I finished another book recently, in which the author is a hedge fund manager who specialises in shorting “frauds, fads, and failures”. It is a fairly interesting book with some quotable quotes and points worth reflecting upon.
“It’s okay to be wrong; it’s not okay to stay wrong.”
“Self-delusion is a powerfully democratic force. It cuts across all social classes. You can be richer, smarter, and more successful than anyone else. But if you’re not brutally honest with yourself about your own potential for failure, you’re going to have a problem—and you’re going to lose money, maybe a lot of money.”
“Because quitting is very important when you re buying and selling stocks”
Ever so often, I get into an investment decision which upon closer scrutiny, turned out to not hold up as well as I initially thought. In particular, consumer discretionary and retail stocks come to mind. In most cases, I overstayed in the positions even after realising there were flaws in my original investment thesis that warranted quick remedial actions.
The most memorable was the case of, lets call it “Duke” Distillers, a manufacturer and marketeer of baijiu in China. At first sight, it looked like an extremely undervalued growth opportunity back in mid-to-late 2013. This was especially given its fast growing revenues (32% year-on-year growth in FY2013 vs FY2012), profit, operating and free cash flows. At that point in September 2013, the stock was trading at $5.00 (split adjusted) or a market cap of about $400 million. With its net cash position of close to $140 million and being valued on a free cash flow / enterprise value basis of about 15%, it was a screaming buy and boy did I buy. The prevailing sentiment for the depressed price at that point was China’s crackdown on conspicuous consumption by public officials (expensive watches, liquor, food, etc). As such, there were plenty of uncertainties surrounding luxury product stocks with exposure to China. I was well aware of that and since Duke supplied mid-range baijiu, my variant perception was that it would not be as affected as its extremely well-known peers such as Kweichow Moutai and Wuliangye. Duke’s financials on the surface compared favourably against its peers and I was elated.
I was also aware of the concerns over frauds when it came to Chinese companies, especially since there were a number of famous blowups in prior to then. I did some checks with a friend who frequented China for business and gathered that the liquor was indeed being peddled in China. Since the valuation was compelling, I jumped in with both feet. Thereafter, the stock price promptly fell and I while I normally would not be fazed, I did get a little jittery, given that it is after all a China-based company which I had no means of truly and personally doing channel checks and scuttlebutts.
I decided to re-run the figures, this time, diving much deeper into its operational metrics to test the reasonableness against its peers. In particular, its revenue generated per dollar of gross and net PPE was extremely elevated at double and triple digit percentage terms above the most renowned of its peers. That raised alarm bells immediately since I found it hard to fathom how Duke, a less established company, was able to produce so much more volume of products per asset employed. Given that the vats and techniques used for liquor production isn’t exactly rocket science and even if I accounted for improved technology, the difference should not have been way off the charts, much less for a small producer. Like a deer in front of headlights, I did what a normal deer would do – freeze up. At that point, I could have got out of the position at a relatively small loss of about 5%. I hoped against hope, that Duke was indeed much superior and that my calculations were wrong. In other words, I was delusional, stayed wrong and that was definitely not okay.
The stock price continued falling and I got out it progressively. By the time I sold the last of my position, that last share was unwound at a 20% loss. The episode was a valuable lesson on doing a more thorough analysis, especially when things seem too good to be true and when it is an unknown name. On hindsight, it seems elementary that I should have investigated deeper. And I really should have, but I was blinded by the compelling valuation. Most importantly, the moment that I knew that I was wrong, I should not have stayed wrong. I continue to learn every day and hope that I do not make the same silly mistakes again.
As a side note, not that I continued to track the financial performance of the company thereafter, but at this moment, the stock price is trading at $0.80, a whopping 84% below when I first initiated the position in 2013. I can count my lucky stars I had self-doubts on myself and the business, and that I got out before losing substantially all my capital tied up in Duke.
Other great quotes in the book worth reflecting on
“Success is a lousy teacher. It seduces smart people into thinking they can’t lose.” – Bill Gates
“I sent a gofer who was working for me at the time to twenty drugstores around my office. I had him put a small nick on the packaging of the first five Chemtrak tests on the shelf at every location. He went back every other week for several months. At the end of this process, those first five tests in all the stores still had nicks on them. Not a single one had sold. That was all the proof I needed. I shorted Chemtrak’s stock.”
“They had come up with all sorts of impressive numbers and projections showing that their product would fill a profitable niche. But, as with Chemtrak’s management team, they hadn’t analyzed the thing that would make them money: the way people in the real world actually behave.”
“If the rate of change on the outside exceeds the rate of change on the inside, the end is near.” -Jack Welch
“He called this fixation on evaluating numbers instead of flesh-and-blood managers going “Excel crazy.” … He would constantly chide me for burying my head too deeply in financial disclosures and earnings reports. “Get up and go outside, Scott,” he’d tell me. “You’ll learn more in five minutes of talking to someone at a company than you will in a week crunching its numbers.”
“In thirty years of visiting corporate headquarters, i don’t think I’ve ever met a single dumb person who had risen to helm a publicly traded company. But very few leaders, despite their intelligence, are willing to face hard facts and revise their thinking. That’s one of the main reasons more businesses fail than succeed.”