“We do not learn from experience; we learn from reflecting on experience.” — John Dewey
Today’s edition will chronicle my investment saga in the final years leading up to the credit crisis which began in the late summer and early fall of 2008. I have decided to forgo describing the investment details of one of my largest successes (Imperial Sugar, formerly IPSU) in favor of describing my temporary diversion from the most important aspect of value investing. Specifically, I will address my failure to maintain a sufficient margin of safety in my investments. Anyone interested in reviewing the investment thesis for Imperial Sugar can access [url=http://www.gurufocus.com/news/156964/principles-of-graham-margin-of-safety-a-practical-application ]this GuruFocus article[/url] which details the “perfect storm” of events that provided the company with a temporary windfall of profits.
Since October of 2002 the family portfolios had climbed steadily, eventually peaking in October of 2007. Many years prior, I had set of goal of becoming a millionaire by the age of 50 — a pipe dream would have provided a better description of my ambition to become wealthy at the time I set the goal. However, by the early months 2006, our accumulative investment portfolios had surpassed that level and the family portfolios would continue to ascend in value for the months which followed.
Unfortunately, the steady appreciation in the market value of our portfolios had begun to take a toll on my approach to risk management. I had started investing large sums of money in companies which carried extremely high levels of long-term debt; that practice had injected an extreme element of downside risk should an economic downturn unfold.
Further, the majority of these companies were theme-related and highly cyclical in nature. This reckless process eliminated any margin for error should the cash flows of the businesses suddenly subside. The family portfolios had become analogous to a stack of perfectly aligned dominoes. Should the first domino tip over, the change reaction would be almost certain to eclipse the entire line. Like many other investors, I had failed to recognize the concept of counter-party risk in regard to my investment holdings. It would seem that the author had forgotten about Graham’s three most important words in investing: “Margin of Safety.”
Successful value investors must first and foremost play defense and let the upside eventually take care of itself. Similar to many sports fans, investors may prefer the excitement that is generated by an offensive approach but long term success is invariably a function of the investor’s ability to avoid purchases which result in large, irreversible losses. Chicks may “dig the long ball” but sluggers typically swing and miss far more often than they drive the ball out of the park. In investing, continually “swinging for the fences” constitutes a deadly sin.
Today’s edition of Reflections from 20 Years of Investing will not focus upon glory; instead it will examine the perilous nature of investment success which can lead to overconfidence and an abandonment of sufficient risk management.
The Investing Climate in 2007 and 2008
By 2007, large bubbles had developed in the U.S. housing market as well as in other housing markets throughout the world. Further, the price of virtually every commodity had skyrocketed to unsustainable levels. The housing boom and the commodity “super cycle” had temporarily distorted the trailing price to earnings ratios of a plethora of businesses. These bubbles created an illusion that many of the related stocks were still valued-priced in terms of their present earnings as well as their balance sheet values.
Mark to market accounting practices will invariably overstate the equity of financial stocks as well as commodity companies during favorable economic periods (alternatively, the book values of such companies will become decidedly understated as the bubble bursts). This phenomenon frequently results in false reads by value investors in regard to the intrinsic value of a company.
In the case of bank stocks, “overstated” balance sheet equity allows the financial institutions to increase their leverage and the level of their outstanding loans, as well as encouraging their officers to engage in risky behavior in the form of proprietary trading practices. Additionally, banks tend to underestimate their loan reserves when all is rosy.
During the housing bubble, lending standards were becoming relaxed and the practice of bundling subprime loans into collateralized debt obligations (CDOs) became a mainstream practice. These securities were backed by highly inflated credit ratings even though the quality of the underlying assets was highly questionable. By 2007, the worldwide demand for this type of asset-backed security (ABS) was beginning to wane and the mortgages which provided the collateral for the securities were starting to come into question.
By the latter part of 2007, U.S. housing inventories were rising to precariously high levels and all the industries which had benefited from the housing bubble were now losing their earnings momentum. Furthermore, the rapid increase in housing prices coupled with undisciplined lending standards had placed many Americans in houses which were well beyond their means.
The problem was further exacerbated by the vast amount of credit default swaps (CDSs) which were written on many of the ABS and CDO that banks and other investment institutions had purchased. The CDSs were purchased in an attempt to hedge the risk of the purchasers in the event that the securities they had invested in would eventually fail.
CDS were intended to be purchased as insurance against defaults (for bonds, ABS, CDO, etc.); however, it was not a necessary condition for investors to own the underlying security in order to purchase the protection. Savvy investors such as John Paulson, who held no investments in any of the CDOs, were building extensive positions in CDSs on mortgage-related investment securities based upon the belief that the U.S. housing market would soon be in peril. If the housing market collapsed, the payouts on the CDSs would result in hundreds of millions of dollars in gains for the hedge funds.
AIG (AIG), seemingly oblivious to the investment risk, was selling excessive amounts of CDSs as if the derivative contracts were similar to other types of insurance. Apparently, the managers at AIG did not understand the underlying weakness in the bundles of mortgages that they were insuring or the interrelated nature of the various entities.
Their risk was spread out in the other forms of insurance that they wrote and no single catastrophe would be sufficient to bankrupt the entire company. Unfortunately, that would not be the case should a rapid housing collapse trigger a series of defaults on the multitude of mortgage-backed securities which they were recklessly insuring.
Furthermore, countless banks and other financial institutions were heavily invested in many forms of asset-backed securities. They mistakenly believed that the hedges which they laid in place (in the form of credit default swaps) would protect them against any potential defaults in the interest-bearing securities and derivative contracts which they had purchased. What the banks did not foresee was their inability to collect upon the insurance they had purchased in the event of a systemic collapse of the financial system. Such a collapse would become imminent if firms such as AIG (and others who were selling the CDSs) were unable to payout the CDS contracts which they had written. In other words, certain large financial institutions had become “too big to fail” without creating a systemic failure throughout the world economy.
The stock market began to collapse when Lehman Brothers filed for bankruptcy on Sept. 15, 2008. The shock waves reverberated throughout the world markets as virtually every stock would begin a downward spiral. The disastrous decline in equity prices would finally bottom approximately six months later in March of 2009.
Investors who steadfastly held their positions in the market would eventually recover their losses; however, many market participants were simply unable to tolerate the seemingly endless days of drops in the quoted prices of their portfolios. Many investors succumbed to the pressure and exited the market after losing a high percentage of their net worth. Most of these timid investors would not return to the market for many years to come. Countless other investors who employed excessive margin were “stopped” out of their positions, permanently losing the majority of their investment funds.
The fall of 2008 marked the end of the housing bubble. It also signaled a sudden and dramatic decline in the prices of most commodities as a wave of worldwide deflation resulted from the impending credit crisis.
The Family Portfolios Take a Shellacking
Anyone who was invested in stocks in late 2008 and early 2009 was virtually assured of sustaining a severe “haircut.” Buffett and Munger have pointed out on numerous occasions: One should never invest in stocks if they are not willing to tolerate a 50 percent decline in the market value of their holdings. In the case of the family portfolios, they were easily able to eclipse that amount. The peak-to-trough decline was more along the lines of 60 percent. Oh well, it was fun being a millionaire while it lasted.
Value investors have little control over the market risk of their stock portfolios; what they can control is the non-market risk of their equity investments. In regard to the latter part of the aforementioned statement, I had become woefully deficient.
My selection of stocks was now almost entirely based upon themes. Instead of seeking out value in out-favor-sectors, I had temporarily diverted to the path of attempting to identify investing themes, although I would only purchase a stock if I deemed it to be a bargain. The major themes I had identified were natural gas related stocks, material stocks such as cement companies, and discounted Chinese growth stocks which made their money by selling their products to Chinese consumers. I also owned significant positions in some other purely American companies which included Casey’s (CASY) and Gray Television (NYSE:GTN). Ultimately, Gray Television would turn out to be a colossal failure (more on GTN later).
In retrospect, the problems with aforementioned approaches are quite obvious: Natural gas and material prices were unsustainably high during that period, and virtually every Chinese stock I held shares in would turn out to be a fraud.
The natural gas stocks I owned appeared to be significantly undervalued based upon their reserves, but that assumption would prove to be entirely invalid when natural gas prices began to drop precipitously. Exactly the same was true in the case of my material stocks. The worldwide wave of deflation which resulted from the credit crisis had destroyed the immediate demand for virtually every commodity.
My only consolation was that I was not alone in my miscalculations; even Warren Buffett publicly acknowledged his poor investment in ConocoPhilips (COP) during that period. It seems that “The Oracle” also made a similar error in calculating the intrinsic value of the company based upon unsustainably high oil and gas prices.
The other glaring weakness in my approach was a total lack of appreciation for non-market risk. Specifically, I owned a number of stocks which held excessive debt to equity ratios, in addition to being cyclical in nature. That strategy produced a particularly toxic combination for stocks I held in the months preceding the credit crisis!
Chinese Stocks: The Accounting Pen Is Mightier Than the Sword (Temporarily)
I must shamefully confess that I made a significant amount of money investing in Chinese reverse-merger stocks. It required a number of years for me to fathom that these companies merely invented the numbers which appeared on their financial statements. I should have come to that conclusion earlier since the success stories that the companies penned simply appeared to be too good to be true. Fortunately, I finally received that epiphany before it became evident to everyone else.
Taken at face value, these small Chinese growth companies appeared to be extraordinary value propositions. It was as if a common author had written the script for each individual company. The companies all shared the following characteristics: They sold products which held favorable cultural or demographic significance, their growth would be enhanced by the rising Chinese consumer and the companies demonstrated extraordinary growth in sales and profits while recording incredible returns on capital.
I bought into the phony stories and financial statements, purchasing shares in companies that provided such things as: traditional Chinese medicines, the world’s low-cost producer of probiotics, a manufacturer of traditional Chinese seafood snacks (don’t knock dried squid until you have tried it), and a low-cost producer of nano precipitated calcium carbonate (NPCC). Try whispering that last one in your sweetheart’s ear during a romantic moment.
Most of the Chinese companies that I purchased now reside on the Pink Sheets or have disappeared altogether, but at one time they all traded on major US exchanges. One of them (AOB), even received the honor of ringing the opening bell at the New York Stock Exchange in 2007, and people say that crime does not pay.
It’s easy to joke about these “investments” now, but at the time I detected the pervasive nature of the fraud in these Chinese companies, I found no humor in the situation. Rather, I felt violated; I can only imagine the feeling of investors who had maintained their positions to the bitter end.
I feel compelled to tell a story about one of my major fraud successes, Shengdatech (SDTHQ), which now trades at 4 cents a share; it was the NPCC company. In the mid to latter part of 2007 I ended up purchasing a substantial position in the company. I set a series of limit buy orders well under the ask price of SDTH and the stock started a precipitous decline. My last order filled at just over $4 a share as the stock reached its final new 52-week low. I ended up with entirely more shares of the company than I had originally intended due to the fact that I set most of the orders at points which I thought to be unrealistically low.
Suddenly the stock turned upwards and in the course of only a few weeks or months it was trading at nearly $15 a share. I have never wanted to sell a stock so badly, but I did not want to record any more short-term gains in my taxable accounts for the calendar year of 2006. I recall sweating out the final days of 2006, hoping that SDTH would not collapse before the calendar year ended so I could defer my short-term capital gains for another year.
On New Year’s Day 2007, while other people were watching football, I was busy setting sell orders on SDTH to be filled on the opening on the first trading day of the new year. As I recall, I did not even bother to use limits. On Jan. 2, 2008, I sold every share of SDTH in the neighborhood of $15 a share. That was the good news; by the end of 2008 the large gains I made in the fraudulent stock were entirely erased by the massive losses that I would encounter by year's end. The only good news was that I had held the stock into 2008, therefore I never became liable for any of the short-term capital gains. You see those capital gains were easily offset by selling shares in my numerous losing propositions which resulted from the market crash that unfolded later on in the year.
For a complete analysis of the Chinese companies which I purchased, see this GuruFocus article.
Gray Television: A Profound Failure
One of my personality flaws was uncovered when I started investing; specifically, I did not easily give up on a stock when I made a miscalculation. Rather, I would tend to buy more and more shares as the stock declined in value. It is quite typical for the common investor to hold on to a stock until he gets back to even but I was taking it a step farther. I was refusing to give up on my original thesis in the face of evidence that I had made a mistake.
I originally became concerned about the onset of the credit crisis in the late summer of 2008 when I read an article that stated that Berkshire would no longer sell deposit insurance above and beyond the FDIC limits. Until that time Berkshire provided that service for certain banks through its interest in Kansas Surety. The announcement had sent a chill up and down my spine. I wandered what potential disaster Buffett saw on the horizon that would cause him to take such an action.
Shortly after I noticed Buffett’s departure from insuring deposits above the FDIC limit and prior to the Lehman Brothers collapse, I decided to sell all the heavily leveraged, economically sensitive stocks which I owned, with one notable exception, Gray Television. Of course the stocks had already tumbled far from their highs as more astute investors had “smelled the rat” much earlier than I had.
The one stock I held which fit the aforementioned conditions was Gray Television, and it was by far my largest holding. I simply refused to give up on my thesis in regard to the company. Realistically, it was already too late to sell as the stock was trading somewhere between $1.50 and $2 a share at the time. In retrospect, I should never have invested in the company (at least at the high price I paid) due to its exorbitant leverage ratio and the valuation metrics it possessed when its enterprise value was taken into consideration.
I liked the stock because of its biannual windfall in the form of political advertisements, the fact it owned the top-rated television stations in college towns, and the concept that local residents would never abandon their tendency to watch local news, sports and weather through their favorite channel. Most of all, I coveted the political revenues which provided guaranteed windfalls on an ongoing basis. It seemed to me that GTN possessed a sizable moat and was unlikely to be threatened by any other form of competition.
At the end of 2007, GTN was trading at price in excess of $8 a share; one year later the market valued the company at 40 cents per share. In 12 short months, my top holding had lost 95% of its market value. At that point in time, the main value of my prized holding was in the form of a tax-loss carryforward.
Although the stock would eventually recover in late 2008, its survival was in serious question. The nonpolitical revenues for the business had dropped off a cliff and the company was now in severe danger of violating the covenants of the favorable credit agreement which they had signed earlier in the year. Gray eventually survived by its ability to sell preferred shares which contained escalating dividends, and as the economy began to recover, the company slowly climbed out of the woods.
I made several errors in regard to GTN: First off, I paid too much for the stock by overvaluing its moat and undervaluing the danger of its enormous debt. Secondly, I continued to average down on the stock and I ended up purchasing way too many shares as a percentage of my portfolio. I simply failed to acknowledge the fact that I might have made a mistake.
By the time I saw the writing on the wall, following the collapse of Lehman Brothers, it was too late to sell the stock for anything other than a tax loss. The stock was now trading at about a buck and a half and was continuing its downward ascent. The market had been correct all along and I had been wrong.
Never before had I purchased such a high interest in a single equity and never before had I so abysmally failed on a stock in which I held such a high conviction. I shudder when I think about how many hundreds of thousand of dollars that error cost me in the long run (I am certain that it cost me at least several points in my long-term CAGR); however, the lesson I learned was probably worth every penny of the losses that I incurred.
Moving Forward and Applying a Margin of Safety
The lessons I learned from the credit crisis and my experience with Gray Television fundamentally changed my investment behavior going forward. Surprising, I started holding fewer stocks, rarely making an investment unless I was willing to commit at least 10 percent of my funds towards a single stock. Additionally, since that time I have rarely purchased a company that does not hold a net cash position, although I have loosened up slightly as the years have passed.
Late 2008 and early 2009 would become a dream come true for value investors — I only wish I had saved some cash on the sidelines. Instead, I traded out of most of my previously held positions in favor of buying better companies which were trading at larger discounts to their intrinsic values. In the process I was able to create some valuable tax-loss carryforwards.
Investors were suddenly able to purchase viable companies which were trading at extreme discounts to their net current assets. The market had become awash with bargains which held legitimate margins of safety. The process accorded me a mild sense of redemption for my past investing sins. The key to redemption for all investors was staying fully invested during the market crash and the thought of raising a penny of cash never crossed my mind as the market continued to plunge.
When Reflections from 20 Years of Investing returns I will discuss some the stocks that allowed the family portfolios to recover from the extensive losses that they incurred during the credit crisis.
“We do not learn from experience; we learn from reflecting on experience.” — John Dewey