Value Investing in 2012: Grown From Infant to Baby
Maybe I was lucky enough that there are quite a few one-legged folks in the ass-kicking competition or maybe I've had the beginner's luck all year. My portfolio somehow returned 31% during 2012, compared to S&P 500's 13.4% return, Dow's 7.3% return and Nasdaq's 15.9% return. As it was during 2011, there were plenty of mistakes and a great deal of lessons learned, thankfully. I had the fortune to learn from my own mistakes without suffering badly from them. I also had the privilege to learn from the best value investors, Warren Buffett, Charlie Munger, Arnold Van Den Berg and Michael Shearn. It is a year full of wonderful learning opportunities and I am very grateful for these great opportunities. There are some comfort to be gleaned from my successful investment such as Bank of America (BAC), JP Morgan (JPM) when it dropped to $31 when the trading loss was revealed, AAR Corp. (AIR), General Motors (GM) and a homebuilder ETF. But in my opinion, learning from mistakes is a much better way to get better at investing. Below is a list of all the mistakes I've made this year:
1. Buying value traps. This is the mistake that I've suffered from considerably this year. I've bought almost all notorious value traps this year and 2011 including Research In Motion (RIMM), Nokia (NOK), First Solar (FSLR) and Radio Shack (RSH). Now that I think about the whole thing about buying value traps, it is like buying a ticket at a deeply discounted price to get on board of the already sinking Titanic. Not until a few months ago did I realize that a cheap price combined with the fear of missing out and the psychological bias of anchoring past high prices is one of the most powerful forces that can suck value investors into value traps. These value traps are often common stocks on troubled companies, some of which are considered legendary like Nokia and Radio Shack. A seemingly simple but sophisticated in actuality solution to avoid value traps is offered by Charlie Munger when he answered a shareholder's question on how to value a troubled business-it's not going to worth much. And Warren Buffett added that they've learned to stay away from troubled companies, the reason of which he had mentioned numerous times in his writings:
"When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact."
If a value investor ever decides to make cigar butts investment, he or she should read the following excellent articles published by Gurufocus.com:
A Simple Way to Spot Value Traps: Nokia, Radio Share and RIMM
Avoiding Value Traps: A Four Question Test
2. Following others' ideas without thorough research. I've learned this the hard way. Similar to a healthy person asking a money-driven quack for suggestions, except that I went above and beyond human stupidity and actually locked in a two year subscription fee for a "professional" investing services in 2011. The editors of this service call them value investors but are constantly making statements like "we are riding the momentum of this stock because the short term chart looks good" or "the volatility of this stock makes it not suitable for our value-oriented service." I was greedy and foolish enough to follow the stock recommendations of this service in a few instances during 2011 and early 2012. The result? I lost more than 30% on Greenbrier Companies (bought at the recommended price of $25 and sold at around $17), more than 20% on Verifone Company, to name a few. Luckily as I kept accumulating more knowledge and worldly wisdom, I realized that this service is anything but value investing related and stopped following it during the first few months of 2012. It makes me uneasy thinking about how many services like this (charging a subscription fee and not aligning their own financial interests with the subscriber's own financial interest. i.e, if the stocks they recommended lost money, the editors still got paid and they would find a way to make it not a big deal. It's like heads I lose, tails you win.
3. A corollary to the second lesson, which was shared by Mr. Michael Shearn, is never copying others' ideas without thorough research. A lot of part-time value investors simply do not have enough time to research every single idea so they go around and look for the filings of Guru investors and pick and choose from Gurus' investment ideas. This seemingly logical approach suffers from a major drawback in my opinion. Not all ideas, even from the best value investors, are exempt from mistakes. In fact, most Guru investors make big money on a few best ideas and they occasionally make very bad decisions. David Einhorn bought Best Buy (BBY) and Dell (DELL), Whitney Tilson covered his short on Netflix (NFLX) when Netflix was trading near its peak, and many other famous value investors bought Hewlett-Packard (HPQ), JC Penney (JCP), Radio Shack, etc. Value traps are dangerous and sometimes even the best investors fall for them. Combined with the human nature of taking a cognitive shortcut (system 1) and the psychological bias of anchoring (especially the high price in the the past), it is not hard to foresee that many small investors blindly follow some famous value investors, only to regret it later. My mistake this year in this area was my purchase of Meade Instruments (MEAD). My only thesis in investing in this stock is that Paul Sonkin sits on the board of this company and he owned stocks of Meade Instruments. It was a micro cap company that is extremely illiquid and the company was facing some major issues in profit margin. Again, I was lucky enough to get out before things got out of control which resulted a more than 50% drop of the stock price. The reason I exited my position early in the game was because as I was reading Meade Instruments' most recent 10-K and 10-Q, I noticed that management had admitted that they had run into some serious problems and they could not see things get better any time soon. My logic told me to exit but there is a little man in my head screaming "don't quit on Meade, you've got Paul Sonkin on your back." To date, this mistake still reminds me of Warren Buffett's famous saying :"After ending our corporate marriage to Hochschild Kohn, I had memories like those of the husband in the country song, 'My Wife Ran Away with My Best Friend and I Still Miss Him a Lot.'"
4. The mistake of omission. It is one thing to hear Warren Buffett talk about his mistakes of sucking on one's thumbs when one knew enough to act but for one reason or another did not react, it is another thing to actually suck on one's thumbs and simultaneously shut down system 2 so that you don't have to react. The reason for this frequent mistake by value investors, in my opinion, is a combination of the sloth and weak will power. For instance, back in March Youku (YOKU) and Tudou (TUDO) announced a merger which would give Youku 71% control of the newly formed entity. The deal is for $ 1 billion (announced). Tudou was trading in a range between $38 and $42.85 after open, with outstanding shares of 28.35 million, market cap of $1.19 billion at $42 and $1.08 billion at $38, both exceeding the announced amount. The fair value of Tudou’s ADR is $35.27 ($1 billion divided by 28.35 millon shares outstanding). I saw an almost guaranteed return of approximately $4 per share if I shorted TUDO at $39 per share. I did not act on this because I was too lazy to call my broker. Another costly example was when New Oriental Education & Technology Group (EDU), a leading Chinese educational institution, was falling 34% based on a rumor that the SEC was planning to investigate its accounting for VIE. I should have bought in heavily because I knew it was a good company with super management, their accounting for VIE is not a problem and that the market overreacted so much that the price dropped more than 50% within two days. I did not act because I did not realize that opportunities like this are rare and the opportunity cost for not acting promptly is very high. To combat the psychologically wired tendency of sloth, a value investor needs to evoke the most powerful force from his subconscious mind and focus on the opportunity. Compound the opportunity cost for 50 years, write it out and think about how much you can do with the money you could've made if you reacted promptly and decisively. If you do this, no matter how tired you are, you will be more likely to act.
5. Use of leverage: I was way too confident about my ability to predict the market and about my ability to discover multi-baggers. Not only did I borrow money, but I also entered into triple short positions against the Russel Small Cap index. The recommendation of buying the triple short ETF was given by the value investing service I mentioned in mistake no. 2, which never admitted it was the service owner's mistake that all his subscribers lost money. He made some right calls during the volatile times during 2011 and I naively thought he had the crystal ball. Well, it looks like in the end, he was no more than a lucky coin flipper that survived after 30 days of the coin flipping competition described in Warren Buffett's 1984 article. Too bad I found out about this more than a year later.
6. Making bad decisions under the influence of euphoria. This is a mistake I made in late 2011 and early 2012. Even though it was a short sale, it could easily be a long position as well. I wish I heard Warren Buffett earlier on shorting. If an overvalued stock is selling at X multiples, how do you know it wouldn't sell at 2X multiples? I shorted Priceline (PCLN) when it was selling at $480 and my only reason was that I thought it could go down to $300. I didn't even look at the trailing EPS and forward EPS, in fact, I didn't even do any other research on Priceline because I thought how could a share of an online travel agency be more expensive than a share of Apple? Another psychological factor that had an impact on me was that my portfolio was doing very well mostly due to extremely good luck. I got carried away and entered into the short position without any thorough analysis even though Priceline was merely selling at about 16x 2012 earnings as a fabulous growth stock.
I know I'll make more mistakes and I welcome them along the way. I also know I'll probably make the same mistakes because some of them are just due to human nature. I am Chinese and my ancestors taught us invaluable lessons on how to deal with mistakes. I'd like to share with fellow value investors my favorite ones:
He who covers up his mistakes intends to make some more.
Success in the end erases all the mistakes along the way.
Be not ashamed of mistakes and thus make them crimes.