Make more money by losing less money

Risk is a complex subject. Whilst there are many official definitions, most successful investors tend to define risk as what you don’t see coming—the unknown unknowns. Understanding risk in these terms may be the key to recognising the emergence of major risks faster, and hence avoiding the more significant financial pain that investment mistakes tend to lead to.

Losing less on your mistakes may well be the key to improving your investment returns…

The outlook always looks bullish at the time of investment

We’ve all been there. You research a stock which you’ve been following for a while. The company’s recent news-flow has been positive which explains why the stock has started to outperform. You make the decision to buy the stock on the expectation that the recent positive news-flow and associated outperformance will continue looking forward.

But…

Seasoned investors will be aware that few businesses consistently report positive news-flow year in, year out.

Then there’s the elephant in the room… it’s not uncommon for businesses to fail.

Hence, successful investing depends upon being able to identify the difference between a short term lull in an investment case and the beginning of a long term decline in a business model.

Time is of the essence in this decision-making process because the first disappointment may lead to a 20% stock price correction, whereas a longer term decline may lead to investors losing all their capital.

The signs that all is not well

Let’s start with the well-worn signs of a longer term business model decline in the making…

1. Over-promising and under-delivering – Sure, most management teams go through periods when they’re wrong-footed by a short term market shift which leads to a profit warning or three. However, if a management team is by their very nature over-promising and under-delivering, that’s likely to lead to poor investment outcomes over the long term. The way to tell the difference is to check competitors’ performance and the broader macro picture for clues as to whether a quality management team should have under-delivered amidst recent market conditions. Needless to say, repeated profit warnings warrant serious questions being asked about management.

2. Sounds too good to be true – If a company is promising enormous sustainable returns thanks to an in-house innovation, or a unique competitive advantage, just remember the golden rule… if it sounds too good to be true, it usually is.

3. You don’t understand it – If you don’t understand what a company does, that’s at best a warning sign that you aren’t well matched to own the stock over the long term since conviction depends upon understanding. However, there could be more to it. Some non-revenue companies have been known to prepare detailed presentations of the macro opportunities they are aiming to capture without ever explaining how their business models work. This is a warning sign which may indicate the company remains theoretical rather than scalable.

4. The CFO resigns unexpectedly - Many investors understand that a CFO resignation often spells bad news, but it remains of value as a signal. It makes sense as the CFO has to sign off on the company’s accounts. So if a CFO discovers accounting practices they are uncomfortable with, or which are misaligned with their ethical standards, they’ll often resign rather than expose themselves to whatever’s coming.

5. Accounting concerns – Accounting concerns are the holy grail for the short sellers of the world—and for good reason. If you can’t trust a company’s accounts, you can’t value a business as anything more than hot air. Many a business which has reported accounting concerns was worthless within weeks or months. If you are invested in a company with serious accounting concerns, your optimal strategy is usually to sell as soon as you can—even into a falling market.

6. Poor investor communication – This is a murkier signal since many companies are weak at investor communications for the simple reason they’re so focused on managing the business. It’s the combination of poor investor communication along with business underperformance which is the problem. Given most companies go through challenging periods from time to time, the safest approach is to avoid investing in companies with weak transparency.

7. Founders selling large quantities of stock – We recently wrote an article about the importance of skin in the game. Whilst it’s normal for founders to sell a small portion of their skin in the game from time to time, it’s a major warning sign when a founder sells a large portion of their stake. This one can’t be overstated.

8. Unethical conduct – We also recently wrote an article about ethical management teams being the best kind. Conversely, unethical management teams are the worst kind. Major red flags to look out for include the sharing of insider information and the use of hyperbole to describe the company’s outlook. Avoid at all costs.

The subtle signs that the dominoes have started falling

Beyond these signals, it’s worth being aware of the pathway companies tend to follow when their business model is veering off course.

Here’s the typical chain reaction of a business in long term decline…

• Management are focused on growing the core business with the limited resources at their disposal.
  
  
• Along the way, new green shoot ideas pop up which excite management so they divert resources away from the core business to capture the new opportunities.
  
  
• Over time, the core business starts to suffer. It starts to disappoint shareholders in the form of weaker than expected revenue and cash-flow.
  
  
• Existing shareholders start selling.
  
  
• The first valuation leg down is met with confident management talk about the company’s outlook.
  
  
• In the background, rather than shoring up the core business, management double down on investing in their new green shoot ideas due to the extent of the long term upside they see in those opportunities.
  
  
• The balance sheet becomes weaker as the cash flow from the core business evaporates. Suddenly, the balance sheet matters more than anything else.
  
  
• More shareholder disappointment follows and the stock crashes.
  
  
• Management are forced to raise more capital to survive which pushes the stock even lower.
  
  
• If shareholders are lucky, an activist shareholder invests and replaces management ahead of refocusing the company on its core business.
  
  
• If shareholders are unlucky, the stock may grind toward ground zero.
  
  
  
  If there’s one point to remember from this chain reaction, it’s the importance of management remaining razor-focused on their core business. Equally, diverting resources away from a company’s core business to pursue new opportunities is almost always a bad sign.
  
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  Case study of a failing business: Blue Sky Alternative Investments

  Blue Sky Alternative Investments remains a cautionary case study of how to identify an investment mistake.
  For those who didn’t follow the story, the company was an alternative investment manager which fell from a peak valuation of $1 billion in 2017 to being delisted and worthless three years later.
  Without dwelling on this sad story in depth, it’s worth highlighting the warning signals that the company was in trouble—which were admittedly clearer in hindsight than during the heat of battle:
• Mark Soweby, Blue Sky’s founder sold 40% of his holding in two tranches for $34.3m in 2018;
• A research report was published by Glaucus Research highlighting multiple and serious accounting/valuation concerns as well as business model challenges;
• There was a distinct lack of transparency in general. Even when management responded to the Glaucus report, they didn’t provide any of the transparency required by investment markets.
  
  
  
  In the words of Soren Aandahl, the author of the Glaucus Research report on the company, there are a number of key learnings from the demise of Blue Sky that all investors should remember:
• “Investors should always be wary of a company that thrives on a lack of transparency.”
• “Blue Sky was masquerading as a story that was too good to be true.”
• “It shows the importance of asking critical questions … and dissenting opinion.”
  
  
  
  These are valuable lessons as Blue Sky won’t be the last ASX-listed company which becomes worthless.
  
  

  Fail faster to improve your returns

  Failing faster could well be one of the most powerful strategies to help improve your investment performance. By recognizing your portfolio losers for what they are ahead of the rest of the market, you’re hopefully more likely to sell those stocks at valuations more reflective of the narrative the market has been told rather than the emerging reality.
  Here’s to avoiding being invested in failing businesses like Blue Sky Alternative Investments looking forward… or at least, selling early.
  
  
  

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  Disclaimer: This article is prepared by Simon Turner. It is for educational purposes only. While all reasonable care has been taken by the author in the preparation of this information, the author and InvestmentMarkets (Aust) Pty. Ltd. as publisher take no responsibility for any actions taken based on information contained herein or for any errors or omissions within it. Interested parties should seek independent professional advice prior to acting on any information presented. Please note past performance is not a reliable indicator of future performance.
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