A Humble Attempt to Trumpet A Failure of Investing

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Jan 26, 2015
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It's a good habit to trumpet your failures and be quiet about your successes.

-Charlie Munger (Trades, Portfolio)

I bumped into Charlie Munger (Trades, Portfolio)’s above quote just recently. Reflecting back on what I have written on this forum, I realized that I have ultimately failed to “trumpet” my failures in investing. As much as I wish I could say that there aren’t any mistakes, the brutal reality is that there are actually so many mistakes during my investment career that it would take a major portion of my living time to write about all of them. One thing I found comforting is that since I was able to add a few items on my personal investment checklist, over time the frequency and magnitude of my mistakes have become more manageable and bearable as I am more aware of my blind spots. However, one mistake that I’ve made in the past two years stands out as a lollapalooza. This mistake actually inspired me on a few of the past articles that I have written. In this article, I’d like to share with the readers my path to misery and what I have learned from this mistake.

I made this mistake in early January last year. From my investment journal, this stock caught my attention because three gurus that I admire enormously – Prem Watsa (Trades, Portfolio), Howard Marks (Trades, Portfolio) and Wilbur Ross (Trades, Portfolio), reported a combined 40% position in this company – EXCO Resources (XCO, Financial). I was fairly familiar with the name because Wilbur Ross (Trades, Portfolio) has been touting this company since perhaps 2012 when it was at a much higher price. The thesis seems simple – EXCO is a low cost natural gas producer. It had about 1,124 bcfe proved reserves at 12/31/2013 with operations in the hottest natural gas regions in the United States.The stock tanked along with the prolonged depressed price of U.S natural gas. There were arguments for the inevitableness of a rebound in natural gas price and when that day comes, EXCO’s stock will fly up high. And it seemed like the price of natural gas should be higher because you can get 5.5mmbtu from 1 barrel of oil, or 0.98mmbtus from 1 Mcf of natural gas and when WTI was at $100/bbl, it is equivalent of $18.2/mmbtu of natural gas versus the then natural gas price at $4.0/mmbtu. Of course that is just based on an energy equivalent basis. You have to take into other considerations such as technicality and transportation, but it sure looked like natural gas was too cheap.

We all know what happened since then. Oil price sank, when WTI dropped from almost $100 to the low $40 per barrel, the natural gas energy equivalent dropped from 18.2 to ~7.5/mmbtu. Natural gas price remains depressed. XCO, with its highly leveraged balance sheet, plummeted more than half.

Fortunately for me, XCO was a small position back in early Jan 2014 because I figured that it will natural grow into a larger position if the stock gets higher. But no doubt this is the biggest mistake I’ve made in the past two years. With the benefit of hindsight, I could see there is a confluence of mistakes that led to this undesirable investment decision. Fundamentally though, the most severe and difficult-to-avoid mistakes are the ones that Buffett and Munger have warned us many times.

The biggest mistake, in my opinion, is not knowing the edge of my circle of competency. If you remember, I wrote an article not long ago about understanding circle of competency and knowing the edge of your competency. In it, I wrote the following:

I know a business is out of the boundary of my circle of competency if:

1. I don’t understand the business model, or

2. I cannot assess the most important factors that will make the business succeed or fail in the long run, or

3. Even if I understand the business model and the most important factors, I cannot confidently assess how these factors will play out in the next 5-10 years.

In the case of EXO, I thought I knew the answers to question two and three above but I clearly didn’t. This inspired me to write another article on the topic, in which I listed energy, metal and retail as areas that we, as value investors should be very cautious in claiming circle of competency in these areas. I wrote the following specific to the energy and metal sector:

Energy and metals are another two sectors where many value investors claim false “Circle of Competence.” If you ask a typical analyst what the business model of an energy E&P company is, he or she will probably tell you that you make all these capital investments in machines and equipment so you can drill oil or gas wells, then you extract them out of the ground and sell them to somebody else, hopefully at a price that not only covers your extraction and development cost but also makes you nice little profit. Similarly, for metal miners, they invest in the mines, extract the metals and sell them to someone else. Of course there are many other sub-industries in this sector such as oilfield services, offshore drillers, steel mills, etc. But if you ask me what is the most important factor that affects almost all businesses in this sector, I would say it is the price of the commodity, be it the price of oil or gas or gold, the future price of which I would argue very few of us can forecast with a reasonable amount of confidence. I was looking at some onshore rig services companies recently and stumbled onto the 2001 and 2002 annual report of this one company. I was shocked to find out that, at one time during that period, oil was below $20 a barrel. That was merely 12-13 years ago and just recently, many people were freaking out because oil dipped below $80 a barrel. Incidentally, during the same period, gold was trading below $300 per ounce, which is about one-fourth of where it is today and one-sixth of what it was two years ago. If we were in the middle of 2002, instead of 2014, could any of us imagine the price of oil and gold would quadruple within the next 12 years? I doubt many of us could. And if we couldn’t, we should think twice if we think energy and metal businesses are within our “Circle of Competence.”

Now you see how I came up with the above conclusion. It was a result of a bitterly swallowed pill.

The other big mistake I made, is something I’ve also written about – borrowed conviction is the most dangerous one. In order to be a great copycat, you have to control your greed and say no to the “action man” inside your brain. You also have to remember that borrowed convictions are often the most dangerous ones. Great copycats have a system that enables them to filter out the ideas that are out of their circle of competency and at the same, keep their greed in control by implementing a checklist approach. In XCO’s case, even though I knew the leverage ratio was too high, which is an important item on my checklist, I went ahead with the decision because the three gurus’ large position reinforced my otherwise fragile conviction that the upside was also very high. We know leverage works both ways and boy was that the case for XCO.

Almost a year later, reading the record I have on XCO, I couldn’t help but laugh at myself for being so ignorant and irrational even though I had always pursued knowledge, rationality and intelligence. It is psychologically hard to admit one’s mistake in public I have to confess. The brutal reality is, all of us will flunk from time to time and the only way to avoid failure is not investing at all. But on the bright side, each mistake gives us something to add on to our checklists so that in the future, if we learn from our mistakes in the past, we will make fewer and less severe mistakes.