This article represents the first part of a series of articles, and will set out to explore what intelligent investing is, and more specifically, what it is not.
I do so, in order to use Charlie Munger (Trades, Portfolio)’s famous mental tool of inversion:
"All I want to know is where I'm going to die so I'll never go there."
The way I will explore this is by illustrating the ups and downs of my own investing forays. As such they will illustrate what I’ve done when I’ve done well, but more importantly they will explore the mistakes I’ve made when I’ve been wrong, and the lessons to be learned from those experiences.
Intelligent investing: Visa
Visa (V, Financial) hardly needs an introduction. It is one of the world’s largest, most revered and reputable companies. Billions of people all over the world use their transaction services all over world, every single day. In 2014 they processed $64.9 billion worth of transactions.
Thesis
From mid-2010 and a year ahead, Visa’s stock suffered a 25% decline because of uncertainty over a certain banking reform, which would cause the fees they could charge on each swipe a Visa card to decline. This would obviously eat into Visa’s profits, but as so often before in politics, the result turned out to be much different from the initially proposed one.
One of my favorite things as a value investor is seeing Wall Street get its panties up in a bunch, due to uncertainty related to a pristine company, as indeed was the case here. It was not only Visa’s stock, which was affected however. Mastercard and Discover took quite a tumble as well during this period, as they would all have been effected by the consequences of this legislation, was it to pass in its proposed form.
Upon hearing the news I analyzed the company’s financials in depth, and figured quite quickly that it was a company that was very tightly run, by a bright, able and honest CEO. This part was fairly easy, and I believe most people would have come to this conclusion. The hardest part for me was convincing myself that the company was undervalued at a P/E of around 30, i.e. that there was more growth to be had, and that the multiple wouldn’t shrink as the company grew. I figured that a company, which was so well run, widely recognized and admired, would only continue to expand as people shifted away from cash and check payments towards digital transactions.
Furthermore, Visa had and still has one of the strongest brands I had ever seen, which translates into a sizable moat. Being an avid reader of “The Snowball,” I couldn’t help but note the resemblance to Warren Buffett’s investment in American Express (AXP, Financial), which worked out so favorably. This is clearly a case of anchoring and availability bias, and represents a mistake caused by biases, but more on that later.
Killing the thesis:
When it came to killing the thesis, I did some back -f-the-envelope calculations and figured, that even if the new fee structure was implemented, the drop in the share price was overdone, and would be reversed as soon as the uncertainty lifted, regardless of the outcome. I figured that Visa’s moat was wide enough to transfer at least some of this fee to customers, i.e. the businesses wanting to use Visa’s services. This factor combined with the fact that I could not imagine a scenario where the volume of transactions wouldn’t increase over time, meant that there was no way I could see this decline as being justified. Visa is almost a perfect company on any relevant metric, and deserves a premium valuation because of this. Now I don’t think that any company is cheap at 30 times earnings, but it was relatively cheap compared to previous valuations (again a mistake of anchoring) and I kept thinking of Buffett’s AmEx investment, and the quote: “It is far better to buy a wonderful company at a fair price than buying a fair company at a wonderful price.”
Outcome
In terms of time horizon, I figured that this was a case of Mr. Market being unduly depressed, as he usually does in times of uncertainty, and so I figured that he would eventually correct his own mistake when he cheered up a bit. And I was right. In the following 12 months I made more than 60% on my investment, which might look impressive, but it doesn’t take in to consideration the fact that the valuation as of this writing is more than twice as high. Looking back, I might have sold too soon, but I looked at the fundamentals, and my opportunity cost, and figured my money could be better placed elsewhere. Hindsight is also 20/20, but reflecting on that situation, I don’t necessarily think selling at that point was a mistake. However, the question of when to sell is one of the toughest questions in investing, and one I haven’t seen answered definitively just yet.
The outcome of this investment was good, because my research was thorough and my reasoning was good, thus I made a successful investment and a handsome profit.
Unintelligent investing: LHC Group
LHC Group (LHCG, Financial) was a company I invested in around the same as I invested in Visa, and the case is quite similar, but the outcome is very different.
Thesis (and the unintelligent investing part):
The thesis I built for this company, seemed sound at the time, but I made two errors that in Value-Investing terms are unforgivable, and a few smaller errors that one can sometimes get away with, but in this case only compounded my errors. These mistakes will cost you money in the long run, and that is exactly what they did in this case. LHC Group provides at-home care for elderly patients, and their stock had dropped because of uncertainty over the way their earnings were accounted for.
There was insecurity mind you, but no evidence of fraud, either before or after my investment. The insecurity arose due to the complexity of their operations and due to the linkages between government and insurance reimbursements, which could take years to be fully accounted for. This made their accounting exceedingly complex and thus highly difficult to understand. But as an outsider looking in to the business, I thought I understood it perfectly well, because I figured their business was just a matter of taking care of old people (Now that’s a case of Overconfidence Bias, if I ever saw one).
So my first crucial mistake was not knowing where the edge of my Circle of Competence is, and overstepping those boundaries exactly because of this. My second major mistake, which is related to the first one, is not being able to judge management correctly. This, of course, arises from the fact, that I didn’t know the business well enough, and thus wouldn’t have been able to tell good management from bad, if the former hit me over the head with the latter.
Now, I will go deeper into the reasons why I made these mistakes, so that they can be avoided in the future. When I came across the company, I was immediately enamored with their mightily attractive financials. They had been growing sales and profits at a highly reasonable number (19-ish % since 2008) and had zero debt. At the same time they were trading at a multiple in the low teens, so if I understood anything, I understood that they were not priced like I thought they ought to be. I figured they probably wouldn’t be able to maintain this growth rate, but I figured they wouldn’t have to. I figured that value and price would converge eventually, which it did. Just not in the manner I had hoped for.
So I had a stock, which I figured would be a wonderful place to deploy my capital. I was completely blinded by their fundamentals, growth and valuation, which made me forget all about killing the thesis, questioning management’s capability and integrity. I did a lot of research on the company, but because of Confirmation Bias, I completely overlooked the evidence that went against my thesis. And there was plenty of it – but there was also plenty that supported my thesis, and that’s the only evidence that I saw at the time. I completely disregarded killing the thesis, which likely would have made me understand that I didn’t know the business as well as I would have liked to.
Outcome
After the company reported its first two quarterly losses, and the stock losing 25% of the value I bought it for, I decided to cut my losses and vowed never to make those same mistakes again.
This outcome certainly has a ring of poetic justice to it, seeing how my reasoning was flawed, I made mistakes and I was punished justly for them.
Conclusion
There are certain companies that are easier to understand than others, and knowing the difference between ones that are easily understood and the ones that are not is a skill that is as essential to successful investing as analyzing a company’s financial statements.
To repeat the lesson of every famous value investor; One must absolutely, 100 %, without deviation stay within one’s circle of competence. This is however, more difficult than first realized because of the tricks that biases can play on your mind.
A key lesson to draw from these two examples is that Behavioral Biases can do a lot more damage, than one might realize at first glance. Therefore it is absolutely crucial to one’s investment outcome to be aware of them. They are however, a law of nature, and knowing how they affect us, to which degree, and in which direction is usually a good place to start.
The last lesson I learned from these two investments, is one relating to uncertainty in the stock market:Ă‚ Specifically the fact there is a major difference between Uncertainty caused by actions within company as opposed to outside the company.
When uncertainty is caused by factors that are outside the company’s control, such as regulation, or changes in the industry, the stock market is prone to reacting unjustifiably harshly and sending the stock into a tailspin. This tends to be overdone, because the changes are usually not as severe as they appear at first glance. An example of this can be taken from the retail-sector. In 2010 the stock market sent most of the clothing-store related stocks tumbling because the market believed that online retail would completely replace brick-and-mortar stores, and they believed it would happen almost overnight. This reaction was too harsh, and as a result most retail stocks rebounded neatly shortly thereafter, rewarding the stockholders.
Uncertainty caused by actions within a company however, are much worse, because they are usually precipitated by some sort of red flag which someone has got a hold of. More often than not, these situations tend to get worse over time, and as such they can be detrimental to your investment performance, so I recommend staying away from those situations, until they sort themselves out, regardless of how attractive the situation appears at first glance.
This concludes part 1, of the series. I hope you enjoyed it, and will be back for part 2.
