The Humility Curve
A look at the investing errors I’ve made, so you don’t have to.
Fifteen years ago I bought my first stock. I had an original idea, researched the fundamentals, and made what I thought to be a well-reasoned decision. My investment process has changed since then, but that first buy kick-started an investing journey and this milestone has been a chance for me to look back at my career and see what I have learned along the way.
Fifteen years is a relatively short investing career. Many professionals and amateurs have been investing for far longer. But it’s been an interesting 15-year span. It began with the dot-com bust, grew up in the housing bubble, got real during the housing crash and ensuing Global Financial Crisis, and more recently has ebbed and flowed alongside historically low interest rates, turmoil in Europe, the threat of terror attacks, crashing oil prices, a strong dollar, and stubbornly low economic growth.
So forgive me if I feel more grizzled than I really am.
Buy what you know!
If you did the math, then you know that I bought that first stock back in 2001. I was in college. It was the aftermath of the tech bubble and 9/11. While most investors were fleeing the market, I had the good fortune of 1. Not having lost any money in that downturn and 2. Taking a class at the time that made a pretty good case that it was a pretty good time to start investing. So with the cash I’d saved from summers spent landscaping I decided to try my hand at investing in common stocks.
But what to buy?
This is a question that faces us every time we have money to invest, and it’s a daunting one for those just getting started. Since I was taking a college finance class at the time, I had just been introduced to the works of Peter Lynch, the seminal Fidelity Magellan fund manager whose investing philosophy has been oversimplified to “Buy what you know.” Eager to get started, oversimplification was exactly what I was looking for.
What did I know? And what did I know?
I got out my credit card statement to see where I was spending the most money. There was one name that kept popping up over and over again: Whole Foods.
Don’t judge me.
It sounds arrogant for a college kid to be shopping at a grocery store that once not unfairly earned the moniker “Whole Paycheck,” but I grew up in a family that loves good food, loves to cook, and loves to garden — three things that remain true of my family to this day. Further, to teach me about money management and self-sufficiency, my parents gave me at the beginning of the academic year the equivalent amount of money that other parents were spending on the lowest tier school cafeteria meal plan so I could feed myself. I jumped at this opportunity because, frankly, the cafeteria food was terrible. But there was a catch. And that was that there was no more money after that. If it ran out, I was on my own.
It became quickly apparent that eating out every meal was not an option. I would run out of money before Thanksgiving break. But I also didn’t have car, and living in Washington, D.C. , there weren’t many other convenient options. The closest grocery store to campus was Safeway a little more than a mile away and up a steep hill. Further, this was 15 years ago, so this isn’t yet the Safeway that’s been pushed by competition to light its stores, diversify its inventory, and sell edible fare. This was the Safeway of the Dark Ages. And while the prices were right, I didn’t want to shop there.
I kept trudging up Wisconsin Avenue and I happened upon a store I hadn’t heard of before. It was called Whole Foods, and it was better. Nice atmosphere, good food, the stuff I was looking for. While the prices were higher, by budgeting, coupon clipping, and optimizing my shopping for promotions, I could make it work.
A routine emerged. I shopped every few days at Whole Foods instead of eating at the cafeteria, being careful with my money and walking up a steep hill past a far more conveniently located Safeway in order to do it. This, I figured, embodied the principle of “Buy What You Know,” and when I looked Whole Foods up and saw that it was publicly traded, then WFMI on the Nasdaq, it became my first stock purchase.
Fun with financial modeling!
We all start simply as investors, but it inevitably gets more complicated. What’s more, Whole Foods went up after I bought it. It was fun making money. I caught the investing bug.
What came next? That was Danaher, which was a combination Buy What You Know — one of my finance professors worked for the company — and my first attempt to apply some of the financial modeling and valuation techniques that I was learning both in school and on my own.
Danaher was and is an industrial conglomerate that goes about acquiring smaller companies and using a proprietary management framework to make them more efficient and profitable. It had an impressive track record for growth, attractive returns on equity, and a stock that always seemed to have gone up. Further, I thought I had a keen insight in the difference between its growth and maintenance capex. To be honest, it’s a complicated company with a dense balance sheet that I feel less comfortable valuing today than I did back then, but I was young and foolish and for better or worse Danaher has worked out pretty well too.
Frontier market micro caps!
Fast forward a few years and I was researching equities full-time. My work was predominantly in two areas: small caps and emerging markets. And while I don’t think my book was all bad, letting an overconfident recent college grad loose in those universes of stocks is like putting a 3-year-old in charge of a cookie jar. Too much temptation.
That temptation culminated with my deciding that I had some kind of an investing edge in researching Chinese micro caps even though I didn’t speak Chinese, had only been to China once, and only barely understood Chinese financial regulatory frameworks. At the time I thought that by voraciously reading books on the topic and consuming everything that I could on the Internet I could develop an expertise and simply apply what I knew about evaluating U.S. stocks onto Chinese stocks.
Expertise, though, can only be developed with time.
Having said that, I learned a lot in studying those wild west companies. While the returns for me were ultimately break-even — some early gains reversed by later painful losses — mistakes were made, particularly with regards to my process. (Early success is a curse.) I can remember the moment it dawned on me that not only was China not the U.S., but that China was not as it seemed.
I was in Xi’an, China, visiting a pharmaceutical company that manufactured vaccines for livestock. The company was called Skystar Biopharmaceutical, and their specialty was a drug for Porcine reproductive and respiratory syndrome virus (PRRSV), or what’s called blue-ear pig disease in China. It had come up in one of our team idea meetings, and the idea seemed promising. The company was growing, it had a clean balance sheet, it had patents, and it was benefiting from government support of the Chinese agricultural industry. Plus, the Chinese eat a lot of pork.
We arrived at Skystar’s headquarters, an impressive building in the “high technology” district outside of the city. The company put us through a complicated rigmarole of putting on sanitary clothing, shoe covers, and face masks since we were entering a high technology medical manufacturing plant. It all seemed very legitimate.
But about 20 minutes into our tour, we rounded a corner and there, standing in an empty hallway, was a stray dog that had sneaked in through a broken door. Where, I asked myself, were its shoe covers?
Twenty minutes after that we found ourselves in the room where the company allegedly kept its inventory. As of the most recent 10-Q filing, the company was holding a little more than $20 million worth of inventory. But there were just a handful of boxes in the room. Where, we asked, was the rest of it? In the boxes, they said. Those boxes are worth $20 million, we asked? No, they said. We shipped most of the inventory out yesterday.
Shipped most of the inventory out yesterday?
All was not as it seemed. Or maybe it was exactly as it seemed. I washed my hands of that idea, but why had I been there at all? Why was I visiting any hard-to-verify Chinese companies? I had bitten off more than I could chew.
Sum of the parts!
Around that time I was doing work on a company called Cresud, an Argentine real estate roll-up run by an ostensibly savvy capital allocator who was seeded with his first $10 million by George Soros. Cresud is the value investing equivalent of the horror movie villain that just won’t die. Every few years its price drops and someone tries to make the case that the value of its commercial holdings and agricultural acreage in Argentina and Brazil is more than the market value of the company. But this an enterprise that has returned approximately zero to investors over the past decade. What’s more, it’s a mostly money-losing enterprise that has been used as a personal investment vehicle for the controlling Elsztain family, racking up debt for shareholders while they build a property empire.
What business do any of us have trying to value business like that? In Argentina nonetheless, where property rights can be fluid?
No matter how an investor approaches a situation like that, or how many comps one pulls, or what discount rate one applies, or how many scenarios one contemplates, mistakes will be made. There’s political risk, liquidity risk, key man risk, information asymmetry, weather risk…the list goes on.
The good news is that mistakes are wonderful provided you recognize and learn from them. In doing so, you can reverse the trend of the naive investor into more and more complicated ideas and apply what you know to the somewhat simpler job of finding great companies.
But what makes a company great? There are lots of definitions, some more pliable than others. One is great management, and the practice of jockey investing — putting capital behind a skilled capital allocator instead of a business — goes through cycles of popularity. The approach has recently been in vogue following the publication of William Thorndike’s book The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success.
The origin story of the jockey investment is powerful. Who wouldn’t want to have invested in Berkshire Hathaway back when a man named Warren Buffett took control in 1965? That investment has compounded at 20% annually since then, turning every single dollar invested into almost $10,000 today.
Yet jockey plays are also inherently good ways to get burned. That’s because they rely on information asymmetry to work. No matter what happens, investors can find comfort in the idea that that the CEO is a genius and the market just doesn’t get the vision. What’s more, for every success, there’s a failure. For every visionary, a dangerous halo effect.
For example, Richard Heckmann, an entrepreneur who once built and sold two billion dollar companies also, through an eponymous SPAC, spent $625 million of shareholder capital in 2008 to get into the bottled water business in China. The company turned out to be a fraud and was quietly divested for a de minimis amount, demonstrating that accumulated wealth is no indicator of where one sits on the humility curve.
On a grander scale, there’s the ongoing debacle of Eddie Lampert and Sears. That stock is down almost 90% since Kmart gave Lampert — previously a high-performing hedge fund manager — the freedom to invest the company’s excess cash. At the time in 2004, Bloomberg and others asked seriously if this was the next Warren Buffett building the next Berkshire Hathaway.
More recently the market has witnessed the implosion of Valeant Pharmaceuticals. Seemingly savvy investors such as Bill Ackman and the Sequoia Fund lined up behind Michael Pearson as he sought to remake the way to run a pharmaceutical company, overlooking operational and personal problems while Pearson fudged his numbers and took on debt to fuel an acquisition spree.
Now the cult of Elon Musk should probably be asking some hard questions of itself following more production delays at Tesla and the strange bid by the company to acquire Musk’s other company Solar City. Musk called the deal a “no-brainer,” but who knows? This is already a deal that most of SolarCity’s board has had to recuse themselves from analyzing due to close ties to Tesla and Musk.
Trusting the jockey inherently means not verifying his or her claims.
For what it’s worth, my jockey phase began and ended with Enstar Group, an obscure financial company that acquires insurance operations in run-off. The thesis there hinged on the investing prowess of J. Christopher Flowers, a Goldman Sachs alum who could help the company get good deal flow and profitably invest the company’s cash as reserves got released. Enstar hasn’t worked out badly, but it’s become more and more inscrutable. My thesis broke when Flowers reduced his involvement and the company opted to start acquiring live insurance operations.
More recently, I purchased shares of Carter Bank & Trust, an illiquid community bank. Although the bank has a great balance sheet and a low risk profile given its loan exposures, it probably needs a change in control or sale for outside shareholders to realize fair value. When I took the idea to a noted activist bank investor, he reasoned that I had no hope of fomenting change given the insider ownership at the bank and that a takeover offer was unlikely to materialize given the old boy network dynamics of the community banking space. Instead, I’d probably have to wait for the founder and CEO to step down for my thesis to play out, which was a low probability event.
Relying on an exogenous event like that is called a “catalyst” in investing parlance. “What x happens, the market will catch on to the reality of the situation here and the stock will appreciate.” But what if x doesn’t happen? It would be better to be invested in a situation where nothing had to happen in order for an investment to go right.
Incredibly, I avoided situations like that for years. My reasoning was that they were too easy or too obvious. What I’ve learned, though, is that the easy and obvious isprecisely what the humble investor should be seeking.
Buy and hold great companies
Where I am now is that my last two stock purchases were obvious names where I could make no compelling case not to own them. I own and use their products and services, their quality is apparent in their financial statements, and both should benefit from long-term growth opportunities.
So I stopped trying so hard and bought those two most obvious names in my universe: Amazon and Disney. Given that I share a house with two young children, it isn’t uncommon for Disney products to show up wrapped in Amazon boxes.
Yes, there are arguments against both — cord-cutting and rising programming costs at Disney and a track record of unprofitability at Amazon, for example — but it doesn’t take a lot of imagination to see long-term investments in these two names working out well. It is possible to be a successful investor and keep it as simple as that.
Now, it can be harder. I’ll cop to having built a financial model for Amazon that tries to delineate between maintenance and growth capex in order to suss out a normalized free cash flow margin, but that increased effort hasn’t yielded much in the way of incremental insight beyond the premise that Amazon has a big economic footprint that should only continue to get bigger.
And there are more mistakes in my financial model for Amazon than there are in that broad statement about Amazon.
Stay simple, stay humble
The rub with details is that the more you try to describe, the more you are likely to get wrong. The investing corollary is that rising idea complexity correlates with a rising probability that you will make an error. By keeping it simple, you increase the probability that you will make a reasonably good investing decision.
Fifteen years in, that’s my insight.
That’s why I measure investing experience not on a scale of 1 to 10 or from beginner to expert, but from naive to humble. There are no investing experts. There is no level 10. There are only investors who have contemplated the craft sufficiently and for sufficiently long to have become a little bit less naive and little bit more humble about buying stocks. Every step down the humility curve is taken with recognition that there is little certainty in the public markets and that there’s no need to make earning acceptable returns harder than it needs to be. This isn’t gymnastics or diving. There are no bonus points for degree of difficulty.