The Invaluable Follies of 2008

Painful as it was, 2008 was an invaluable learning experience. That may be a gross understatement.  The investment turbulence of 2008 may have been a formative experience — one of those events that truly molds people and perspectives for a lifetime.  That I managed to only lose -15% vs. a 39% drop in the S&P 500 takes the edge off a year where I managed to violate Buffett’s Rules 1 & 2: Don’t lose money.

In this week’s Barron’s, Bill Gross talks about Barton Biggs’ recent comment that he was “a child of the bull market”, trained to buy the dips and take comfort in the immutable fact that asset prices always go up over time.  2008 condensed a decade’s worth of dislocations into one year and heavily damaged the concept of stocks for the long run.

I have no formal training in financing or investing.  When it comes to investing, I am self-taught, mostly through books, as I am with nearly every other meaningful endeavor in my life.  And as much as I strive to take the lessons of Graham, Dodd, Klarman, Buffett, Greenblatt and other master investors to heart, you can only learn so much from books.  Some lessons can only be truly ingrained through the crucible of experience.

Living and investing through 2008 allowed me to firmly internalize some of the fundamental tenets of value investing.  Here are some of those tenets which were reinforced for me by my mistakes, in the words of a master, when available:

1. “People fail to have sell discipline because they can’t hold cash.”  – Seth Klarman.

Both sell discipline and my utter disrespect of cash caused me some pain in 2008.  In June 2008, I was up +18% for the year and as recent as September 2008, I was even on the year.  The run-up in commodities had gripped me in its throes. Several positions ran up past my intrinsic value estimates yet I held on in hopes of even higher prices.  Commodities began their marked descent during the summer and I quickly learned my lesson, selling Agnico-Eagle Mining (AEM) and Devon Energy (DVN) as soon as prices recovered near peak levels. I did not include Chesapeake Energy (CHK) in this group despite its run-up. I view the Haynesville Shale play as boosting CHK’s intrinsic value and still hold to this (readers can get more of my thoughts on CHK here.

For me, the second part of Klarman’s admonition, inability to hold cash, has its roots in much of my macro viewpoints and my dollar bearishness.  For nearly seven months, I refrained from buying stocks, with transactions mainly in naked put options.  During this time, cash comprised 30-50% of my portfolio, which I disliked.  Hence, when the breaks finallly came in September and October, I was all too eager to jump in.  Little did I know that break was only a prelude to collapse due later in the year.

If I had been more comfortable holding cash, I may have slowed my early buying spree.

2.  “…whenever there is money to invest, it is invested & if the owner cannot find a good security, he will buy a poor one.” — Benjamin Graham

I mostly avoided stocks up to September since I thought stocks were somewhat expensive given the reckoning we had coming via the housing mess.  Nevertheless, with such high levels of cash burning a hole in my pocket, I lowered my standards and began writing naked put options on lower quality prospects.

For value investors,  the overriding principle with respect to naked puts is never write contracts on stocks you don’t want to own. As stocks were expensive, I began writing puts on stocks I didn’t really want to own, if pressed: Precision Drilling (PDS), Northgate Minerals (NXG), Talisman Energy (TLM).  Eventually, I began writing options on stocks of which I only had a passing familiarity or which I based my decision on other investors’ opinions with little research on my part.  It was only through sheer luck of timing that I avoided disasters like Idearc (IAR) and Horizon Lines (HRZ).

Graham’s warning against lowering standards has some parellel to the previous mistake — not lowering standards means being comfortable with holding cash.

3. “Invert, always invert!” — Charlie Munger /  “Investors should pay attention not only to whether but also to why current holdings are undervalued.” — Seth Klarman

Or perhaps the poker corollary to these words of wisdom say it best, “If you look around the table and can’t tell who the sucker is, it’s you.”  Every stock has a seller to your buyer and each seller has a reason for selling. It is imperative to have a handle on what that reason is. This will help investors avoid walking blind into inherent risks associated with that investment. Even as we disbelieve in the efficient market hypothesis, it is a deadly sin to ignore the intelligence of the collective market.

My biggest loss on the year was American Capital (ACAS).  I can honestly say that if I was the sucker, it was not an unaware sucker.  I was cognizant of the risks present in ACAS.  But could I have done more to gain better understanding of the situation?  Undoubtedly, yes.

I could have ignored Nicholas Yulico’s immature, snipy tone and took his ACAS critique truly to heart or at least dug in harder than I did.  I could have read Einhorn’s Fooling Some Of The People All Of The TIme, which would have given me great pause to continue holding ACAS.  The warning flags were up and I buried my head and found comfort in management’s track record and seeming low leverage.

Finally, I don’t have a snazzy quote for it but some of the 2007 mistakes are still hanging around, specifically, my ego and lack of preparedness.  My ego is more problematic.  As hard as it is to believe, the embarassment of revealing my mistakes publicly on my blog is almost as much motivation as losing real money. And until reading the recent Buffett book, The Snowball, I’ve had a block against piggybacking on other investors’ positions.  I will post more on this shortly but as Buffett makes abundantly clear, “coattailing” (piggybacking, whale-watching, etc.) is absolutely essential.

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