March 15, 2008

Investing Errors

If you're like me, your most valuable lessons came from first hand experiences rather learning from other people mistakes. Generally speaking people learn better through the mistakes they make. I have read about the same issues that I am writing about elsewhere but sometimes you need to make these errors to realize what it means.

In this post I will review some mistakes and how I adjust for them. I will go through these mistakes by category:

Valuation errors:

  • Not accounting properly for the business cycles. I used to take 5 years average of EBIT margins to do my Earning Power Valuation, while 10 years average is more appropriate as it includes at least one full cycle of economic activity. A 5 year average can distort valuation by including either the most favorable margins of the economic cycle or the worst. A 10 year cycle will almost guarantee including a business cycle from bottom to peak and will reflect the most likely EBIT margins for the business going forward for the next decade.
  • Relying too much on one valuation technique. Valuation is very illusive and can differ from one person to another. I used to use Discounted Free Cash Flow approach exclusively to determine a business intrinsic value, however the approach is as good as the estimate I use for it. Now I deploy several other approaches to validate my results. I use Earning Power Value, liquidation value if appropriate, and sum of the parts, again if appropriate.
  • Not using IRR and ROE concepts to measure my return on investments. I use these concepts all the time when I evaluate capital decisions for my business, however I failed to use them to choose between stock investments. Buying a stock is no different from buying real estate or machinery for the business and should be treated as such. You need to buy the stock that will maximize your IRR and ROE ratios.
  • Intrinsic valuation changes; it goes up or decline it never stays put. I started to update intrinsic values of my holdings and targets at least on an annual basis.

Business Analysis

  • Now I understand the value of equity analysts. I used to dismiss their analysis altogether but I have learned to use the good parts. I completely ignore buy/ sell recommendations, price targets, and earning estimates, however some qualitative analysis and risk assessment contain value added information.
  • Good businesses do not make for good investments. Investing in a well run company in the absence of a distress situation would not yield exceptional returns. If the same company came under selling pressures due to a crises of some sort, for example a product liability suit such as Merck's Viox, it will be far better investment potential.

Investment process

  • Patience in establishing positions. I used to go all in, once I find a business I like, but now I am establishing my positions over time this way it will ensure that I may still get it cheaper over time.
  • Straying away from my comfort zone into industries and companies that I do not understand or far way too complex for me to value. This will always prove detrimental to my returns.
  • Not trusting my own analysis and thinking "I must be missing something". This happened several times, as I develop an investment thesis and arrive to my conclusion but I second guess myself because market prices do not provide me with any validation. However I learnt that market prices are the last place to look for any validation of any sort. If I have checked and double checked my analysis this is the only validation I need.
  • I used to invest in undervalued business independent of the reason why it is undervalued. I have learnt what is meant of the term "value trap"; some businesses fall in this category for a reason or another. These are lousy investments. Now I focus on investment that became undervalued and distressed due to macro or micro circumstances.
  • Concentration of holdings and portfolio. Having too many positions to track will dilute my analysis and increase the risk profile of my investment and make my actions more susceptible to emotions rather than logic. Deep and through assessment of a business gives you a piece of mind and an ability to analyse company specific events with more depth than the market.

1 comment:

John said...

Great post

I have made most of these mistakes and some of them twice.