Francois Sicart: “Mistakes Must Service a Purpose” by Tocqueville

In his latest piece, Francois Sicart, Founder and Chairman of Tocqueville Asset Management, examines some investment mistakes he’s made in the past.

He details five investments, explaining the rationale behind the purchase, what went wrong, and what he learned.

Francois Sicart: Mistakes Must Service a Purpose – Some Early Lessons

Experience is that marvelous thing that enables you to recognize a mistake…when you make it again. – Franklin P. Jones

It is not that easy to talk about one’s mistakes.  In the early days of Tocqueville Asset Management, I suggested that the senior partners jointly write a report about their most memorable investment mistakes and what they had learned from them.  At the time, several of my partners thought this could result in unnecessary negative publicity.  Now, nearly 20 years later, I sense the same uneasiness at the prospect of my writing about my own mistakes.  Nevertheless, I was comforted in my project by a Financial Times editorial of February 4, 2015, in which Seth Klarman, one of today’s most successful investment managers, celebrates the 50th birthday of Warren Buffet’s leadership at Berkshire Hathaway by recalling, “What I’ve Learned from Warren Buffet.”  Among those lessons:

7. You can make some investment mistakes and still thrive.

10. Candour is essential.  It’s important to acknowledge mistakes, act decisively, and learn from them….

With these points in mind, I recall the slip-up that involved me and a few of my partners – perhaps the only time when a majority of us stumbled together.

Even We Are a Crowd

In a review of the firm’s 1999 investment performance, I explained:

I have fought long and hard to avoid investment by consensus at Tocqueville.  Consensus decisions amount to management by committee, which is an unfailing recipe for mediocrity.  Instead, I have purposely assembled a high-level team of strong-minded individuals who share and debate their best investment ideas.  There is a great deal of intellectual exchange, both formal and informal, among managers, and most wind up buying some of the others’ stocks – but they do so of their own free will.

As it happened, though, prior to that, in 1996, several of Tocqueville’s strong-minded early musketeers had purchased shares of Integrated Health Services (IHS), one of the largest and, we thought, strongest healthcare organizations in the country.

Our confidence was enhanced by the fact that a government audit prior to their acquisition of a troubled competitor had given IHS a clean bill of health, according to its supervisory agencies – a comforting factor in an industry often plagued with irregularities.  While its balance sheet carried a substantial amount of debt, most of it was related to real estate underlying their healthcare facilities, so we felt that it was largely “secured.”  Finally, there was a possibility that IHS would soon float a fast-growing and valuable subsidiary on the market, releasing ample funds to reduce the debt burden.

But in 1998-1999, everything went wrong.  We had underestimated the impact on margins of government-mandated changes in Medicare and Medicaid reimbursement procedures, and the zeal with which bureaucrats would go about implementing these changes.  Even as things deteriorated, we felt that the pressure on margins would soon be relieved, because these trends equally affected the rest of the industry; and, we believed, the government could not afford to let a whole segment of the nation’s healthcare complex collapse.

However, with a balance sheet heavy with debt, reduced earnings soon complicated debt service, making the value of the underlying real estate irrelevant.  To make matters worse, the company could not reach agreement with its debt holders on the modalities of a possible IPO of the valuable subsidiary, on which we had pinned our last hopes.  As a result of all this, IHS was now struggling for survival, with little or no likelihood that there would be any money left for shareholders once the debt was restructured.  The result can be seen on the graph below.

Mistakes

My 1999 review concluded:

The main lesson from this sorry episode, I believe, is that our basic principles (such as insisting on a firm’s financial strength) should be unbendable, no matter how attractive a company’s investment story sounds.

I could now add another lesson:  In assessing a company’s financial strength, liquidity (the ability to face current payments through the ups and downs of the business and financial cycles) is at least as important as solvability (the accounting surplus of assets over liabilities).

Finally, the IHS episode also reminded us that consensuses are typically shaped by what Charles MacKay called “the madness of crowds,” while a committee tends to work as “a group of men who keep minutes and waste hours” (Milton Berle).

It is to avoid situations like this that we have since assembled a team of our analysts (“The Skeptics”), whose duty it is to question and argue against all new ideas presented at our research meetings.

Looking back, Integrated Health Services turned out to be our poorest-performing investment in 1999.  In the accounts that I personally managed, for example, I estimated that the IHS collapse had cost about four percentage points of performance.  Fortunately, in spite of this, 1999 still was a fairly good year for our managers and our clients.
Besides buttressing my bias against consensus investing, this episode reinforced my conviction that even good investment managers will make some mistakes, and that what counts, besides adequate diversification, is to make fewer of them than the investing crowd as a whole.

Today we are a much bigger and more diversified firm; and, in spite of the high level of consultation and cooperation among our various teams, few of our investment errors are firm-wide.  So, I feel freer to reflect on some of my own mistakes, and to wonder what I’ve learned from them.  The ones mentioned below took place in the 1970s, at Tucker Anthony, when I clearly was learning a lot of lessons fast.  My memory of the details has become a bit fuzzy, but the lessons have not.

Can You Do It Again?

It must have been in 1971 that I purchased some shares of AVCO Corporation.  The company, originally a military contractor, had since become one of the most diversified conglomerates in America.  This complexity should have alerted me.  However, at the time I had more brains than common sense, and I was receptive to the arguments of leading Wall Street analysts, who promised marvels from the conglomerate craze in the form of “economies of scale” and “growth synergies.”  Unfortunately, besides the accounting liberties allowed by conglomeration (which I will explain later), it was difficult to figure what a company’s recurring profits were, when they originated in a multitude of disparate subsidiaries.

As a case in point, in 1967 AVCO had purchased Embassy Pictures, whose film The Graduate became the top-grossing movie of 1968 (and remains one of the best-grossing movies of all time), considerably boosting AVCO’s profits.  Earnings per share, helped by the pooled record of the Embassy acquisition, had nearly tripled between 1965 and 1967.  In 1968 and 1969, the success of The Graduate helped cushion already deteriorating profits elsewhere in the company.  But by 1969 and 1970, reality and the first post-Vietnam-War recession caught up with AVCO, and earnings collapsed.