I’m a bit late to the party but have finally had the time to
do a review of 2016. Although 2016 was a better year than 2015 in absolute
returns (+18% vs +10%,) the relative out-performance vs FTSE all share has been
much lower. So again rather than celebrating too much on the high performers I
focus on my mistakes with the aim of continuously improving my investment
process. These mistakes broadly fall into 3 categories, buys or sells that
shouldn’t have occurred, missed opportunities and incorrect position sizing.
Wrong Buys or Sells
Selling Lavendon for £1.33. I sold because I was worried
about the increasing debtors from its Saudi Arabian business. Although the
company appeared to be cheap even if they did have to write off significant
portions of the Saudi debtor book I feared the negative market reaction if this
happened. Letting the fear of price action rather than valuation lead my
decision making process turned out to be a mistake as Lavendon received
competing takeover offers from a number of larger hire groups. Currently it
looks like they will be sold for about £2.70.
Another sale mistake was selling Somero (SOM.L) after the
surprising Brexit vote. Being in the construction industry Somero’s markets are
highly cyclical so I thought that any economic weakness would
disproportionately affect them. In reality there has been little sign of any
significant economic weakness and Somero’s dollar earnings combined with
continuous shift into eCommerce (whose warehouses require the flat concrete
floors that Somero’s equipment provides) means that their business continues to
thrive and it was a mistake to sell.
In terms of purchase mistakes almost all of these took the
form of companies that I didn’t research fully enough. For example low end
clothes retailer Bonmarche (BON.L) looks very cheap on historic earnings and
cash flow metrics. What became clear though is that the free cash flow
generated was through cutting all capex to the bone. When it became apparent
that the company was going to have to spend significantly on IT systems simply
to have a viable business going forward I sold at a loss. Another example of
where previous private equity owners managed to generate good earnings and
cash flow for a stock market flotation
at the expense of the long term success of the business. I am now very wary of
all Private Equity floats.
Missed Opportunities
A couple of times I missed good opportunities because I
didn’t react quickly enough. In one example Sirius Minerals announced a placing
at the bottom end of their proposed 20-30p range. Good news for me since I had
initiated a short position at an average of 35p. The price reacted negatively
at first as one would expect – an underwritten placing at the bottom end of the
range almost always means that the underwriters have taken some and will sell
as soon as they get the shares down the placing level. So when the shares
briefly rallied to 31p to sell this essentially was free money – I just wasn’t
quick enough to grab it.
One of my core positions is in the airline Flybe (see here
for investment thesis: http://www.dangercapital.co.uk/2016/09/flybe-dog-is-value-investors-best-friend.html)
I believe that in the long term their strategy of flying short routes with
turboprop planes that jet operators can’t compete economically on is a good
one. (For example a friend of mine regretted spending 11 hours on the train to
get home to Inverness for Christmas when he could have caught a 1hr Flybe
flight. If he had booked a month or so in advance the Flybe flight would also
have been cheaper.) In the short term though they face some significant
headwinds. Therefore I was pleasantly surprised when their interim results in November
were not as bad as I thought they would be. I read the results, thought no
drama there and got on with my day. Being the day that Donald Trump was elected
I was also distracted by other news. It is only later that I saw that the
initial price had dropped as low as 30p (maybe due to the Trump factor) before
rallying to close at around 40p. Again there was a brief market inefficiency
that I should have taken advantage of and didn’t.
Probably the biggest missed opportunity that I didn’t
purchase was Boo Hoo (BOO.L). Paul Scott made a convincing investment case for
this up and coming internet fashion retailer when it traded as low as 20p in
2015 after it missed broker forecasts following flotation. I was late to see
the attraction and the price had rallied 20% to 24p before I became convinced of
the investment thesis. However I became anchored on the 20p low and never
bought. The price today is £1.44 having rallied 363% in 2016. Given the current
rating I’m sure I would have sold too early but even so price anchoring has
cost me significant gains.
Position Sizing
Towards the end of last year I had to reduce some losing
short positions because my exposure became too large. Essentially I
underestimated the extent that the current market would ignore bad news and in
the light of this my initial position size had clearly been too large. There
are pockets of the market that currently seem crazy to me. Here are a few
examples:
- A company with a history of aggressive accounting treatment that hasn’t generated any real cash return for shareholders in the last 4 years doubles when based on the company’s own highly adjusted earnings figures it is no longer losing money. The market gives it a rating of 37x forward adjusted earnings.
- A bank doubles to trade on 3x Book Value when it is revealed that the regulators are unlikely to clamp down anytime soon on its lending practices to criminals, foreign nationals & high risk short term borrowers (payday loans) and that a Trump presidency is likely to be even laxer on regulating banks. The market completely misses the point that the risk here isn’t more regulation but that those type of borrowers are at a much higher risk of not paying the bank back. If that happens in any significant numbers the equity is toast.
- A company whose product generates almost no consumer benefit reacts positively when it is announced that they are to do a corporate transaction with no economic merit whose sole purpose seems to be to reward Chinese officials for allowing them to keep selling their product in China via a Multi-Level-Marketing scheme.
- The market thinks that 4.5x Sales & 6x Book Value is the right price for a highly indebted company that aims for 8% revenue growth and consistently misses that aim.
To me it seems that particularly the US market is bid up on
expectations of rapid earnings growth across the board and if this fails to
materialise there could be a big correction. I expect most of the examples
above to trade significantly lower in the next few years but that doesn’t
remove the fact that I made a mistake in position-sizing them and had to reduce
my position to prevent over-exposure.
None of these mistakes proved to be catastrophic but they
did take the shine off an otherwise good year. On a positive note there were also a few key learning points for me during 2016
that didn’t necessarily come from investment mistakes but will help prevent
them:
When to average down
This is one of the most difficult decisions for a value
investor. I touched on this topic briefly in the past here:
However John Hempton covers this topic better than I ever
could in a simple but profound blog post with one of the best explanations of
how to do it while effectively managing the risk of doing so:
Also in this space the book The Art of Execution by Lee
Freeman-Shor which I read in 2016 gets a very honourable mention.
How to react to a
profit warning
Recently published
research from Stockopedia suggests that on average you are better off selling
as rapidly as possible on a profit warning:
Of course market being complex adaptive systems if it gets
to the stage where everyone follows this advice and sells at any price
following a profit warning then it will become better advice to buy. It feels
like we may be a long way from this at the moment though – particularly in the
more inefficient small-cap space. Michael Mauboussin also covered this topic
from a slightly different angle here:
I'm sure 2017 will have plenty more learning opportunities to come!
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