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The Science of Hitting
The Science of Hitting
Articles (454) 

Three Simple Lessons from My Investment Blunder

December 07, 2011 | About:

In early 2009, I purchased a stock that I had been following for some time: Callaway Golf (ELY). At the time, the stock was trading for around $8/share, and was off a peak of nearly $20/share in mid-2007. In addition, the company had a book value of nearly $9/share, and had been profitable in ever year besides one from 2001-2008. While the company was on its way to a net loss in 2009, I felt that this was a temporary setback and that the company would soon be profitable and back to a mid-teens share price (consider the fact that in 2005 the company had received an all-cash $16.25/share offer from Bain Capital and MacGregor Golf). Fast forward two years and the stock is trading for $5.59/share, down more than 30% from where it stood in late 2009; here are the lessons that I took away from the failed investment (I exited with a miniscule loss in early 2011):

WATCH THE CASH – As Whitney Tilson noted in a recent interview on CNBC, Microsoft (MSFT) should issue debt to buy back stock and pay dividends because they have a consistent free cash flow generating machine and have no need for $50 billion plus in net cash on the balance sheet; for Callaway Golf, this isn’t the case. A great example of this is in 2008, when the company brought in a solid $66 million in net income; however, they also spent $51 million on capital expenditures, $10 million on acquisitions, $23.6 million on share repurchases, and $17.8 million on dividends. For a company like Callaway, which has proven highly cyclical, capital preservation should be paramount and the mix of reinvestment and distributions of cash to shareholders must be intelligently planned, a strategy they did not follow in the boom years leading up to the crash.

WATCH THE DIVIDENDS – In June 2009, Callaway was forced to issue $140 million of 7.50% Series B cumulative perpetual convertible preferred stock to remain in compliance with financial covenants. Sounds like a good time to cut the dividend, right? Well management eventually did… to a quarterly payout of $0.01. Why they felt the need to maintain the payout at a time when they were bleeding cash is beyond me; all I can tell you is that it was not in shareholders’ (meaning the long-term owners of the business) best interests; management’s insistence on maintaining the dividend at a time of turmoil showed a clear focus on stabilizing the short term stock-price and should have been a red flag to any prudent investor.

STAY AWAY FROM CRUMMY BUSINESSES (“When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”)– At the end of the day, the most important lesson is that I have no merit in blaming the jockey; I should have realized the horse was a loser and never bought a ticket. The company has no sustainable competitive advantage, and was competing against a fierce competitor in Titelist (which at the time was owned by a division of Fortune Brands). It was highly dependent upon a country where participation in golf had consistently declined over the previous five years, and showed no real signs of slowing (an issue further exacerbated by the economic crisis). Despite knowing all of this well before buying any shares, I set it aside by telling myself that international growth would revive the industry (hasn’t happened) and that Callaway would catch up to Titelist and eventually lead the industry (hasn’t happened).

In the end, I walked away with nothing to show for my efforts while the DJIA & the S&P 500 both increased by 50% plus; over time, the lessons learned will hopefully pay for themselves many times over and prove to be a blessing in disguise.

About the author:

The Science of Hitting
I'm a value investor with a long-term focus. As it relates to portfolio construction, my goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach to investing is "patience followed by pretty aggressive conduct". I run a concentrated portfolio, with a handful of equities accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

Rating: 4.7/5 (32 votes)


Adib Motiwala
Adib Motiwala - 5 years ago    Report SPAM
Thanks for sharing. You did not comment on what was the valuation when you bought this stock in 2008...
Jayb718 - 5 years ago    Report SPAM
We all makes mistakes, the trick is to try and not get too good at it ;-)
Augustabound - 5 years ago    Report SPAM
I appreciate articles like this one. Learning from mistakes are usually the most important lessons.
AlbertaSunwapta - 5 years ago    Report SPAM
One, few saw, let alone prepared for the financial crisis

Two, the recessionary effects of that crisis will persist for a few years

Three, golf courses must be suffering too

Four, golf comes second to mortgage pmts, doing overtime at the office and working a few years longer to afford retirement

I wouldn't be surprised if you made a great purchase but your short term outlook and the fears of former owners selling out at lower and lower prices have caused you to doubt yourself. I don't follow the market but I suspect demographics, course fees, slow economic recovery were all in your favor.

Can you answer this? Is the entire industry equally under stress or is Callaway falling behind the competition? Maybe the right decision was to add to your holdings rather than sellout.

As far as it not tracking the benchmark, I believe that in 2008/08 the market essentially became a cash only market and many highly leveraged companies, banks and commodity based firms were driven to great depths and then participated in the great top down bailout based recovery. During that time there was initially a flight to quality then a flight from everything. As the market rebounded there was a flight back to crap. You shouldn't be surprised if quality and near quality lagged.
The Science of Hitting
The Science of Hitting - 5 years ago    Report SPAM
Thanks for the comments everybody; here are some responses:

Adib - I mentioned it above: the stock was around $8/share. Book was around $9, private investors had shown interest around 2x the market price, and I thought the company was trading around 8x my estimate of normalized earnings...

Jayb - very true; hopefully I get worse each and every day haha

Augusta - thanks for the comment; agreed 100%

Alberta - a couple of points on what you had to say:

1. I certainly could prove to be wrong, and I think you are right about the demographics over time. My point was that this isn't a good business, the company isn't an industry leader, and value was not being created over time (in my opinion being destroyed by poor capital allocation), which meant my IRR was going down the longer it took for price to converge with value. From my perspective, I would rather buy a great business at a decent price, where I can watch the value of the business increase over time regardless of the short term reaction in the stock price.

2. The entire industry is under stress, but the point is that weaker competitors are under additional stress compared to the market leader; while Titelist has remained profitable throughout the recession, Callaway has lost money. In addition, poor capital allocation (inappropriate dividends, leading to preferred issuance) has put the company in a position where solvency is an issue, compared to Titelist and Taylor Made (owned by Adidias), which have continued investing in their brands/technology with subsequent favorable results.

3. My final decision to sell wasn't due to the stock's price; as you noted (and which I agree with), ELY was increasingly attractive as the price declined. My main issue was with poor management and capital allocation decisions, with increased fear of dilution (look at the damage done to common holders from the preferred issuance); at the end of the day, I found it difficult to justify holding a poor business at a cheap valuation when I can buy great businesses like MSFT which are continuing to generate value for shareholders (even if it isn't reflected in the current market price) and trade at a similar discount to intrinsic value.

From my perspective, I would still be interested in buying ELY; however, it would need to be at a market cap around $300M, which I think is roughly 6x their normalized earnings power of $50M/year and a 30% discount to tangible book. My original purchase was too high a multiple for a cyclical business with limited pricing power and significant sensitivity to fluctuations in the business cycle.

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