Market Musings - November 11, 2017
We continue our blog series: Market Musings, Volume 1, Edition 7, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present Three Hard Lessons Learned.
Reflecting on past mistakes and learning hard lessons therefrom is a key method by which an investor can improve his or her performance. Put another way, if one does NOT learn from one’s mistakes, then one is doomed to repeat them endlessly--which is really, really not good (or profitable). With that preamble, we present herein three key Investing mistakes we have learned (the hard way) to avoid:
Rule #1: Don’t try to predict commodity prices – The first key mistake to avoid is thinking one has the ability to predict commodity prices. Just about two years ago, the price of oil collapsed when Saudi Arabia and other OPEC members could not agree on production cuts (source):
At the time, we believed that while oil might go down considerably from levels then prevailing, we also thought the commodity would quickly rebound to the ~$80 per barrel level within a year or so, just as it had quickly rebounded during the 2007-2009 financial crisis. Because of this thesis, we viewed it as relatively safe to pick up some levered E&P producers (who shall remain nameless) that had hedged their oil production for the ensuing 12-18 months, on the theory that by the time the hedges rolled off, oil prices would be back to "normal" levels.
Of course, oil prices did not rebound to normal levels within one year (and in fact did not even bottom out until early 2016, almost a year and a half after the initial OPEC meeting). The reason? Collectively, it turns out, oil and gas producers like to drill, baby, drill, regardless of price--in fact, the lower the oil price goes, the more furiously they drill. Individually, they might be quite sane and agree that "they other guys" shouldn't drill so much, because it depresses prices; but when faced with the quintessential prisoner's dilemma, they are hopeless (and we discovered this the hard way). Consequently, most of the E&P companies that we had purchased suffered irreversible stock declines (even following the huge declines that had preceded our purchases), including some which eventually went to zero via bankruptcy. Fortunately, we realized our mistake about six months after our initial purchases and sold the entire sector position, escaping with "just" a 10% overall loss on the capital risked. In this sense we learned another good lesson, which is when you realize you are wrong, the best option is just to “get out” no matter how much you are down at the time.
Rule #2: Don’t Listen to Management – Generally speaking, management teams are better politicians than politicians are politicians (follow that?). You see, in most large corporations the person who finds his (unfortunately, it's still usually a "him") way into the C-suite is the person who has not just developed operational skill but, more importantly, political skill in climbing the corporate ladder. To put it more bluntly, the better of the bullshit artist and butt-kisser one is, the more likely such person will ascend the corporate hierarchy. Carl Icahn's view on this phenomenon (comparing CEOs to college fraternity presidents) is summarized quite well in the excerpt below from a speech he gave following last decade's financial crisis (source):
Hence our rule #2, which is “never listen to management”. Management will say anything, no matter how preposterous, they believe will give desperate investors hope and prop up the stock price--which only works until it no longer works (at which point the stock drops back to its natural level, dictated by the fundamentals of the business). They will promise the sun, the stars and the moon, even when there is zero chance their promises will come to fruition. Their base operating assumption it appears to be “You can fool some of the investors all the time--so why not do it?". Therefore, we tend to not listen to management. Or, if we do, it is always with Reagan’s maxim in mind: "trust but verify” (and preferably verify in more ways that one).
For one particularly painful example of how listening to management can cost investors dealy, take the case of Bill Ackman and Michael Pearson of Valeant Pharmaceuticals. Ackman drank deeply of Mike Pearson’s Kool-Aid regarding his Pharma 2.0 model (see, for example, "Mike Pearson’s New Prescription for the Pharmaceuticals Industry") and he and his hedge fund's investors paid a huge price--to the tune of over $4,000,000,000 in losses (source):
Rule #3: Don’t Believe Non-GAAP Financial Statements – Finally, we come to our third investor “don’t”, namely don’t believe non-GAAP financial statements. This is in the same vein as the immediately preceding don’t [“don’t listen to management”] since, unlike under GAAP accounting (the standards of which are set by an independent entity called the Financial Accounting Standards Board, or FASB), corporate management is always the sole author of the non-GAAP financials. Such numbers are subjective and can be manipulated by management to come out reading however management wishes. Moreover, often management's compensation is predicated on "hitting the [non-GAAP] numbers", giving them millions of reasons to massage things accordingly. Don’t like your expense levels? Simply throw some more expense items into the “unusual and/or non-recurring” bucket, and presto they no longer count (and your non-GAAP earnings are consequently higher). In addition, any expense that can be classified as “non-cash” can also be discarded as irrelevant, on the wacky theory that if an expense is not a cash expense in the relevant measurement period, it is thus not a real expense ever (note, however, that management never seems to exclude “non-cash” revenue [e.g., accrued but unpaid revenues] from their non-GAAP calculations). Put simply, non-GAAP figures are akin a self graded exam and should be ignored in most instances.
Nevertheless, if an investor is having difficulty with financial statements that appear to be too ”lumpy”, looking at the average of the past three or five years for the applicable company should provide an effective remedy. This (at least theoretically) will smooth out the lumpiness, in which case there is no need to resort to any non-GAAP financials. If necessary, one can construct one's own non-GAAP "owner earnings" figure using Buffett's methodology, described as follows:
The key point is that an investor should not outsource his or her decision-making. Thinking of blindly accepting the non-GAAP financials emanating from a company's (usually conflicted) C-suite? Don't do it--you will thank us later.