Books #18: Security Analysis - Part 2

This is one of those long awaited sequel post as we took time to discuss T bills and dividend stocks given the interesting market movements in the recent months. As mentioned in the past post, Security Analysis is this seminal book which provides good lessons for any investors but it's a bit difficult to read. But we can still learn a few lessons from it.

As promised, let's discuss the financial shenanigans and bad management which happened then (i.e. c.1920s) and will still happen as long as humans are greedy. As the gurus put in, the financial statements that will uncover financial shenanigans are usually the balance sheet and the cashflow. The P&L statement is the most straightforward and since most laymen can read it, shrewd management will not screw that up. 

The balance sheet and the cashflow statements require more financial knowledge and it is the balance sheet that is used to hide the bad stuff. As such, the authors of Security Analysis warned against bloated balance sheets. By bloated, we are referring to account receivables, other assets, other liabilities and lines in the balance sheet that is used to hide the bad stuff. 

Most of the time, it is not easy to uncover because bad management has gone all out to hide stuff. I managed to find Enron's balance sheet in year 2000 online. Without hindsight, it is not easy to say things are wrong. The lines - "asset from price risk management activities" were where most of the bad was parked under, USD21bn worth of it, but management made so much effort to explain it so well that it's difficult to fault analysts for not being able to figure things out. 

Bad management will never admit that they are bad so sometimes, in the end, it really boils down to gut feel. I have written about this on various posts in the past: Billon Dollar Whale Fraud Detection Lessons and Theranos, the fraudulent startup. To jot down a few tell-tale signs:

1. Bloated balance sheet, what we have we talking about so far

2. Keep talking about importance of secrecy, trade secret and know-how, trademark protection to mask the lack of disclosure

3. Lack of governance

4. Past issues with the law, including ongoing litigation.

As a side note, companies with litigation risks should also be avoided because the cost is simply to hard to measure. We discussed BP and Bayer in the past on this infosite. Both names did not recover past their previous peaks after the litigation mess broke out. BP was the infamous Deepwater Horizon accident and Bayer was ensued in the supposedly cancer causing Roundup fertilizer class action lawsuits.

In the next and final post, we discus other lessons learnt from Security Analysis.

Huat Ah!

Lessons Learnt from 4 Biggest Losses - Part I

Most people brag about their investment wins. It is just human nature. We need to show we are better, so we get status, pride and get to lead and enjoy the benefits that get accrued to leadership in tribes. In prehistoric times, alpha males who can hunt, have muscles, can fight well tend to get the best food, the best shelter and the women and produce more offsprings and win the natural selection competition. 

As such, bragging is biological.

Alpha male primate can even get cookies!

Today, it is about money. You can be bald and fat but if you are a billionaire, then prestige and goodies and some women will come your way. So we brag about investment wins to showcase that. We buy cars, watches, houses and NFTs to display wealth. It is imperative, biologically and socially.  But what is truly and fundamentally beneficial is to learn from our losses. That is how we get better as investors. That is what this post and the next is about. 

As I look at my portfolio, there are now four big loss-making positions which I felt compelled to write about. The losses amount almost to six digits and you can imagine how it pains to write about them. But I believe there are many lessons learnt and I hope readers can really takeaway some of these so as not to repeat them. But trust me, it will be easier said than done! Here are the losers in no particular order:

1. Overseas Education, negative c.30%, I have blogged about this stock.

2. SIA Engineering, negative c.20%, pandemic victim, I have also briefly blogged about this.

3. Under Armor, negative c.70%, hit by overvaluation and the pandemic.

4. Cinema related small cap name, negative c.80%, looks like I will never recover my capital.

As I looked at the four painful names, I see similar mistakes and recurring lessons. While all four names were somewhat impacted by Covid-19, it was not just the pandemic. It was overpaying i.e. valuations, it was ignoring small cap risks and not understanding all the issues and most importantly, it was not getting the sizing right. Actually, sizing is so crucial so let's talk about that in more detail. 

What I got from Google wrt to sizing

For me, the sizing mistake relates to all four names but it had the biggest absolute damage in the first two. As such, despite the percentage loss was only 20-30%, the outsized impact on the absolute damage was big and this is the nutshell lesson about sizing:

We must size the bet such that we can still sleep if we lose 80% of the amount invested. We must also think in terms of percentage of the portfolio. In most professionally run portfolios, there are hard limits like 10% for one position but for personal accounts, we may want to size it lower depending on our own psychological construct and the amount of absolute loss we can bear.

Let's use so numbers to illustrate the above. First we must determine how much we can afford to lose in one position. I will arbitrary put that as S$40,000 which is close to half of Singapore's median household income. (Imagine when you need to tell your better half that you lost half a year's income on one stock. This should be good pyschological threshold ;) Looking at my actual losses, since a position can go down 80%, that means the maximum bet on one stock should be c.S$50,000. Of course that also depends on your portfolio. If this is more than 10% of your portfolio, then perhaps it should be smaller. 

There is also a minimum size for a position which relates to transaction costs. When I first started, round trip (buying and selling) transaction cost can cost minimally $100 which means that any position should be c.S$10,000 otherwise it doesn't make sense as it costs 1-2% every time you do some buying and selling. Well, the world has changed and transaction costs can go to zero with some brokers, but still, sometimes it's not and it pays to know what is the optimal minimal size for you.

Going back to my mistakes, if I sized the bets correctly, I could have reduce my absolute losses by half and the pain will also be halved and I would not have to endure the wrath of my better half! When you can size correctly, losses cannot hurt your portfolio and your family peace and you can sleep better at night. There is a lot more to talk about sizing which perhaps deserve its own post but let's stop here for today and we shall discuss in the next post:

1. Valuations 

2. Small cap issues

3. Unknown risks

There are two rules in investing. First rule: don't lose money. Second rule: don't forget the first rule.

Huat Ah!