Investing is not a precise science, and sooner or later you are bound to make a mistake that will cost you money (if you haven’t already).
It’s how you act after this mistake that defines your investment career. The best investors will cut their losses and move on to the next opportunity, fully acknowledging the severity of the error, what went wrong and what can be improved next time around.
Meanwhile, inexperienced investors will likely hold on to the position and blame of the market for their problems.
For experienced investors, trying to establish whether or not a losing position was a mistake on their part or just part of investing is crucial. You can learn something from every mistake, but sometimes, no matter how good your processes is, you will have to take losses as the market has a habit of throwing unexpected developments out at you.
This happens to even the world’s most successful value investors, those investors who spend hours researching each opportunity and have decades of experience.
One such example is the story of Horsehead Holdings (ZINCQ, Financial) and Mohnish Pabrai (Trades, Portfolio).
Horsehead Holdings and Mohnish Pabrai
Pabrai first acquired Horsehead in 2008 as a traditional Benjamin Graham investment. Initially, the stock performed well appreciating by over 400% in less than 13 months. Pabrai continued to add to his position as he was impressed by the management and the company’s growth prospects.
However, in 2016 the company collapsed into bankruptcy, something few investors saw coming. Indeed, at the beginning of 2016 Horsehead was valuing its assets at around $1 billion; two months later when the company filed for Chapter 11 bankruptcy protection management listed $421 million in secured and unsecured debt obligations. Four months later, the company was estimating the value of its assets to be around $300 million –Â even for a commodity business this drop in value is staggering.
As explained in the article and the company published in the New York Times at the end of August 2016:
“Horsehead’s valuation history certainly seems odd. Its audited financial statements for the September 2015 quarter show assets worth $1 billion. An unaudited report from early February valued the assets at roughly the same. A KPMG report commissioned by Horsehead shareholders values the company at over $1.1 billion.
“But in a July filing with the court, Horsehead’s financial adviser said the company’s assets were worth an estimated $280 million to $375 million. The main reason for the decline? The company’s decision to write down to almost zero the new zinc plant in Mooresboro it built for $550 million.”
Alongside Pabrai, Guy Spier also owned Horsehead going into the bankruptcy, and he wanted answers. Spier’s investigation revealed that Horsehead had received substantial and valuable cash offers from potential buyers before its bankruptcy, but management had turned these offers down, leading Spier and his team to conclude that Horsehead had become the subject of a very well-planned loan-to-own raid by a group of distressed debt funds led by Greywolf.
At this point, there was little either Spier or Pabrai could do to recoup their investments. The money was gone, but they both took some valuable lessons away from the experience, from which other investors can learn.
In Spier’s full-year 2016 letter to investors he wrote:
“Leverage I already knew about the dangers of leverage – especially in an operating business exposed to one commodity and where the company is building a new plant. But in a classic case of the boiling frog syndrome, the leverage slowly crept up during the time that I owned the shares. Such that had I run my checklist during the year prior to the bankruptcy filing, I would likely not have invested on account of the high leverage. But because the debt gradually increased, it did not set off the alarm bells that it should have.
“In order to protect against this boiling frog syndrome, and as a result of my experience in Horsehead, I have implemented an in-flight checklist – in which I periodically review changes in leverage in our investments.”
Meanwhile, Pabrai acknowledged the Horsehead loss was just “the nature of the game”:
“Was the Horsehead investment a mistake? Well, the original bet was not a mistake. The mistake was buying over 4.9% of the shares outstanding. In the last 16-plus years at Pabrai Funds, we have bought over 5% or even over 10% of a few public companies. In no cases have we ever ended up with a winner. It is a small data set, but there are obvious reasons why going over 4.9% is dumb. Buying over 10% makes us subject to a variety of insider disclosure rules. Going over 5% requires us to make a 13G filing. All these Form 4 and 13G filings not only add cost and administrative time, but they also make it hard to increase or decrease position size.
“If we owned less than 4.9% of Horsehead, it is almost certain we would have done tax loss selling in 2015 at significantly higher prices – and decided not to buy it back based on all the updated current facts. We are going to endeavor to never ever go over 4.9% anymore on any stock in the U.S. Been there. Done that. Got the T-shirt.
“One can make mistakes in investing and end up with a profit (e.g., Chesapeake [CHK]). Or you can lose money and the bet would still have been the right one to make. If the odds of tails in a coin toss is 75% and pays 1:1, it is a very worthwhile bet to make even though there is a 25% chance you lose the bet. We are going to lose some, even when we are ultra-vigilant and prudent. It is the nature of the game.”
”‹Disclosure: The author owns no share mentioned.
Start a free seven-day trial of Premium Membership to GuruFocus.
Also check out:
