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Geoff Gannon
Geoff Gannon

How to Avoid the Same Mistakes Your Heroes Made

You can afford to miss out on opportunities, but you can't afford to lose your own subjective sense of risk

Someone who reads my blog emailed me this question:

"I still remember clearly that I asked you about Valeant (VRX) during their heydays. You said you would never consider it. I understood your logic but just couldn't refuse the temptation to study it more closely. I didn't put any money in it. My point is, unlike you, I got caught up with all its positives still.

"You seem to be so good at staying the course, focusing and just thinking more independently. Have you always behaved like this since you began investing in your early teens? Or did you learn to be more so through experience and time?

"The more I learn about investing, the more I understand how much a negative art this is, maybe more so than a positive one. Saying no to things is just so incredibly important in this game."

OK. A few points here. One, some really bad news. I was better at saying no when I first started investing. I started investing my own money when I was 16, and I knew I didn’t know anything. But then I read Ben Graham and Warren Buffett (Trades, Portfolio) and all the others. I read about net-nets and low price-book (P/B) and merger arbitrage. And I read about different strategies and “rules” and so on that value investors have.

A little knowledge is a dangerous thing. And it certainly was for me. I was probably at my worst when I was reading the most. I think that’s true for a lot of investors. And for a lot of novices in a lot of fields. People do not start out blindly following bad ideas. But then they start reading these books and start falling into groupthink. Even value investors are a herd.

I like Sequoia Fund. And I like Glenn Greenberg (Trades, Portfolio). And they both owned Valeant. The reason I wouldn’t consider Valeant doesn’t have to do with me being better or worse than you at seeing these things. It has to do with where our blind spots are. I’ve made plenty of mistakes. I bought Barnes & Noble (NYSE:BKS), Weight Watchers (WTW) and Town Sports (CLUB). Those were all mistakes. Everybody makes mistakes.

Buffett bought Bank of Ireland. He’s made a couple of investments when he probably lost close to everything he put into the stock. Graham made mistakes. You can read about some of them in his memoirs. Each of us has our different blind spots. The value investors who liked Valeant most tended to be those who paid a lot of attention to management.

I co-wrote a newsletter with Quan. And we had the opportunity to talk to management at some companies. He exchanged emails with some chief financial officers. If you read the newsletter, you might never have known this. We tended not to include comments management made to us. I tended not to be that interested in talking to management at all. We were always more interested in talking to the people (customers) who made purchasing decisions or the store managers or something like that. We just aren’t very focused on the “jockey.” We make plenty of mistakes. They’re just different mistakes than someone who would buy Valeant stock would make.

In fact, you could say that not thinking enough about the “jockey” was part of my mistake in buying Barnes & Noble. I bought into Barnes & Noble during a proxy fight between Len Riggio (the founder) and Ron Burkle. I knew someone who worked at Barnes & Noble. Talked to him quite a bit about the stock, the company, the industry and the Riggios. I might have even known more about the culture of the place than the average investor who was short the stock knew. I should have known that the No. 1 priority wasn’t going to be shareholder value.

Barnes & Noble – in the founder’s hands – wasn’t just a corporate cash cow. It was a force in the book industry. Management wanted it to stay relevant – not just commercially but culturally. It didn’t want to effectively put the stores in runoff and re-invest the free cash flow. So it bet big on money losers – but potential saving throws – like the Nook.

If I had been more of a “jockey” than a “horse” investor, I wouldn’t have touched Barnes & Noble. But I was attracted by the free cash flow I thought it would throw off in the years of relevance the stores had left. I’ll remind you here we were talking about 2010 not 2016. Barnes & Noble had some years of decent cash flow ahead of it.

I knew free cash flow would run well ahead of reported earnings. The proxy vote was close. I mean, it’s rare to even challenge a company's founding management when it controls so much of the stock. But Burkle lost. And then I was stuck with a horse with a price I liked, but it had the wrong jockey. That’s the kind of mistake I’d make that someone who invested in something like Valeant wouldn’t make.

Quan (my newsletter co-writer) and I would do post-mortems from time to time. We’d look at our successes and our failures and see what traits were unique to our failures. What mistakes did we keep making? We bought stocks that were too highly leveraged. This is the result of stock prices being historically high at the time we were writing the newsletter. We’re such value investors in terms of things like price-earnings (P/E) and price to free cash flow that we were more willing to buy a heavily indebted company (like Weight Watchers) rather than some unleveraged, high quality stock with a P/E of 30.

This has happened to me before. I bought some stocks with too much financial risk in the last years (2006-2008) of the pre-financial crisis boom. Not predicting the financial crisis wasn’t the issue for me. Choosing leveraged stocks over expensive stocks was my mistake. You can pay too much for a stock. It’s not the problem I have. I’ve lost money in specific stocks before. But it’s never because I paid too high a price for an otherwise good stock. Plenty of other investors make this mistake.

You must look back at your own history and see which mistakes you make. Think of risk as a subjective measure rather than an objective measure. Some people might think that a high beta on a stock or a high short interest are the signs for which to watch. When Quan and I looked back at our past decisions, that wasn’t true. Short interest is a good example. Some of our big mistakes had high short interest. But so did some big successes. In fact, when we broke down all our past decisions, there wasn’t any consistent pattern in terms of short interest predicting bad outcomes. Some stocks that seemed by all measures to be safe – and which hindsight vindicated – had high short interest.

Short interest wasn’t a good predictor of mistakes for us. We included it on a list of warning signs. But short interest was never as useful as things like Z-Score, Net Debt/EBITDA and F-Score.

F-Score is another example of a good measure objectively that didn’t have much meaning subjectively. When talking to other investors, I always encourage people to check the F-Score and Z-Score on all stocks in which they are interested. It’s a good idea for most investors to eliminate every stock with either a Z-Score below 3 or an F-Score below 5. I also encourage most investors to avoid any stock that posted an operating loss (negative EBIT) in any of the last 10 years.

For Quan and me, this didn’t matter much. We found when we looked at the list of stocks that we would naturally pick that we almost never suggested investing in stocks with an F-Score below 5 or with an operating loss in the last decade. We were naturally or instinctively screening those stocks out. But we weren’t instinctively screening out high debt stocks. Using something like Z-Score and Net Debt/EBITDA was useful.

Some investors are independently minded. Others less so. I’d say that I’m pretty independently minded when it comes to rejecting the ideas of value investors I like a lot. Quan has said that Greenberg might be his favorite investor. Yet, when the topic of Valeant came up, Quan had no doubt. He wasn’t interested in that stock. It was one of Greenberg’s biggest holdings. But Quan didn’t even want to look at it. Likewise, Quan and I decided – this was probably sometime after doing an issue on Progressive (NYSE:PGR) – to focus on U.S. banks. We thought a bunch of them were cheap. And we ended up doing issues on Prosperity (NYSE:PB), Frost (NYSE:CFR), Bank of Hawaii (NYSE:BOH), Commerce (NASDAQ:CBSH) and BOK Financial (NASDAQ:BOKF). You’ll notice we didn’t do an issue on Wells Fargo (NYSE:WFC). Why not?

It’s not because we didn’t think Wells Fargo was high quality. In fact, we said in the Frost issue that while Frost was better than Wells in some measures, Wells was the higher quality bank overall. It had better fee income. It had a better loan portfolio. It could cross-sell. We thought Wells was at least as high quality as Frost. When we did issues on Bank of Hawaii and Frost, we used Wells as the best benchmark for a bank with an awesome low-cost deposit base.

We also did some calculations on which banks were cheapest. We thought – although this part is a little speculative – that Wells Fargo was at least as cheap as Frost (if you put growth aside). We thought Wells Fargo was one of the highest quality banks in the U.S. And we thought it was one of the cheapest banks in the country. It is also Buffett’s biggest investment. It’s his favorite bank. When asked about banks, he’s said that although he owns both Wells and Bank of America (BAC), Wells is his favorite. Charlie Munger (Trades, Portfolio) runs investments at Daily Journal (DJCO) and that company concentrated in a big way in Wells Fargo stock. Other investors we like – like Tom Russo (Trades, Portfolio) – own plenty of Wells.

Why didn’t we write about Wells? We did issues on five different banks. Isn’t Wells safe? Isn’t it cheap? Don’t we trust Buffett and Munger? The answer to all those questions is yes. But we simply couldn’t understand Wells. Not really. It’s a lot more complicated than the banks we picked. The banks we wrote about were simpler, regional banks. Frost doesn’t even really make loans to households. It collects deposits from households and businesses and then it lends to Texas businesses and buys state of Texas (and related) municipal obligations. It was easy to look at the loan portfolio and the bond portfolio and apply some tests like what would happen if rates rose by a certain amount or loan losses in energy were 50% for one year. We could apply extreme tests like that if we wanted.

Wells was trickier. Quan and I talked a lot about the bank. And, frankly, we didn’t come away thinking the bank was simple enough. We found the interest rate risk – the risk of higher rates in the future – an especially difficult one to work out in our heads. We never said that Frost was a better investment than Wells. I’d never say that. But I would say that I feel more comfortable owning Frost than I would owning Wells. And the only reason for that is independence. I trust Buffett and Munger and Russo know what they are talking about when they talk about Wells. But I can’t talk about Wells as easily as I can talk about Frost. And that means I don’t understand Wells enough independently of these other investors. I can repeat what they say. But I can’t say much of my own. That’s not a good sign.

Some people disagree with me on this one. They think coattail riding makes a lot of sense. They’d say it’s much safer to buy Wells than to buy Frost. Maybe that’s true. But Quan and I thought Wells had too much regulatory risk (too big to fail, deposit market share limit, etc.), made too many different kinds of loans and had too complex a risk position in terms of exposure to movements in things like mortgage rates. We never definitively disproved the idea of investing in Wells. We never uncovered stuff we were worried about. We just couldn’t get comfortable with it in the same way we were comfortable with something like Frost. That doesn’t make Frost objectively better than Wells. It just means we felt subjectively more comfortable with Frost than with Wells.

Being a good investor doesn’t mean ignoring your feelings or not having feelings. Ultimately, you make investment decisions based on feelings. We felt greater comfort with Frost than with Wells. So we wrote about Frost instead of Wells.

We can be stubborn that way. And sometimes we’re too stubborn. When we started the newsletter, Quan and I just knew, knew, knew that we’d never ever write about a single bank stock. We ended up writing about five. When we started the newsletter, I’d tell you the industry I knew the least about was banking. But, over time, we got comfortable moving from an analysis of one stock to the next to pick banks.

Some of it was that we didn’t see a lot of opportunities in businesses that weren’t suffering from low interest rates. We were pushed into considering banks and insurers and housing stocks and furniture stocks and so on because they were underearning in the wake of the financial crisis. That’s part of it. But oil fell way below my best guess of what the long-term real price per barrel should be – and yet we never picked oil stocks for the newsletter. There was something about banks we felt we could understand in a way we couldn’t understand oil.

Let’s recap. One, you aren’t necessarily going to make less risky decisions as you learn more about investing. I found that total ignorance can make you pretty safe. A little knowledge is a very dangerous thing. The more I read about value investing, the more tempted I was to do things outside my circle of competence. You must be constantly vigilant when it comes to risky behavior sneaking into your stock selection process.

Two, I make riskier decisions when stock prices are high and opportunities are rare. You probably will, too. It’s easy to make safe choices when there are a lot of high return opportunities. When the average stock is trading at 20 times earnings rather than 10 times earnings – you’re going to take bigger risks than you should. Everybody does.

Three, I have a bad tendency to prefer highly leveraged but cheap (on a leveraged basis) stocks over unleveraged but expensive (high P/E) stocks. That’s a mistake. It’s better to pay 30 times earnings for a company like Luxottica (LUX) than 10 times earnings for a company like Weight Watchers. The value investor in me – the stuff I learned from the books I read in my teens – rebels against the idea of paying a high P/E for anything.

Four, everybody has his own blind spots. Yours will be different than mine. Look through your own past behavior and come up with a list of the ways you always manage to screw things up.

Five, you must be independently minded. You must pay attention to your gut. If you’ve ever seen the movie "Double Indemnity," Edward G. Robinson is an insurance claims investigator who has this “little man” (his gut) who starts bothering him whenever a phony claim comes in. You need to pay attention to that “little man.” If you’re looking at Valeant or Wells or anything else and that “little man” starts acting up, go ahead and put the stock aside. You can afford to miss out on the opportunities of which other value investors take advantage. In the long run, cultivating your own healthy subjective sense of risk will be more valuable than buying when Buffett, Munger or Greenberg do.

Disclosure: Long Weight Watchers and Frost.

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Geoff Gannon

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