Saturday, March 7, 2015

Some popular investing techniques are flawed

Some popular investing techniques have drawbacks or complications that aren't readily apparent.


Specializing in one industry or asset class gives investors the advantage of doing something they know inside and out, allowing them to develop an informational advantage over other investors. But it also has a big drawback: if an investor specializes in one thing, then he has to keep doing it regardless of circumstances.

In a Wall Street Journal interview from last year, venture capitalist Bill Gurley said that he thought venture capital was in the midst of bubble, but he also said that he continued to invest in start-ups because "choosing not to play the game on the field doesn't work."

During the early 1980s, an influx of money into venture capital increased the competition for deals and forced returns down. Unsurprisingly, many of the new funds that were formed during this period had bad performance. But as Jerry Neumann writes, the experienced venture-capital funds fared just as badly:

But poor returns weren’t limited to new VCs: returns broken out between first-time venture funds and follow-on funds show both the noobs and the experienced producing similarly dismal results.

This doesn't mean that venture-capital experience was worthless. Rather, I think it indicates the limits of specialization. The experienced VCs had raised funds for the specific purpose of investing in start-ups, so they had to invest the money even though competition had destroyed the opportunity to earn excess returns.

Another drawback of specialization is that it makes spotting bubbles harder. Financial markets are so vast that there's always a bubble happening somewhere, but within any particular industry or asset class bubbles tend to be infrequent. A generalist who has experience with multiple industries will recognize the signature of a bubble more easily than a specialist, who's likely to miss the forest for the trees.

Investing with owner-operators

Many investors assume that having an owner-operator at the helm of a company is a good thing because his interests are aligned with those of other shareholders. It's not that simple.

Owner-operators don't necessarily eliminate agent-principal conflicts. Some owner-operators have manipulated their companies' results in order to depress the share price and buy out minority shareholders on the cheap. And while it's true that owner-operators tend to create more value than agents, some of them take all of that additional value for themselves. Sardar Biglari, Ron Perelman, and Frank Stronach are notorious for enriching themselves at the expense of their companies' outside shareholders.

Shareholder activism

I expect shareholder activism to earn low returns over the next few years. In part that's because it's become a crowded strategy, but I think there are also structural reasons why it will fare poorly:

1. Most hedge-fund activists are bean-counters with little or no managerial experience. They may be right that a company is being mismanaged, but that doesn't mean they have the skills to manage it better.

2. My sense is that activism becomes more common as the economic cycle ages and valuations rise. When a bull market is in its infancy, there's less need for activism because stocks are cheap enough to deliver strong returns without improvements in corporate governance. Once valuations have risen and multiple expansion is off the table, investors need to see cost cuts, management changes, or similar actions to justify further appreciation.

3. As a result of 1 and 2, there's a "squeezing blood from a turnip" aspect to activism. Many activist campaigns are gimmicky: they involve calling for spinoffs, issuing debt to buy back stock, or doing something else that's intended to juice the stock price but doesn't improve risk-adjusted returns. According to an academic study, "[A]ctivism targeting purely capital structure or corporate governance related agendas earns relatively low returns."

At the risk of overgeneralizing, I think activists are most successful when they act as a veto on bad capital allocation at an otherwise-sound company.

Using other investors as contrary indicators

Few investors are wrong consistently enough to be good contrary indicators. I can't think of any offhand. I've frequently criticized Jim Rogers on this blog, but even he has made a number of correct predictions.

Many people who lose money over time do so because they rigidly adhere to a specific view regardless of circumstances-- for instance, they're bearish all the time, or they think every dip is a buying opportunity. Although these people are usually wrong, they aren't true contrary indicators because their opinions never change.

There's a self-congratulatory element to having contrary indicators that can be dangerous. It's tempting to look at an unsuccessful trader and think, "He's an idiot who always loses. I'm much smarter, and I'm going to prove it by taking the other side of the trade." Experience has taught me that this kind of thinking is a great way to make bad decisions and lose money.

Buying based on liquidation value

In theory a company that has significant assets can be liquidated, meaning that the value of these assets serves as a floor for the value of the company. In practice that's rarely true, for a variety of reasons:

• Liquidating goes against a business' nature. Corporate managers want to keep their jobs. Companies are oriented toward growth, or at least toward a steady state of doing business. No one starts a company while thinking ahead to the day when it will have to be liquidated because it's losing money.

• Liquidations take time. A company with $100mm of assets isn't worth $100mm if it will take a decade to sell all the assets.

• The point at which a liquidation is most attractive is also the point at which a liquidating business is least likely to get a good price for its assets.

Let's say you own a furniture store that's losing money because there's a recession. You think it's better to close the store and sell all your inventory than stay open and continue losing money. But the thing that makes it difficult to stay in business-- the recession-- will also make it difficult for you to clear out your inventory at a decent price.

• Even simple liquidations can be expensive. In 2008, I bought shares of a company called Soapstone Networks that made networking equipment. Its business was almost dead-- it hadn't sold any equipment in six months-- and I anticipated that the company would be liquidated.

Soapstone's balance sheet showed $6 per share of cash net of all liabilities, so I assumed it would return nearly $6 in a liquidation. When the company finally liquidated, the proceeds were much lower-- approximately $4.50. Operating costs, lease termination fees, professional fees, and severance payments ate a quarter of the cash.

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