor

[Cardboard]

As I enter 2015, I do feel horrible. After a wonderful start to 2014 or being up just over 40% in June, I am now down 50% from that lofty level. My portfolio now needs to double to just get back to that important psychological level. Trust me it is hard to accept. You look at the value of your portfolio and you realize that you are now back to where you were 2 or 3 years ago. You feel like dumb shit.

 

The main reason for the disaster is being heavy into oil & gas name since 2013, not selling enough of them between May and July and using my cash reserve to buy more of them too early or in September and October.

 

Despite the dangers of investing in commodities related names, here are the lessons that I believe should be useful to all value investors:

 

1- Whenever your price to value ratio of your portfolio goes above 50% you have to get worried. Or a portfolio of at least doubles based on a reasonable fair value assessment.

 

Back in 2013 and 2014, I could not find very many sources of value. Some oil & gas names however seemed to meet the test, so I bought. Where I got wrong is to not sell all of them when the remaining upside based on my reasonably calculated fair value appeared to be only 30 to 40%. They were barely doubles when I got into them anyway, so the test would have also kept me clear of that entire area.

 

Food for thoughts: There are many people invested in BAC on this board currently. I exited the name at around $15 in 2013 after buying in late 2011 around $5 because I could not see more than a 30 to 40% necessary jump to fair value over the next 18 months. So I will simply say just be careful if you are holding something for little upside left. It means that your margin of safety has declined significantly.

 

2- Whenever you feel knowledgeable and are making great gains each week or month you have to get worried.

 

Every time I started to feel great in my 18+ years of investing, there was a humbling moment right around the corner. And being a value investor and having relatively long holding periods (2 to 3 years), it takes a while to shake out the facts that you assumed were right and to react adequately. So if you start feeling intelligent, please look carefully at your portfolio, weightings, cash balance and hedges.

 

There were signs that oil production was in a bubble. I actually visited Fort McMurray in July and could not believe the level of activity. It was impossible to predict $48 oil, but to realize that optimism was too high back then, not hard at all. There was also a small supply glut in NA from the time I bought in 2013. When the price did not spike much after the Ukraine issue and ISIS, it was a big danger sign.

 

3- Whenever I bought a stock with an appealing dividend, it almost always got into trouble.

 

This must be a disease affecting many value investors. I would have to look long and hard in my trading history to find a stock with an above average yield that did not result in, at least temporarily, significant losses. These stocks are often decent value, held artificially high by the dividend and ripe to be taken down hard on any more bad news. Dividends should never be part of your thesis.

 

4- Whenever delaying taxes is on your mind, you are prone to make big errors.

 

I was sitting on big gains in June. Selling all oil stocks to meet my point #1 met an issue in my mind or a large tax bill this year. Not being my number one reason, still slightly thinking about it affected my judgement.

 

How often have you lost money because you held on to a stock in November and December only to sell it in January at a lower price to avoid paying taxes that year? And all you are doing is delaying the tax bill by one year. So basically, all you are saving is the capital cost on that tax bill for 12 months. In fairness, you also have decreased installments. However, at a maximum rate of 25% of your capital gain in Canada and at the rate that things can change in the stock market, it is not worthwhile at all playing with fire IMO.

 

5- Whenever a thesis is brought to you by an "expert" be skeptical.

 

I don't care if it is Watsa, Ackman, Buffett or whomever. These guys rarely make money with the idea that you have retained and it is often the one that will make you lose money.

 

You really have to make an idea for yourself about an investment and remove from your head target prices, buyout possibility or whatever rosy scenario someone may have mentioned. It includes things that are said on this board and that stick in your mind. It is something very hard to do, but you have to purge from your mind anything positive or that is not a cold hard fact.

 

For example, Sanjeev had mentioned that TPG-Axon would try to sell Sandridge. Sanjeev is successful and right much more often that he is wrong, but that thing stuck in my mind and seemed to make a lot of sense. This was reinforced by Cooperman's $10 target. Fairfax also held a very large position and Watsa mentioned publicly that SD was worth $20. The CEO mentioned not that long ago $15. Unfortunately, TPG-Axon was likely greedy and did not do the sale. Maybe they could not either. The reasonable target now if things don't change rapidly, is much less than $5.

 

It was not that hard for me to realize that this investment was much worse than all my Canadian oil & gas names: higher debt, tougher reservoir with lower oil content. What kept me in was hope of a take-out.

 

6- Oh yes. Hope is an investor worst enemy!

 

Cardboard

 

 

[hyten1]

cardboard,

 

awesome posts.

 

#4 and #6 has bit me in the ass many times

 

just recently with BAC around end of Dec 14 BAC was around $18. I was thinking I need unload some of this, but then i thought its almost 2015 will delay the cap gain until 2015. Then 2015 comes around the stock started to drop, I thought/hope it should pop back up a little then I'll sell some etc. :(.

 

#4 and #6 working hand in hand.

 

hy

 

As I enter 2015, I do feel horrible. After a wonderful start to 2014 or being up just over 40% in June, I am now down 50% from that lofty level. My portfolio now needs to double to just get back to that important psychological level. Trust me it is hard to accept. You look at the value of your portfolio and you realize that you are now back to where you were 2 or 3 years ago. You feel like dumb shit.

 

The main reason for the disaster is being heavy into oil & gas name since 2013, not selling enough of them between May and July and using my cash reserve to buy more of them too early or in September and October.

 

Despite the dangers of investing in commodities related names, here are the lessons that I believe should be useful to all value investors:

 

1- Whenever your price to value ratio of your portfolio goes above 50% you have to get worried. Or a portfolio of at least doubles based on a reasonable fair value assessment.

 

Back in 2013 and 2014, I could not find very many sources of value. Some oil & gas names however seemed to meet the test, so I bought. Where I got wrong is to not sell all of them when the remaining upside based on my reasonably calculated fair value appeared to be only 30 to 40%. They were barely doubles when I got into them anyway, so the test would have also kept me clear of that entire area.

 

Food for thoughts: There are many people invested in BAC on this board currently. I exited the name at around $15 in 2013 after buying in late 2011 around $5 because I could not see more than a 30 to 40% necessary jump to fair value over the next 18 months. So I will simply say just be careful if you are holding something for little upside left. It means that your margin of safety has declined significantly.

 

2- Whenever you feel knowledgeable and are making great gains each week or month you have to get worried.

 

Every time I started to feel great in my 18+ years of investing, there was a humbling moment right around the corner. And being a value investor and having relatively long holding periods (2 to 3 years), it takes a while to shake out the facts that you assumed were right and to react adequately. So if you start feeling intelligent, please look carefully at your portfolio, weightings, cash balance and hedges.

 

There were signs that oil production was in a bubble. I actually visited Fort McMurray in July and could not believe the level of activity. It was impossible to predict $48 oil, but to realize that optimism was too high back then, not hard at all. There was also a small supply glut in NA from the time I bought in 2013. When the price did not spike much after the Ukraine issue and ISIS, it was a big danger sign.

 

3- Whenever I bought a stock with an appealing dividend, it almost always got into trouble.

 

This must be a disease affecting many value investors. I would have to look long and hard in my trading history to find a stock with an above average yield that did not result in, at least temporarily, significant losses. These stocks are often decent value, held artificially high by the dividend and ripe to be taken down hard on any more bad news. Dividends should never be part of your thesis.

 

4- Whenever delaying taxes is on your mind, you are prone to make big errors.

 

I was sitting on big gains in June. Selling all oil stocks to meet my point #1 met an issue in my mind or a large tax bill this year. Not being my number one reason, still slightly thinking about it affected my judgement.

 

How often have you lost money because you held on to a stock in November and December only to sell it in January at a lower price to avoid paying taxes that year? And all you are doing is delaying the tax bill by one year. So basically, all you are saving is the capital cost on that tax bill for 12 months. In fairness, you also have decreased installments. However, at a maximum rate of 25% of your capital gain in Canada and at the rate that things can change in the stock market, it is not worthwhile at all playing with fire IMO.

 

5- Whenever a thesis is brought to you by an "expert" be skeptical.

 

I don't care if it is Watsa, Ackman, Buffett or whomever. These guys rarely make money with the idea that you have retained and it is often the one that will make you lose money.

 

You really have to make an idea for yourself about an investment and remove from your head target prices, buyout possibility or whatever rosy scenario someone may have mentioned. It includes things that are said on this board and that stick in your mind. It is something very hard to do, but you have to purge from your mind anything positive or that is not a cold hard fact.

 

For example, Sanjeev had mentioned that TPG-Axon would try to sell Sandridge. Sanjeev is successful and right much more often that he is wrong, but that thing stuck in my mind and seemed to make a lot of sense. This was reinforced by Cooperman's $10 target. Fairfax also held a very large position and Watsa mentioned publicly that SD was worth $20. The CEO mentioned not that long ago $15. Unfortunately, TPG-Axon was likely greedy and did not do the sale. Maybe they could not either. The reasonable target now if things don't change rapidly, is much less than $5.

 

It was not that hard for me to realize that this investment was much worse than all my Canadian oil & gas names: higher debt, tougher reservoir with lower oil content. What kept me in was hope of a take-out.

 

6- Oh yes. Hope is an investor worst enemy!

 

Cardboard

[alertmeipp]

This drop in oil stocks is comparable to the financial one we have had.

Brutal.

 

But if u only need a double,  it will come along. SD double,  will be 2.5. Tpg and prem will need another double from there to get to ur position.

 

Hope is a good thing as long as it is not the only thing.

 

 

[rijk]

priceless advice! thanks for sharing!

regards

rijk

[innerscorecard]

I really appreciate this post.

 

Do you think that the groupthink on CoBF is very strong? What were your main sources of investment conversation during this period? Mostly this board, or other investors in real life, or something else?

[Hielko]

It seems to me that the obvious lesson is missing from your list, and it's called diversification and risk management.

[KCLarkin]

I have made all of those mistakes in the last year. Fortunately, they were mostly in very small positions. Everyone should add these to your checklist.

 

You didn't add excessive sector concentration to your list though?

[innerscorecard]

It seems to me that the obvious lesson is missing from your list, and it's called diversification and risk management.

 

I thought your risks were managed adequately if you hedged your one stock a year with puts? Or if your potential upside was "asymmetric," even if you ended up losing a lot of money. ::)

[nikhil25]

Thanks for sharing, Cardboard!

[oddballstocks]

It seems to me that the obvious lesson is missing from your list, and it's called diversification and risk management.

 

How dare you mention those two things on this board.  Don't you know only lousy investors diversify?  Buffett only has 20 punches, Munger says 3 stocks are all anyone needs, how can that now work? 

 

All Cardboard needs to do is put 100% of his portfolio into SD, someone above said it will double this year.  There you go, all his losses back in a single gain.

 

In all seriousness, I appreciate the candid post Cardboard.  Introspection into mistakes is where growth comes from.

[sculpin]

Great post, Cardboard

[Vish_ram]

Thanks for sharing.

 

What I've learnt and still learning is

 

1) value investing can still help you lose tons of money, just like any other forms of investing

2) A P/E of 10 that you think is cheap can trade at P/E of 2 and still be cheap and can still declare bankruptcy.

3) Any famed investor's (or even super investor) opinion can go wrong. The superinvestor will still cling to fame and you wont cling to your money. Remember a famous investor's proclamation "book value is solid"

4) In any successful trade by any investor, it is hard to know what % of success can be attributed to the "dart throwing monkey" or to brilliance.

5) The #1 enemy of an investor is the urge to make extraordinary returns. A high probability of low returns is much better than low probability of high returns.

6) You don't need a lot of money to be happy.

 

 

[Cardboard]

"It seems to me that the obvious lesson is missing from your list, and it's called diversification and risk management."

 

That is definitely a fair point and a missing lesson, but not obvious.

 

Concentration, which is often touted on this board, was the reason for my success early on. More diversification would have saved a lot my losses post July, but not all.

 

The problem with diversification is the definition. Diversified within Canada may mean a disaster in the coming year if things don't improve for energy. I can also easily conceive a few scenarios at this point where the S&P tumbles by 50% in the coming year. So diversified within the stock market does not work.

 

Risk management is also tough to define. Do you buy puts against all your position and by that I mean 100% correlated or direct if not, you are fooling yourself by the level of protection. And isn't forcing yourself to hold cash when you are finding values a speculation on the future direction of the market? 

 

 

If you doubt that this can happen to you too then ask yourself the following:

 

1- Who predicted that oil would go down to the $40's a year ago? Who was foolish enough to buy this product at $100 when rail cars, vessels were all apparently over-flowing with it in H1 2014? This is the most important commodity in the world after all. Not a tulip or some internet start-up.

2- Who predicted that the Swiss would let down their cap on their currency?

3- Who thought that the oil price would now be seen as a concern by most central banks regarding deflation? A cost saving should be seen as positive, no?

4- How many things happen in any given year that no one ever thought possible?

 

In any case, I cannot stress enough how important it is to build a fortress of value holdings, to always remain skeptical and humble.

 

And no, I don't think that this board is responsible with too much: "group thinking". There is generally always someone expressing skepticism or presenting issues to any thesis. It is anyone's responsibility to sort through it.

 

Cardboard

[petey2720]

Cardboard, great post!!!  Thank you for sharing.

[Liberty]

priceless advice! thanks for sharing!

regards

rijk

 

Yes, thank you for sharing your hard-earned lessons with us Cardboard, I really appreciate it. I made some notes for each of your points in my investment journal, and hopefully rereading it someday will help keep me out of trouble when things have been going too well for a while and I become less careful.

[Uccmal]

Awesome post Cardboard.  Kind of echoes my own experience.  But, you know as Peter Lynch has said "it is darkest before the dawn...  or the pitch black". 

 

Maybe Passive investing is just really difficult.  Maybe, my returns have been 95% luck.  I dont suppose I will ever answer that. 

 

Perhaps it is instructive to look at what Buffett did rather than listen to his pithy wisdom, like 20 punches etc. 

 

Buffett and Peter Lynch had one thing in common.  They bowed out at the top.  Buffett decided to go the private company route around 1970.  Lynch retired before he got bit in the ass.  Buffett is renowned for his stock picking but isn't his real skill at identifying and buying good businesses, where he has control.  He kept stock picking along the way, but he always had cash flow from his businesses to invest when things looked worst. 

 

Buffett managed to avoid some of the pitfalls of the conventional value investor by buying wholly owned businesses.  He never had to "hold cash" forcefully. 

 

I think one way around our problem is to diversify enough that you generate dividends continuously from your holdings.  There is a whole slew of companies that never cut their dividends.  I know it is sacrilege to mention dividends on this board, but that is what I am leaning toward.  In the past few months I have gotten my dividends up to the level I need to live on.  Anything above what I have today, including increases, will be gravy to reinvest.  This is essentially what Buffett has done.  He has dividended earnings from his investments, and companies up to Berkshire for redeployment. 

 

To handle the possibility of cuts diversity is required.  I would love to have Seaspan as 100 % of my holdings but it is just dangerous. 

[thefatbaboon]

Interesting post Cardboard. We have been doing this for about the same time so it is good to compare notes.

 

I mean this with the utmost respect but I completely disagree with most of your points! 

 

1.  My finest investments have been holding positions with predictably rising intrinsic values even when discounts have narrowed.  Some of my biggest regrets have been selling companies because the discount has narrowed.

 

2.  I have been doing this for a couple decades now and enjoy the confidence gained from lessons learnt.  It saves me a lot of time and heartache.

 

3.  I have bought many good dividend paying stocks and have enjoyed rising dividends, sometimes for many years.

 

4.  Taxes are massive costs.  Having a good strategy to manage taxes has been invaluable.

 

5.  AGREED

 

That all said, if you are prefacing your list of lessons learnt with "IF one is investing in cyclical businesses then lessons learnt are 1, 2, ...5"  then I agree with you.  Cyclical industries are tricky.  I have made money and lost a lot of money: tanker market of the '90s, the iron ore market end 90s beginning 00s, asbestos/building materials, financials 07,08,09...I've become exceptionally careful when I step into these areas, and as my capital and experience has increased over the years I venture in less and less because it's always a hell of a lot of work and very stressful and unless one is really buying in the gutter (think net-net with assets valued at trough) one's margin of safety is invariably a lot less than one thinks.  I think that last point merits saying again: MOS in cyclical businesses is smaller than one thinks.  Why?  because of the often very reasonable probability that there is a bust and that in a bust nearly all cyclical businesses lose money.  So, take a company with reserves - say iron ore.  Pretend you know exactly whats in them, and what they are worth.  Well, say you can buy at 50% of the value.  Is that really a 50% MOS?  When a decline in iron ore prices would make the mining company not economically viable?  I have a pet peeve about cyclicals, on this board and generally, they should be approached (if at all) with humility, skepticism and a lot of care.  No one should venture in who doesn't know history because there be dragons.

 

(Didn't stop me putting a couple percent into Sandridge though!!  But generally I only allow myself one or two of those kinds of things in the portfolio and only in very small size)

 

If you focused more on businesses with various types of intellectual property then I think your "lessons learnt" would be very different. 

 

[Guest longinvestor]

Nice lessons, thanks for posting. Your circle of competence perhaps got more clearly defined with this reflection. Good luck! 

 

Nothing like learning from mistakes and in investing, it does not get more benign than to reflect on others' mistakes and apply them in your own approach. So, thanks for sharing. 

 

[tytthus]

my returns have been 95% luck.

 

The corollary to that is " my losses have been 95% bad luck"...

[Investor20]

Buffett was reasonably diversified even in his partnership days.  I think some people take the concentration idea too far.  Mistakes happen but no one mistake should kill you. 

 

Here are the criteria Buffett laid out in his partnership letter dated January 20, 1966. 

 

"We are obviously only going to go to 40% in very rare situations - this rarity, of course, is what makes it necessary that we concentrate so heavily .when we see such an opportunity. We probably have had only five or six situations in the nine-year history of the Partnership where we have exceeded 25%.."

 

Page 9 (Diversification) http://www.rbcpa.com/WEB_letters/1966.01.20.pdf

[hyten1]

in regards to #4, what are some of your tax strategies?

 

Interesting post Cardboard. We have been doing this for about the same time so it is good to compare notes.

 

I mean this with the utmost respect but I completely disagree with most of your points! 

 

1.  My finest investments have been holding positions with predictably rising intrinsic values even when discounts have narrowed.  Some of my biggest regrets have been selling companies because the discount has narrowed.

 

2.  I have been doing this for a couple decades now and enjoy the confidence gained from lessons learnt.  It saves me a lot of time and heartache.

 

3.  I have bought many good dividend paying stocks and have enjoyed rising dividends, sometimes for many years.

 

4.  Taxes are massive costs.  Having a good strategy to manage taxes has been invaluable.

 

5.  AGREED

 

That all said, if you are prefacing your list of lessons learnt with "IF one is investing in cyclical businesses then lessons learnt are 1, 2, ...5"  then I agree with you.  Cyclical industries are tricky.  I have made money and lost a lot of money: tanker market of the '90s, the iron ore market end 90s beginning 00s, asbestos/building materials, financials 07,08,09...I've become exceptionally careful when I step into these areas, and as my capital and experience has increased over the years I venture in less and less because it's always a hell of a lot of work and very stressful and unless one is really buying in the gutter (think net-net with assets valued at trough) one's margin of safety is invariably a lot less than one thinks.  I think that last point merits saying again: MOS in cyclical businesses is smaller than one thinks.  Why?  because of the often very reasonable probability that there is a bust and that in a bust nearly all cyclical businesses lose money.  So, take a company with reserves - say iron ore.  Pretend you know exactly whats in them, and what they are worth.  Well, say you can buy at 50% of the value.  Is that really a 50% MOS?  When a decline in iron ore prices would make the mining company not economically viable?  I have a pet peeve about cyclicals, on this board and generally, they should be approached (if at all) with humility, skepticism and a lot of care.  No one should venture in who doesn't know history because there be dragons.

 

(Didn't stop me putting a couple percent into Sandridge though!!  But generally I only allow myself one or two of those kinds of things in the portfolio and only in very small size)

 

If you focused more on businesses with various types of intellectual property then I think your "lessons learnt" would be very different.

[thefatbaboon]

Don't mean to be coy but tax strategies will vary person to person, net worth to net worth, investing style to investing style, and country to country.

 

As a very general point for most tax payers who are not successfully deferring most cap gains: tax expense should be part of the valuation process.  i.e. make sure a potential "forever" type investment like Berkshire versus a probable "must sell at approach to IV" type like BP has a tax component in their respective valuations.  It's important, it's just as much an element of value as anything else.  (Edit: that might read a bit vague.  If BP goes according to plan and I sell in 2 years and pay 20% on gains and 20% on divs; and then go to cash and rinse and repeat with the next BP...that's different than holding BRK till I die.  This needs to be reflected, however imperfectly, in my valuation when I try and see whether to buy)

[KCLarkin]

That all said, if you are prefacing your list of lessons learnt with "IF one is investing in cyclical businesses then lessons learnt are 1, 2, ...5"  then I agree with you.

 

I think many of the points also apply to lower quality deep value investments.

[Hielko]

"It seems to me that the obvious lesson is missing from your list, and it's called diversification and risk management."

 

That is definitely a fair point and a missing lesson, but not obvious.

 

Concentration, which is often touted on this board, was the reason for my success early on. More diversification would have saved a lot my losses post July, but not all.

 

The problem with diversification is the definition. Diversified within Canada may mean a disaster in the coming year if things don't improve for energy. I can also easily conceive a few scenarios at this point where the S&P tumbles by 50% in the coming year. So diversified within the stock market does not work.

 

Risk management is also tough to define. Do you buy puts against all your position and by that I mean 100% correlated or direct if not, you are fooling yourself by the level of protection. And isn't forcing yourself to hold cash when you are finding values a speculation on the future direction of the market?

Don't get me wrong, I think that it is great that you are starting this thread, but I find this reply very strange. You are an investor, not a writer. You don't need to define diversification or risk management, but you do need to practice it.

 

 

If you doubt that this can happen to you too then ask yourself the following:

 

1- Who predicted that oil would go down to the $40's a year ago? Who was foolish enough to buy this product at $100 when rail cars, vessels were all apparently over-flowing with it in H1 2014? This is the most important commodity in the world after all. Not a tulip or some internet start-up.

2- Who predicted that the Swiss would let down their cap on their currency?

3- Who thought that the oil price would now be seen as a concern by most central banks regarding deflation? A cost saving should be seen as positive, no?

4- How many things happen in any given year that no one ever thought possible?

That's exactly the point of risk management. You need to expect the unexpected.

[CorpRaider]

Thanks for sharing.  Hang in there, we are probably closer to the bottom than expected if people are feeling like this.