As the year 2013 draws to a close, it is time to sit down and reflect upon the investment mistakes that I’ve committed during the year. In doing so, I am immediately reminded of an excerpt from Warren Buffett’s 1989 letter to shareholders.
“To quote Robert Benchley, ‘Having a dog teaches a boy fidelity, perseverance, and to turn around three times before lying down.’ Such are the shortcomings of experience. Nevertheless, it's a good idea to review past mistakes before committing new ones.”
Alas, how I wish I had a magic dog to teach myself to avoid soggy cigar butts on the street. The biggest mistake I made this year unmistakably falls under this “cigar butt” category. In a year where S&P advanced more than 30%, I’ve brilliantly managed to invest in a company whose share price has sunk over 50% since the beginning of the year. It is certainly not fun to slip up but getting up and learn from the fall has proved to be extremely rewarding. Heck, in fact, I consider this the best investing lesson that I have ever learned because as a result of the mistake, I now have a much better understanding of the shortcomings of the cigar butts approach to investment.
This cigar butt is called JC Penney. The mistake I made is a multifaceted one that involves analytical errors, human psychological biases, and a horrible purchase price.
To be clear, I don’t think buying JC Penney is a mistake per se. I’ve bought JC Penney in 4 tranches, the lowest at $8 and the highest at $17.Whether it is a mistake depends on the price paid. As Howard Marks has said before:
“In investing there is no such thing as a good or bad idea. Only a good idea at a price. Anything can be a good idea at one price and time, and a bad one at another. There is no investment idea so good that it can not be ruined by a too-high entry price. And there are few things that can not be attractive investments if bought at a low-enough price.
It has been demonstrated time and time again that no asset is so good that it can’t become a bad investment if bought at too high a price. And there are few assets so bad that they can’t be a good investment when bought cheap enough. No asset class or investment has the birthright of a high return. It’s only attractive if it’s priced right.”
I have certainly paid too much for JC Penney and that was a huge mistake that has cost me dearly. At the time I bought the first tranche of JC Penney, it was around $17 per share. In an article I wrote called “JC Penney – Maximum Pessimism,” I laid out my thesis based on JCP was trading around the liquidation value estimated to be between $13 to $16 per share. One of the readers made the following great comment: Liquidation value is one of those things with a big range of possibilities IMO. In a bankruptcy preceding, I doubt current shareholders will get even $9 per share or even $5 for that matter. Although I don’t know this member personally, I can tell he is without a doubt a much better investor than I am.
I’ve learned the hard way that liquidation value is as real as a mirage. First of all, the liquidation value is very likely to evaporate like liquid left in the sun if the business is not improving. JC Penney’s book value dropped almost by half within a relative short period of time. Therefore, using the present liquidation value was very foolish. Had I extrapolated the liquidation value for JC Penney based on the speed at which the business was deteriorating, I would have come up with very different scenarios. Secondly, as I have learned through studying Buffett’s partnership letters, liquidation value itself provides very limited downside protection unless you can accumulate a controlling position and even if you can end up controlling the business, the liquidating process is likely to be very painful.
Given the inadequacy of liquidating value, it is not surprising that my worst case scenario was way too optimistic, which leads to another lesson – risk means worst case scenario can happen more often and can be more severe than you think. Frankly, I did not think JC Penney was going to drop to merely $6 per share. Mark Twin said “a man who carries a cat by the tail learns something he can learn in no other way.” My experience with JC Penney has certainly proved his point. Almost everything that could go wrong did go wrong. Sales dropped precipitously; the board room was full of dramas; drastic leadership turnovers; solvency issues; liquidity crunch; massive equity dilution. Even when sales are improving, no one seems to care because everyone is now concerned that margin will stay low forever. I would be lying if I tell you that all the negativity did not bother me one bit. It was unpleasant mentally to go through the turmoil but I am also fully aware that I deserve such agitation. Without such agitation, I probably won’t be able to fully appreciate the beauty of “it's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
I wish I could stop right here and tell everyone that’s all the mistakes I’ve made about JC Penney. Unfortunately, the dimension of this flub extends beyond sheer analytical blunder. I also failed utterly to recognize the human psychological forces that were in play.
At the time I made my purchase decision, JC Penney had a very promotional CEO and a promotional activist, Bill Ackman, who I actually admire a lot. Looking back, my analysis was heavily influenced by the way Ron Johnson and Bill Ackman presented information (framing bias) and the ease at which the information can be recalled (availability bias). What initially got me really interested in JC Penney were a few articles on gurufocus and Bill Ackman’s presentation. Unfortunately, the presentation served as my initial anchor. Below are the slides that got the neurons in the nucleus accumbens part of my brain fired like wild.
Upon deep reflection, I think the root of my mistake lies in the part of my brain that handles anticipation for rewards. In Chapter 3 of the great book “Your Money or Your Brain” by Jason Zweig, the author noted that “Making money feels good, all right; it just doesn’t feel as good as expecting to make money. In a cruel irony that has enormous implications for financial behavior, your investing brain comes equipped with a biological mechanism that is more aroused when you anticipate a profit than when you actually get one. The arousal piece is actually the main component of euphoria, and it’s expectation- not satisfaction – that causes most of that arousal. When rewards are near, the brain hates to wait. Neurons in the caudate nucleus, a region in the center of the primate brain, become active even before the predictive cue is presented.” Now I can imagine that the neurons in the caudate nucleus must have been fired up when I saw Mr.Ackman’s base case offered a 6.5 times upside when JC Penney was trading at $17 per share.
Fixating on the upside made me overlook the magnitude of the downside. Under influence, my calculated risk reward ratio seemed favorable: using 20 year low of $10 as worst case and $39 - only half of Mr. Ackman’s base case as fair value, at $17 per share, the downside was $7 and upside was $22 with. For every dollar of risk, I thought I was getting 3 dollars of rewards. The odds were favorable.
The reward seemed so real and the anticipation was so exciting. There was only one little problem – in reality, it doesn’t work that way. The rewards are imaginary while the risks are real.
I had the fortune to talk about JC Penney with a few renowned investors including Arnold Van Den Berg, Stephen Yacktman and Michael Shearn. All of them have considered investing in JC Penney yet all passed. Among the reasons they ultimately did not invest are promotional management, too hard to figure out and too much downside. None of them even mentioned the upside during our conversations. This is the difference between a wise man and a fool when it comes to investing. The wise man knows that if you take care of the downside, the upside will take care of itself. Now I realize that even though the risk reward was favorable, the downside of 40% was too much and because the uncertainty was so high, one should pay a lot less for taking on the risks, not more.
The above may all seem very obvious to most of the readers but I had to learn it the hard way over and over.The confluence of the framing bias, the availability bias and the anchoring has been skewed my reasoning in the past to the more euphoric side of the pendulum. It was not until the second half of this year did I recognize the power of the lollapalooza effect, which Charlie Munger has warned us. But better late than never. The JC Penney experience will definitely serve me as a reminder going forward.
The last mistake I made with the JC Penney investment is related to portfolio sizing. It had been a 15% position in my portfolio. I am still debating whether this is as huge as a mistake as the analytical error and the lollapalooza effect. After all, I resonate with the idea of concentration unless everything gets cheap like the experience of 2008. Nevertheless, a 15% position in a struggling retailer does seem too high with the benefit of hindsight.
Now that I have finally listed out all the mistakes I’ve made with JC Penney, I feel obligated to apologize for having rambled so much on an investment that has been discussed very extensively on gurufocus. Of all the mistakes I have made and believe me, there are a lot, the JC Penney blunder is by far my favorite because I have learned tremendously from a multidisciplinary approach.
Charlie Munger once said “I like people admitting they were complete stupid horses’ asses. I know I’ll perform better if I rub my nose in my mistakes. This is a wonderful trick to learn.”
Therefore, at the end of 2013, I’d like to admit that I was a complete stupid horse’s ass but I’ve learned to rub my nose in my mistakes.
Thanks for reading and happy new year!
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