Learning From Your Investment Mistakes

“But it did teach me to respect derivatives,” Series now. “I have used them throughout my career but I have a very ingrained focus on risk management. I’m happy for the experience.”

It wasn’t Series’ last mistake, nor the last time he learned something from an error. In the early 90s, managing money for James Capel Investment Management, he bought shares in the Perpetual UK fund manager (now Invesco Perpetual). They soared and, delighted, he sold out at a handsome profit, only to see the share price increase many times over during the next few years. “Not selling too early, and running your winners, is a really important lesson,” he says.

Series has built the lesson into his business: his fund tries to envisage a clear pathway to success for any business it might invest in, something that might take years. “And as long as they’re delivering on that path, provided the valuation doesn’t become absolutely crazy, we stick with it,” he says. “We no longer just say: if the stock goes from 15 to 20 times PE we’ve made our money. The valuation piece is truly an art rather than a science.”

John Murray was among the first boutique managers in Australia, founding Perennial Value Management, where he is still managing director. He, too, can point to many mistakes over the years, all of which had useful lessons. ”We’re in the business of taking risk,” he says. “That’s what our clients pay us for. I’ve always said to my analysts, if you can get two out of three right, that should deliver returns we’re looking for. The flipside is you’re going in with the expectation of getting one out of three wrong.”

Perennial doesn’t get one out of three wrong, but like everyone it does make errors. One was steel manufacturer BlueScope, through which Perennial lost money during the global financial crisis. This was hardly a surprise – BlueScope was, as Murray says, “hit by a perfect storm,” but Perennial realized that there was a problem with the firm’s approach to sensitivity analysis – that they simply hadn’t factored in the possibility of anything so extreme happening to things like coking coal and iron ore prices. Perennial changed its methodology in 2012; Murray contends that this process may have kept it out of Arrium Mining and Materials Investment, which might have looked appealing to a contrarian fund manager like Perennial but instead collapsed into administration in April 2016.

Murray also wishes Perennial had held more of Commonwealth Bank of Australia stock over the past decade – “we held some, but in hindsight we should have held more” – and also learned plenty from an unfortunate holding in Billabong. Murray recalls a period of time when he was considering selling, but noted that Gordon Merchant, the founder, had bought more shares in the company. “We said to ourselves: the founder would know this business better than we do. Surely that’s a reassuring signal. But it turned out not to be the case.” Perennial lost money by holding on. The manager continues to pay close attention to insider buying and selling by major shareholders, and generally takes it as a positive signal when a founder buys more stock. “But you shouldn’t take that for granted. If the circumstances were to happen again, we would say to ourselves: is there an emotional attachment involved?”

“Clearly these were mistakes, but none of them hurt us in a really big way,” says Murray; typically the fund holds 40 stocks, so a problem in one of them is not great but is also not debilitating. “We don’t bet the house on any one stock.”

Murray’s point about his trust in Billabong resonates with the experience of Olivia Engel, managing director and head of active quantitative equity in Asia Pacific at State Street Global Advisors. Early in her career she worked as a fundamental equity analyst, and was tasked with writing a company research report and making a recommendation. She built her analysis using a range of approaches, went on a tour of the company, saw the operations first hand, met the management. “I knew that company inside and out,” she says. “I had spoken, personally, with the people who ran that company and were responsible for its strategy.”

But if anything, she had come to know it too well. “When it came to making my recommendation to the portfolio manager as to whether to include that company in the portfolio, I found it impossible to remain objective: the stock could only be a buy to me,” she says. “All the various well-documented and recognized investor behavioural biases hit me at once: anchoring bias, availability bias, confirmation bias, overconfidence bias.” At first, she seemed to be right: the stock outperformed the market by 8% over a few weeks, making her feel she’d “uncovered a rare investment gem”. But then it started sinking, underperforming the market by 20% over the next three to four months.

“I learned very quickly how human we are, and how difficult objectivity is,” she says. This is one reason she admires quant investment processes. “They are explicitly designed to take advantage of these biases in the market, and help us to avoid them when deciding whether and when to trade securities for the portfolio. I was a convert to this approach very early on in my career.”

The challenge of knowing when to buy or sell is universal, and nobody gets it right all the time. “During the tech boom in the early 2000s, we rode the share market up as investors believed that the world had change – and, as such, that the values of many of the new tech companies were justifiable,” says David Bryant, CEO of Australian Unity Investments. “The tech wreck proved how wrong that theory was.” The whole market was still working out how to value companies like these, and concluded eventually that it had got things wrong, hence the crash. “As their prices reached stratospheric levels, only the best businesses and business models ever recovered their prices,” Bryant says. And the lesson? “Make sure you know how to value the things you buy. If they look expensive, they probably are. And know when to sell: a great profit in the bank is much less painful than the alternative.”

Nader Naeimi, head of dynamic markets in the multi-asset group at AMP Capital, also took lessons from the tech boom. “During the tech bust and the drawn-out global bear market from 2000 to 2003, we paid too much attention to economics and not enough to valuations and sentiment,” he says. When economic news was good, valuations were expensive, and when the news was bad, valuations were cheap. “We ended up suffering from analysis paralysis,” leading to problems in 2002. “The hard-learned mistake helped us hone our investment philosophy and process by acknowledging the fact that the market cycle leads the economic cycle.”

Naeimi learned another lesson in 2011 following the tsunami in Japan. As Japanese shares started to fall, AMP chose to take a significant exposure. As the nuclear disaster at Fukushima took shape, and the country’s outlook worsened, Japanese shares continued to fall, until eventually they cut the position at a hefty loss. “Lesson learned: cheap valuation is a good signal to take when the fundamental backdrop is bad but getting less bad – not if it is bad and getting worse.”

Manny Pohl runs ECP Asset Management, and is a great believer in looking backwards in order to move forwards. “Investors need constantly to reassess the year that’s just gone by, figure out what cost them money and work out what they could have avoided.”

“There’s always something you could have put money in that would have made more, but you should be less worried about missing those than avoiding pitfalls to make sure they don’t repeat themselves.”

In previous years Pohl would try to hold stocks involved in mergers and acquisitions, but found that the synergies that were supposed to follow either didn’t or took years to come together. “In most cases, instead of one and one making three, they made one and a half. Or just a half.” A change of tack was needed. “Now, when there is an acquisition that is more than a third of the enterprise value of the stock that we won, we tend to get out, wait for the dust to settle, and go back in afterwards if it looks reasonable.”

Pohl, like many others, had investments that were hit by the financial crisis, and he particularly recalls Babcock & Brown, which went under in the early stages of the GFC. He notes that analysts tend to look at management accounts instead of statutory accounts, but that in this case the more complex statutory accounts would have served them better. “They are a truer assessment of the state of health of a business,” he says. Specifically, Pohl is wary of any business with operating cash flow that does not exceed the interest they pay on the debt, but in management accounts there can be some confusion as to whether the figures are net or gross.

But beyond that technical point, there is a broader behavioural issue that we might call catching a falling knife. Many investors in Babcock & Brown – and Lehman Brothers, and many more – bought the stock while in heavy decline in the belief that it could not go bust and would eventually turn good. (The author applied this logic with Citigroup and is still 50% down eight years later.) “You have to be sure that a business is going to survive the economic cycle,” says Pohl. “If businesses aren’t on a sound footing they can get washed away with the tide.”

Mistakes aren’t limited to the stock markets. In the run up to the global financial crisis Bill Bovingdon, now at Altius Asset Management but at the time at another firm, recalls the pursuit of overseas credit in order to add more sources of alpha (returns over the benchmark). About 15% of the manager’s Australian bond funds were placed offshore, which, “at a conceptual level, I don’t disagree with,” says Bovingdon. “But when the GFC hit, that was the part of the portfolio that got absolutely murdered. In hindsight, over-complicating products and over-reaching for alpha is a sign that the end of the risk cycle is close and you need to take stock.”

Other lessons might include being blinded by jargon and buying something you don’t understand; believing a fund’s claims about daily or weekly liquidity when the assets it holds should tell us that it can’t provide the liquidity it promises; and being so trigger-happy getting in and out of stocks and funds that any gains are negated by brokerage costs.

Our interviewees have been agreeably candid in this article, so it’s only fair to do the same. The author is supposed to be an award-winning personal finance writer of many years’ experience. He has also been guilty of almost every investment error in the book: the falling knife (buying Lehman Brothers near to the death in the belief it would be bailed out – it wasn’t); the over-familiarity (buying into a Chinese listed company in Singapore after meeting the management and being greatly impressed, only to discover too late that the sum total of its assets was a small herd of cows in another country – the stock was suspended and all money lost); the gullible (buying a student property development in Liverpool, UK with a “guaranteed” return – the developer went bankrupt, the guarantee was meaningless, and it took two years to get half the original capital back); the too good to be true (LM Investments); and the extraordinary (buying surely the only apartment in Sydney that has failed to appreciate in value since 2004). That list is not exhaustive. Suffice to say, now you know where the idea for this feature came from.