I haven’t written a post for quite some time. I currently have a few topics in mind. Hopefully, I will have them written down in a short period of time.
As a starter, I would like to talk about diversification/position sizing, which is something I have been thinking heavily about. But first, let me explain why I came to contemplate this.
It has something to do with the investment record I have thus far compiled. And it can be described in one single word: abysmal. Yes, more than terrible, my record until now has been really abysmal.
I have really just meaningfully invested in three stocks since 5th September 2013, the day I bought my first stock. China Agrotech, Weight Watchers (WTW) and Town Sports International (CLUB). A lot more money (in relation to my net worth) was invested in the latter two. But all of them have given me more than 50% of losses. (>~70% for the later two) Realized loss for the first and unrealized for the latter two. Naturally, it bugs me and gets me into thinking what went wrong?! Self-afflicting and self-condemning aside, at least we ought to figure out what we can learn from our mistakes.
I made the first investment solely on my own. It was cheap. Maybe dirt cheap, since it was a net-net when I first found it. However, it turns out to be some sort of a fraud. The stock stopped trading after one of its creditors (I think it’s Standard Chartered) demanded they repay their loan. I summarised my lesson on a previous post. The focus here will thus be the latter two.
I invested in both WTW and CLUB alongside Geoff and Quan, both of them I consider my mentors. While WTW has awesome business economics and CLUB only has a so-so one, they were both cheap enough to get anyone’s attention when we bought into them. Yet, at the same time, they were both cheap for a reason. As weight-loss businesses, they were in constant need of replenishing their customer base. But they just haven’t been doing a good job at that. Some of that is due to new technology (like free apps and wearable technology attacting WTW’s basic business), and some of it comes from new exercise regimes (like studios taking customers away from CLUB’s traditional gyms) Worse still, they are also carrying meaningful amount of debt. So why did we still like them?
Basically, we believe they had certain moats around them that will make the challenges only temporary. We also believe both have the capacity to handle their debt obligation. The verdict for whether they can handle their debt is still out because they don’t have to repay or refinance their debt in a few years. But with both their revenue declining non-stop, we have been very wrong about their moat so far. And we may well be proved wrong about their capacity to handle their debt for the same ultimate reason.
The argument for WTW’s moat is simply that they are the most effective weight losing program out there. While free app is easy to get and use, they just aren’t as effective. People don’t stay with something they got for free easily long. And without sticking with the same program, there is no way you can lose meaningful weight with it. We have always envisioned it will take three or more years for things to get back to normal. Or in other words, for the fad in free apps to die down. But what about Apple Watch? With wearable technology maybe starting to get ingrained in people’s lives, wouldn’t there be more ways for such free apps to do its damage in the longer run? Or maybe as a gadget, it does help people lose weight easier, but can’t replace the psychological help found in a weight watchers program? I don’t know the answer to be honest. Geoff and Quan think the initial thesis is still pretty much intact. I personally ain’t as certain about it anymore.
CLUB, on the other hand, is all about economies of scale. They have the densest network of gyms in NYC. And it’s almost impossible to replicate it without throwing a lot of money into the sea. Even if studios really can gain traction in the longer term, we reckoned that they will certainly have enough time to convert their gyms into studios. Moreover, they were at the lower range in terms of leverage historically. But after more than 1.5 years, things just weren’t getting any better for either of them. We all agree CLUB is in the weaker position between the two. And that’s because in addition to its debt, it also has high operating leverage in operating leases. Now, that’s really a problem.
For WTW, it at least can adjust its marketing cost by its own will to gain more time for a turnaround. Maybe, in theory, CLUB can really gradually convert all their gyms into another format that fits what customers are looking for at the moment. But in reality, CLUB may already be bust before they can do anything close to that. Not only did we already lose money in CLUB, we also “lost money” in an opportunity cost fashion of missing the price uptick in LTM, another gym operator, due to the LBO of that company. CLUB, LTM and WTW are not the only stocks that Geoff and Quan (and later, we) looked into. If you take a look at the market price changes of everything that was looked at, you would certainly point out how silly it was for us to have actually invested in these two. (Quan has talked about the experience so far in this post, http://gannonandhoangoninvesting.com/blog/2015/4/23/stock-picks-review-and-lessons-learned. You can see how the other stocks performed there) This begs the question for us. Should we have been more diversified?
All the three of us were pretty concentrated with our investments. I just agreed with them that going for a more concentrated portfolio is the way to a better than decent investment record. If you pile up a list of investors that have a long term track record of compounding money in the 20s percent per year for over a decade, you will mostly come up with a list of investors that favor concentration. For instance, Joel Greenblatt, Eddie Lampert, Bill Ackman, Glenn Greenberg, Ted Weschler, Allan Mecham, and so on… They all basically had a pretty concentrated portfolio of having most of their capital in below 10 stocks.
I also came to think about diversification because of my current new job, where I am being fed a lot more attractive opportunities than ever before. When you are given 10+ names a time, you would naturally think whether it’s actually better just buy all of them instead of trying to make a judgement on which one to pick. Then, there is the fact that Buffett once held 40 stocks at a time during his partnership days.
That was the question I asked myself. Was it wrong to be so concentrated?
And here’s how I came to my own conclusion on the subject. I don’t think the degree of concentration was wrong. A more diversified portfolio of owning everything we looked into would have yielded much better results that what I have gotten so far for sure. But that’s missing the point. That’s not the real lessons that is being offered here. Now, to the real lessons from my investing failure. Really, instead of not diversifying, we simply made the most sinful mistake in investing. Selection mistake. One that is due from greed.
A declining business is usually not a good investment proposition. It’s only “usually” because in cases where you can control the pace of decline of the business or there are some structural characteristics ensuring a gradual decline and easily adjustable cost base, then you can probably exit the business in a profitable way. But in cases where there is essentially a “customer problem”? Then sorry. At best it would be a terrible experience before you break even at the end; and at worst, permanent loss of money. Adding leverage to it makes things maybe ten times worse and much more skewed to the worst scenario. Well, if you add in more than one layers of debt? You are primed for a disaster.
By customer problem, I meant a fickle customer base where they don’t naturally like your product/services or are susceptible to fads and trends. Geoff and Quan did mention they have to replace 1/3 of their customer base every year. This challenge never really caught my attention until now. If CLUB instead is a company that sells cigarettes, soda, chocolate, system software and so on, it would be a totally different story now… That’s lesson number 1 for me.
The second one is more general. As I pointed out, CLUB has been primed for disaster all along. And the major reason why it’s in a worse situation than WTW is it has both debt and operating lease. So what if CLUB owns all the places that hold its gyms?! Ah… maybe then they can deal with the turnaround with much greater ease. That sounds obvious to us now. How I wish I was this wise before. Essentially, we did study a gym operator without debt. And that is Life Time Fitness (LTM). Unlikes CLUB, it operates huge facilities that pretty much act like a country club to its members. They own most of their facilities, with many already mortgage-free. And yes, we believed it’s a better buy-and-hold candidate from the start. Yet, we still went for CLUB in lieu of LTM. WHY? Well, the answer is simple. We were greedy. That’s it. Instead of choosing something that is much safer, we opted for the one that provides the higher leveraged yield. And I, specifically, was lusting for the potential 3 bagger built into the stock of CLUB.
I thought I read enough about “focusing on the downside and the upside will take care of itself”. Turns out I was as clueless as ever. Maybe there really are things you cannot learn from books, but only from pain. Don’t be greedy is the lesson number 2 for me.
Diversifying is only a way of hiding from the real mistake of making a wrong selection here. While the above points out my own personal experience isn’t a logical argument for diversification. It doesn’t mean I have successfully argue against diversification. In fact, I don’t think I will ever be able to do so. But I did finally come up with my own personal view on the subject.
My own answer for that comes from my new working experience in a hedge fund and an excellent answer I got from Geoff. (Which you can read from here: http://gannonandhoangoninvesting.com/blog/2015/5/19/when-should-you-diversify) I think most importantly, the level of correct diversification, for me personally, is pretty much limited by my own time and ability to absorb information needed to support that level of diversification.
From a risk management perspective, the biggest advantage of diversifying more is reducing the impact of a blow from any single investment. However, to successfully implement a more diversified portfolio, I think you have to first pass the hurdle of getting enough time to understand all that are in your portfolio. The problem I am starting to experience is I simply don’t know enough about a few of the investments currently in the portfolio of the hedge fund I am working in now. When a piece of negative news crops up about any one of them, I simply have to do a lot of work before I can add valuable comments to the team. (Trust me, when you are managing other people’s money, even if it’s only a 5% position, you want to know everything and make the right decision of either selling or averaging down) Having too many stocks in your portfolio simply dilutes the effort you put into each stock.
Or so I thought. But Geoff reminded me this isn’t necessarily the case. In fact, what is the most brilliant part of his response as mentioned above is that you can hold 10 or 30 stocks and still be putting up the same effort before you buy each stock. The only difference is you will have to hold, on average, each stock much longer if you were to hold 30 of them instead of 10. The key is not to dilute your effort you put into each stock.
The second important factor is of course the amount of bargains being offered by Mr. Market. It makes natural sense to buy more in times like 2009 when many obviously high quality businesses are selling on the cheap, or when you can find stocks that have a long history of profitability selling below net cash. Being stubborn and study every one of them to unnecessary levels of depth will be a costly mistake for sure. But barring such obvious cases or unusual times, real bargains should be scarce.
Combining the above two points, it just seems better to concentrate a bit more to me.
Substantia Investing 