Someone who reads my blog sent me this email:
One thing that would be very helpful to me would be a case study, so to speak, of an investment you’ve made in the past that didn’t work out. Maybe you had a sufficient margin of safety but the company allocated its surplus capital terribly, or the consistent ten-year history of free cash flow deteriorated rapidly, or you held the stock for five years and the valuation simply changed and you gave up. An example or examples such as these would be appreciated.
Thanks a lot,
We don’t have to go back far to find a mistake.
Almost exactly one year ago, I wrote a series of GuruFocus articles about my investment in Barnes & Noble (NYSE:BKS).
Quantifying My Mistake
I bought shares of Barnes & Noble at an average cost of $15.36. And sold them at $14.82. In the meantime, I received 50 cents a share in dividends. As I recall, the stock market was up quite a bit during this period. So my dollar loss understates my opportunity cost. Anything else I bought probably would’ve done a lot better.
In fact, I keep reports on my portfolio that allow me to tell you exactly how much putting money into Barnes & Noble instead of just dividing it equally between my other holdings cost me.
That’s the (non-annualized) return my combined holdings other than Barnes & Noble had during the period I was invested in Barnes & Noble.
And that’s the true cost of my mistake.
Qualifying My Mistake
Even those numbers don’t really capture how big a mistake I made.
Buying Barnes & Noble was not a mistake because I lost a few cents per share after dividends. Buying Barnes & Noble was a mistake because I lost a lot of time. I tied up cash that would’ve been better used elsewhere. Like buying more of the stocks I already owned.
Time combined with good ideas produces big gains.
I already had the good ideas. I could’ve put more cash into them. I didn’t. Instead, I wasted my time investing in Barnes & Noble. Big mistake. We’ll harp on the egregiousness of this particular error later.
Buying Barnes & Noble stock was also a mistake because it cost me time while adding risk. Obviously, holding cash would’ve been riskless. And — as it turned out — cash had a slightly better return than buying Barnes & Noble. That would be true even if I never came up with a better idea. If the cash just sat there — it would still hold its value perfectly well without taking any risk. And, of course, if I did later find a truly great idea (rather than a stinker like Barnes & Noble) I would’ve had the cash to buy it. Turing cash into Barnes & Noble shares added risk for no return. And it removed future flexibility.
On top of that, holding cash is a no brainer. It doesn’t require any work on my part. No analysis. No number crunching. No nothing. Buying Barnes & Noble did.
Some of you may scoff at that last bit. Surely I can spare a couple brain cells. Is thinking really such an awful cost?
In many situations, bad thinking is potentially the most destructive cost of all.
Losing money is no fun. It’s bad for compounding. Big losses can set you back years.
But bad thinking can set you back decades. Trust me on this one.
I started investing when I was 14. I spent the first few years learning as I went. Studying companies myself. But I also did the next best thing. My Dad told me about a guy called Ben Graham. Told me Graham had the same sorts of ideas about investing I did. So I read "Security Analysis" and "The Intelligent Investor." I had a hero. A framework. I could’ve stopped there.
I spent the next ten years learning and unlearning a great many bad habits.
The unlearning took longer.
Reliving My Mistake
I bought Barnes & Noble in the summer of 2010. Ahead of the proxy battle between Ron Burkle and Len Riggio. Riggio won. He went on to spend tons and tons of cash developing the Nook. We’re going to go against the way the B&N story is usually told here and err on the side of the truth: The Nook is not the one bright spot at Barnes & Noble. I mean it is if all you do is look forward hoping for growth. Sure. You won’t find any sales growth at Barnes & Noble’s stores. And the Nook is growing.
But what you will find at those stores is $167 million in operating profit. That’s right. The stores are not losing money. B&N.com, however, is losing money. It's losing $233 million to be exact.
This is obviously where I made a huge mistake. You see, Barnes & Noble had a market cap of around $900 million when I bought my shares. So, the funneling of 25% of the company’s market cap into a consumer electronics start-up is a big deal. To put this in perspective, it would be like buying shares in Apple (NASDAQ:AAPL) and then learning that they plan to spend $90 billion next year on something new and unproven. Now Apple is constantly spending money on new and unproven stuff. They’re constantly spending very small amounts of money on new and unproven stuff. Apple does not spend $90 billion on anything. Try adding up their cap-ex, R&D, whatever — you’re not going to find an investment on that scale.
That kind of investment destroys a lot of value. And if it goes on for more than a year — as I think it will at B&N — it destroys any margin of safety the stock had.
And that’s the B&N story.
It’s a sad story.
Explaining My Mistake
It’s not as sad a story for Barnes & Noble’s other stakeholders.
This is what I was getting at in my blog post Barnes & Noble - The Human Element:
One of the really big issues with Barnes & Noble — and probably the reason I sold out — is that the non-profit motivations of Riggio and others didn’t align with my very much for-profit motives of buying the stock. My fear was that once Riggio defeated Burkle in the proxy contest, the company would be geared to relentless pursuit of being a big, relevant force in bookselling regardless of what that meant for profits that could actually repay shareholders.
In other words, I was very scared that Nook spending wasn’t a one-time thing. That the existential threat to Barnes & Noble as a company was what management would respond to instead of minimizing direct investment in the Nook and maximizing the milking of today’s cash flow from the actual stores. Basically, I thought Burkle’s motives were safely capitalistic while Riggio’s motives were dangerously paternalistic.
I still do.
Justifying My Mistake
I’m sure I could rationalize it. Perhaps in pretty convincing language. A few graphs might help. But let’s face it. The actual mistake was simple, inexcusable and entirely mine.
The best place to go if you want to quickly understand my reasoning is actually not my own writing. It’s a blog post over at Can Turtles Fly?
The post does a great job of explaining the reasoning behind my Barnes & Noble purchase. It even includes a lovely bit of foreshadowing: “Initially, Gannon’s investment seemed uncharacteristic of him.” If people wrote investment horror novels that’s how they’d start them.
But seriously, the author pulls two good quotes from me that state the upside potential and downside protection plainly.
The upside potential was the proxy fight. A Burkle takeover. A bid for the company.
The downside protection was the margin of safety provided by the profit from the stores. Historically, margins had been around 4%. Sales were $5.8 billion. Barnes & Noble was the low cost operator. Better than Borders. They wouldn’t be the first guy to go down. They’d take additional share of a shrinking pie.
The stock price you were paying could be justified even on 2% margins at much, much lower sales levels. About 50% lower. In other words, it was going to take a ton of sales declines at the stores to erase the value propping up the company’s share price. As long as Barnes & Noble didn’t put money into new stores — and other folks closed theirs — everything was going to be fine.
Yes there was an elephant in the room. His name was Nook. But I carried on with my calculations. And what I said, as far as it went, was entirely true. Things have played out exactly as expected in printed books. Borders took a dirt nap. Barnes & Noble’s store sales were flat. Selling square footage is down. Capital spending is far below depreciation.
It’s everything you could dream of in a declining business. A textbook case of a graceful, capitalistic demise.
Except they spent it all — and then some — on the Nook.
That was my mistake. I totally ignored the destructive power of the Nook.
It’s a simple mistake. An obvious mistake. A dumb mistake.
And I made it.
Should I be excused for not focusing on the human element?
No. I knew all this before. Barnes & Noble had been clear about their intentions. I know companies are run by human beings for human beings. That they are sometimes self-destructive. That corporations are never as rational as they are accused of being.
There’s a lovely story in "Good to Great" about Kimberly-Clark (NYSE:KMB). You know them today as a tissue paper company with strong brands (Kleenex, Huggies, etc.). Until the 1970s they thought of themselves as a paper company. That was their history. And that history wasn’t especially tied to a couple strong brands. It was tied to paper mills. One day, they closed a lot of those mills. They exited the coated and commodity paper businesses. And they focused on branded tissue paper. It was a very rational thing to do. And a very odd thing to do.
When you’re reading a microeconomics textbook, something like that sounds very normal. When you’re reading actual business history, it jumps out at you. Companies tend to be as slow, sentimental and self-destructive as they can afford to be. They are surprisingly human.
And I knew that. And I still bought Barnes & Noble.
There’s a great interview Warren Buffett did with Charlie Rose. Charlie asks Warren why — many years ago — he only bought a small position in Walmart (NYSE:WMT). Warren tells him the price kept going up. And he was stubborn. He wanted it at his price. He was waiting for the stock to come back down. It was a multi-billion mistake. Charlie asks Warren if he’ll make the same mistake again. Warren says probably. But he’ll be a little less likely to next time.
I’d love to end on that story, but I did promise you I’d harp on an especially egregious error I made. When I bought Barnes & Noble shares, I already owned a couple really good stocks. I mean I actually had them sitting in the portfolio staring at me day after day. Real gems. I knew they were cheap. I knew they were better than Barnes & Noble. So…
Why didn’t I just buy more of them?
For the last few years, I’ve had this thing where I don’t put more than 25% of my portfolio into a single stock — except when I do. Once every couple years you come across something so absurdly cheap and safe and wonderful you have to ignore all the rules. You just have to. And if you don’t know what I mean, you’ve probably never come across one of these nuggets. Because they’re small and rare and most people miss them.
Anyway, in the last five years, I’ve broken the 25% rule exactly once. And, as it turned out, I didn’t get all the stock I wanted in that case. But I was out there bidding and bidding and bidding well after I had 25% of my portfolio in the stock. Otherwise, for the last five years I’ve never put more than 25% in a single stock.
Is this smart or stupid?
I tend to think stupid. Most people tend to think smart.
The truth is, if I put 33% of my portfolio into each of three stocks, I never would’ve bought Barnes & Noble.
So it would’ve saved me from doing something stupid in that case.
I waffle on this one. Lately, I’ve been waffling more in the direction of saying a 25% cap is a stupid rule, it’s made me do stupid things in the past, and it’s probably going to make me do stupid things in the future.
What’s wrong with owning three great stocks?
I tend to think nothing. Most folks tend to think I’m crazy.
Now, here’s the thing, the 25% cap feels stupider when prices are high. It’s tolerable when stock prices are low. When you have a month like the one we’re having right now — isn’t it just a joy to wake up to wildly different prices every morning — it doesn’t feel too hard to come up with four or five great stocks.
Which brings me to…
The truth is, I never would’ve bought Barnes & Noble after the Japanese earthquake. Because I was too busy buying stocks in Japan.
Now, a lot of people happen to think that was stupid too. So, a year from now, you might see me writing an article breaking down my Japanese mistake.
I doubt it.
But we’ll see.
The point is you tend to make mistakes when you have too much time on your hands, too much cash in your account, and too few ideas on your radar.
The real reason for most mistakes is: I couldn’t sit still long enough.
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Someone who reads my blog sent me this email: