Over the past 15 years, we’ve had the privilege of managing our investment partners’ portfolios. During that time we have made mistakes that ranged from mild to significant impact on the portfolio. In this week’s article I wanted to share some of these mistakes, the reasons we made them and how we’ve changed to decrease the chances of making such a mistake again.
Before we get into the specific examples of mistakes we’ve made, it’s important to make the distinction between sins of omission versus sins of commission. In the words of Warren Buffett (Trades, Portfolio) one is a case of thumb sucking whereas the latter is a case of unforced errors. While neither leaves you with a warm feeling, we would much rather have the former than the latter in our investment performance.
In the case of sins of omission, there have been many cases where we should have pulled the trigger versus the proverbial chewing on the fifth digit. There are too many examples to name in this category (such as MasterCard (MA, Financial) at its IPO price of $39/share) but we defend ourselves with the following excuses:
- We Didn't Invest Because the Numbers Didn't Meet Our Criteria. While we regret not participating in some companies’ stock performance, we are satisfied knowing our outperformance is based on these very criteria that made us miss such an opportunity. If we lost a couple percentages in returns because we stuck to our model and sleep comfortably at night we can live with that. And so can our investors.
- Hindsight is 20/20. L.P. Hartley said once, "The past is a foreign country: they do things differently there." Ain’t that the truth. If I had a nickel for every time somebody told me they were eighth investor in Microsoft, I wouldn't need to be managing investment portfolios. In our case we revel in our missed opportunities. When that happens we know we are living within our circle of competence and sticking to our investment strategy.
- We Didn't Have the Cash: As a focused portfolio shop with extremely long holding periods (7-10 years), we don’t usually have a lot of cash sitting around waiting to be invested. In addition, we generally don’t sell a stock to replace with one with better valuation (we have done it before but generally avoid this). Once we have found a great company that allocates capital well and compounds value like a machine we are very leery of letting go.
We haven’t really found a great way to eliminate these missed opportunities from our investment performance. As long as we stick within our circle of competence and investment criteria, we are clearly going to miss some opportunities.
That which doesn’t kill you … makes you really sick to your stomach
So where do we start in regards to our proactive mistakes or “unforced errors”? There have been a lot. More than we care to recall. But one that sticks out as particularly painful – and enlightening – is our investment in Corporate Executive Board (CEB, Financial).
We first purchased shares in the company in 2004 for $39.45/share. By 2007 the price had risen to nearly $90/share and we were congratulating ourselves on our brilliance. Stultum facit fortuna quem vult perdere indeed. And fools did we look like after the stock dropped from $85/share to roughly $22/share by the end of 2008. As if this wasn’t punishment enough, the company cut its dividend from $1.76/share to $0.44/share. Revenue dropped from $16.26/share in 2007 to $12.70 by the end of 2010. Gross margins dropped from a tradition mid-20’s to less than ten percent.
So how did we get this investment so wrong? First, we completely overestimated the need for businesses to purchase CEB’s products and services. Rather than a core-need it was a “nice-to-have” which was quickly eliminated from corporate purchasing during the Great Recession. While we thought the company had a wide moat it was actually a great business for the time – just not for the future. And that’s not a sustainable competitive advantage in any way, shape or form.
Second, we vastly overestimated the cash flows in our modeling assuming the company could continue its same growth over the past five years. Free cash flow went from $119M in 2007 to $22M by 2009. In no way did we create a worse case scenario that built these numbers into the model. Shame on us for not keeping an open enough mind and really think as business owners.
Third, management made several extraordinarily bad decisions about capital allocation. One of these was using $303M to repurchase stock during 2007. While it seemed wise at the time, the use of cash for this purpose was a simply awful use of capital. The average price paid was roughly $65/share. Less than 12 months after purchasing these shares to stock was roughly $27/share. Somebody once said that a person’s act of jumping off a cliff “was either incredibly brave or remarkably stupid.” We unfortunately believe this was the latter.
Conclusions
As we look back on the error we made on Corporate Executive Board, we realize how apt Seth Klarman (Trades, Portfolio) was when he described investing as an "arrogant act". In this particular case we were guilty of intellectual laziness. The arrogance of our success got the best of us. Since that investment we have built into our process a more detailed – and extreme – model for worst-case scenario testing. In addition, we have dramatically upped the time we spend on understanding both the demand and stickiness of our investment company offerings. Mistakes are only valuable when you learn from them. We know we will make bad investment decisions in the future. That's a given. Our success will depend on what we've learned and how we minimize the chances of repeat offenses going forward. As always we look forward to hearing your thoughts.
