Investment Mistakes Part 2: Hard Learned Lessons

Investment Mistakes Part 2: Hard Learned Lessons
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Investment Mistakes Part 2: Hard Learned Lessons by Andrew Hunt. Hunt is an Investment Manager and author of Better Value Investing: A Simple Guide to Improving Your Results as a Value Investor.

In Part 1, I wrote about how to take responsibility for mistakes and get the most out of them. In this second part, I am going to share five of my most salient mistakes, what I learned and what I did about them. In practice, I’ve made dozens of errors over the years, alongside hundreds of small modifications to my investment process and checklists. This is merely a taster.

Investment mistakes – 1: Trying to be too clever by half

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A few years ago I had a go at risk arbitrage. Risk arb involves buying companies that have been bid for and (hopefully) capturing the spread between the eventual takeover price and the current market price. In most cases, this actually worked out, and I made a few percent over short holding periods. However, in a number of cases, the buyers walked away from fundamentally weak companies, the stock tanked and I was left holding a big loss and a rubbish stock. Strategies like risk arb can seem very appealing to outsiders, but in practice require a lot of specialist knowledge and experience that I did not have. Moreover, I was doing it for the wrong reasons – I thought markets looked expensive and was trying to use it as a tool for market timing.

What I learned and what I did


I learned that clever sounding, esoteric strategies are harder to execute than they seem – there are no free lunches – so stick with what you know and keep it simple. Secondly, don’t try and do market timing. In the long run, it hasn’t helped anyone. If you can find stocks that meet your criteria, buy them and the value will out. If you can’t, sit back, accumulate cash and be patient. Trying to be too clever lost me money and was a distraction.

Investment mistakes – 2: Investing in weak banks

I had a couple of run-ins with weak banks.  The trouble with banks as value investments is that they are highly leveraged and utterly dependent on confidence. Seth Klarman describes value investing as “buy a bargain and wait.” Unfortunately, with financially vulnerable businesses, you simply don’t get to wait for things to turn. If you’re timing isn’t spot on, you’re in trouble. Moreover, authorities are now far more reluctant to step in and support troubled banks than they were in the past.

What I learned and what I did

Various pieces of empirical evidence have emerged showing that buying low P/E banks or banks with low price to book ratios and making relatively high returns on equity, are more effective strategies than just buying the lowest P/Book banks. Basically, you want to buy banks that are continuing to be profitable. Continuing profitability provides banks with cover to work through their issues and to survive the cycle.

Thus, I modified my screens to look for the lowest quintile of banks on price to book but then added an extra RoE filter to screen only for the most profitable among these. This tends to give a list of banks with both low price to book values and low P/Es.

I also introduced a special banks checklist which demands decent capital ratios, low assets-to-equity, stabilizing or falling NPLs (non-performing loans), and, most importantly the banks must be profitable and forecast to stay profitable. This screens out a lot of the really cheap banks, but it also screens out the really distressed ones.

Investment mistakes – 3: Weak cash flow cyclicals

Just as with banks, cyclicals generating negative or very weak cash flows in the down-cycle can often turn out to be value traps unless your timing is perfect. Price-to-book is not much good when the company is loss-making and heading for a liquidity crisis. I actually think weak liquidity (especially cash generation) is a far more important red flag than high debt – most lenders will generally find a compromise if the company is still throwing off cash.

Moreover, demanding both deep value prices and financial strength stops you buying in way too early – a common problem for value investors. Only when the higher quality names in the sector that can generate cash at the bottom get really cheap do you begin buying in.

What I learned and what I did

I made my financial strength checks far more comprehensive. These include making sure long term, short term and forecast cash generation is positive. In addition, I check the profitability record, fixed charge cover, debt-to-equity and debt to EBITDA metrics, current ratios and total liabilities (including off-balance sheet ones).

I also made passing this section a must-have. In other words, if the stock is financially weak – and especially if the cash generation is weak or negative – I simply stop and move on to something else.

Investment mistakes – 4: Mismanaged or fraudulent businesses

There are plenty of stocks which appear to have decent financials and dirt cheap valuations, but turn out to be either complete frauds or grossly mismanaged. This is particularly the case for many Chinese companies. When I invested in three companies of this ilk, I had my doubts about them from the beginning. After a few quarters, the cracks began to show: one company issued convertibles for an acquisition in spite of a large cash pile and lowly valuation; another issued a big profit warning with an incoherent justification. I was fortunate to get out in one of the China rallies and basically avoid any overall losses. Subsequently, one of the stocks was suspended while the other two have performed poorly.

What I learned and what I did

I read books on short selling as well as watching many insightful interviews with short sellers on Youtube. Two particularly excellent resources are The Art of Short Selling by Kathryn Staley and Financial Shenanigans by Howard Schilit. These are great reads for fundamentals-driven investors, and really improved how much I get from reading the financial statements and notes to the accounts.  

From this research I built a pretty comprehensive set of due diligence checks. However, there is one feature I rank above all else when it comes spotting dodgy companies: the cash from financing record. Cash from financing is the third part of the cash flow statement. It is also the hardest part of the financial statements to manipulate or lie about. This is because it is predominantly made up of the cash that is raised from or paid to debt holders and shareholders – the very people who read the financial statements! So it’s no surprise that almost every incident of fraud or serious mismanagement around the world has been accompanied by a long record of positive cash from financing (meaning the company has had to keep going to lenders or shareholders for more money). By contrast, companies that are paying out real cash to their owners or lenders are not only less likely to be frauds, but are also displaying valuable capital discipline. Now, unless a stock is a long-established blue chip, I will only consider it if it has at least a five year track record of consistently negative cash from financing, including shareholder returns. All my stocks screen now employ a negative cash from financing filter as well.

Investment mistakes – 5: Mindless averaging down

As a long term contrarian value investor, I am typically buying stocks as they fall and holding them for several years till they fully recover. Averaging down (i.e. systematically investing more as the price falls) has been a core component of my returns. Most of my biggest winners have been investments where I’ve added several times to the position.

That’s great with stocks that eventually turn around, but it can be a big risk with value traps. Instead of just taking a loss on a half or one percent position, there is a danger you end up magnifying your loss by throwing good money after bad.

What I learned and what I did

I have always been quite disciplined about how much I am willing to invest in any one stock and use a systematic approach to averaging down, adding at certain discounts to intrinsic value. This has meant the losses from the odd value trap have never been disastrous.

Furthermore, I have become much more disciplined about when I am willing to average down. Adding to positions is not something I do automatically or reflexively.  To counter the risks, I created a separate pre-dealing checklist that I apply every time I put on a deal – whether it’s a buy, a sell or an addition. This makes me systematically re-check all my assumptions and the investment case, check for recent news, and especially check the latest financial strength metrics. I only add if all those criteria are still met.

To help me remain disciplined, I also apply a pause point. In other words, if I decide I want to trade, I make myself wait for at least an hour. This forces me to take the time to work through the dealing checklist thoroughly, take a step back and really consider my actions.

In Summary

So there you have it; five top tips to help long term value investors:

  1. Stick to your knitting, be patient and avoid market timing or trying to be too sophisticated.
  2. When picking banks, look for quality – and especially profitability – alongside cheapness.
  3. When picking cyclicals, demand a record of positive cash flows even at the bottom of the cycle.
  4. Avoid frauds or grossly mismanaged businesses by doing full due diligence. Insist on a long record of negative cash from financing.
  5. Make a pre-dealing checklist with pause points and apply it before making any trade. It will make you recheck your assumptions and help you stick to your process.

What is striking is how the majority of investor mistakes are either quite simple oversights, or, more rarely, just plain bad luck (i.e. an unpredictable turn of events). As most fall into the former category, simple mistakes usually offer simple solutions that can help investors avoid making the same mistake twice.

Andrew Hunt is an Investment Manager and author of Better Value Investing: A Simple Guide to Improving Your Results as a Value Investor.

Investment Mistakes


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