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Anatomy of a failed investment

11/18/2016

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Better to equivocate, when required, than to show conviction when it is not warranted”.

                                                                                    - John Rekenthaler 

“This episode taught me the importance of always fearing being wrong, no matter how confident I am that I’m right. As a result, I began seeking out the smartest people I could find who disagreed with me so I could understand their reasoning. Only after I fully grasped their points of view could I decide to reject or accept them. By doing this again and again over the years, not only have I increased my chances of being right, but I have also learned a huge amount”.
 
                                                                                  - Ray Dalio
 
As many of you know, over the years I have written about the dangers of high portfolio turnover. It generally signifies someone is trying to time the markets (bad) and driving up frictional costs that eat up returns (really bad). It doesn't mean high turnover is always the wrong choice, but it certainly isn’t a great sign of a long term, patient investor. Conversely, maintaining an obstinate position in the face of changing data is little better. An investor has to remain open to changing dynamics about the strengths and weaknesses of their investment thesis.
 
I bring this up because I generally don’t sell too many positions (my turnover rate since inception at the Nintai Charitable Trust is 5.4% annually). This number could tell me several things. One is that I’m content to let my holdings compound value over the long term (true). Second, I may be holding on to my winners or losers too long (somewhat true). Last, the possibility is that I’m simply too slothful to find new investment opportunities on a weekly basis and spend my time trading (absolutely true).   
 
It’s the second option I wanted to discuss today. In particular, hanging on for far too long with my losing positions. It fortunately hasn’t happened too much over the years. But when it does, it’s generally a real doozy. I wrote about one here that I still haven’t lived down. I should make it clear nobody twisted my arm or convinced me to hold on. This was a genuinely unforced error brought on by bad modeling, closed thinking, and hubris involving my circle of competence.  I have unfortunately committed another such blunder with my investment in Computer Programs and Systems (CPSI).  

CPSI: Anatomy of a Mistake
 
It seems like yesterday when I wrote about CPSI in my article “Thoughts on Return on Capital vs. Return of Capital” (it was actually on August 1, 2016). In that article I talked about how I had allocated roughly $400,000 of Nintai Trust dollars only to see that value drop by 25% in the two months I had owned it. I made the point that my losses had been mitigated by a dividend yield of roughly 6%. My confidence in my industry knowledge – as well as faith in management – quickly clapped a stopper on any doubts I might have been harboring.
 
I published my well thought out defense on August 1, 2016. One week later the bottom dropped out of the stock price – dropping from $39.10 on August 4th, to $27.47 by end of day August 5th.  Just to be clear, at this point my average purchase price was $51.40. The price dropped all the way to $22.90 by November 10th representing a whopping 55% (paper) loss.
 
So what happened? How in the world did I get an investment so wrong? More importantly, what should I do with it now? Before making any snap decision, I sat down with three years worth of 10-K, 10-Qs, and a list of customers to call to ascertain any long term change in my estimates. I also looked at my written investment thesis/assumptions and mapped them against actual results. One thing was crystal clear – this was not an example of Murray Gell-Mann’s random accident.[1] Oh no. As I mentioned, this was a full blown unforced error with your writer bearing full responsibility. While the results of my review would take an entire article to outline, three findings became apparent that I thought I would share.  
 
Too Confident in My Circle of Competence
Having been in healthcare consulting for nearly two decades, I assumed CPSI lay well within my circle of competence. To put it succinctly, it wasn’t. I was wildly off in my estimates of market growth, adoption rates, technology implications, and impact on CPSI’s financials. All of these led me to entirely wrong conclusions and estimates. 
 
Didn't Listen to Counter Arguments
As if erroneous estimates weren’t enough, I chose to ignore counter arguments to my investment thesis. There were warning signs that should have given me pause. As my constitutional law professor used to say, “extreme cases make bad law”. Information that contradicted my model were regarded as “extreme” and removed from the calculations. In addition, several Nintai Board members involved in healthcare asked some very astute questions. I simply didn’t utilize their expertise. Hubris indeed.
 
Ignored Management’s Warnings
In plain sight were warnings by management the electronic health record market in rural hospitals was saturated. While management didn’t explicitly state this explicitly, they were clearly moving into the informatics management side of the business. This was further reinforced by their acquisition of Healthland[2]. While I believe it is a wise strategic move, this choice made my initial thesis entirely outdated. My inability to acknowledge this was a key mistake in the process.
 
What Can Be Learned?
 
We all know the adage that mistakes are some of the great teachers of wisdom. If that’s the case, I should have a PhD with this investment. That said, I think there are three lessons I can take away and apply going forward.
 
Write Down your Investment Thesis
You can’t learn from your mistakes if you don’t have a clear record of your choices. In CPSI’s case, I had detailed records of my customer interactions, market growth estimates, and financial models. All of these – including my assumptions – could be tested against actual events. Let’s just say it wasn’t a very pretty picture.
 
Track Quarterly Statements with Your Thesis
It is vital to take a look at your investment’s 10-Qs with a detailed eye. Information in these – such as the Management’s Discussion section – can give you early warning of changes or issues that need to be reflected in your model. Every quarter you should be able to predict – within a range – the chances your investment thesis remains valid. 
 
Have a Firm Definition on Why and When to Sell
As conditions change and your investment thesis gets increasingly out of whack, it is no time for what Warren Buffett calls “thumb sucking”. A dispassionate look at the data should tell you to buy additional shares, stand pat, or sell. You should have firm criteria for this decision-making. Whether it’s based on valuation or stock price increase/decrease it should be clear when you need to act. In my case, thumb sucking has proven to be an expensive mistake.  
 
Readers likely want to know what we did with our holdings in CPSI. I continue to hold my shares for a couple of reasons. The company’s strategy to focus on data and informatics is a solid one. New federal outcomes requirements along with reimbursement tools are already starting to make EMR outcomes data quite valuable. Second is valuation. Since the company has dropped roughly 50% since our purchase we believe the stock is undervalued. Building out an entirely new valuation model, we think current price is significantly below my estimated intrinsic value.
 
Conclusions
 
Nobody bats 1.000 in baseball or investing. You are sure to make mistakes on the way. As I’ve written about before, it’s less about winning and more about not losing. My investment in CPSI clearly violates the latter. Huge losses are hard to recover from even in the long term. Going forward, I’m looking to strengthen my research process. I regularly try to break an investment process through sharp discounts to actual growth. This clearly was not enough in this case. The ability to process alternate views on market assumptions (such as competitors, adoption rates, etc.) needs to take place earlier and be far more robust.  The measure of my learning will be the absence of new investments similar to CPSI.
 
As always I look forward to your thoughts and comments.
 
 
Disclosure: The Nintai Charitable Trust is long CPSI.

-----------------------
[1] Murray Gell-Mann is considered a leader in understanding complex systems. He outlines two key themes – fundamental laws and random accidents. Random accidents are actions where there can be multiple possible outcomes. These accidents – and those that follow – are “frozen” in the history of that system and provide it with complexity. See https://www.edge.org/conversation/murray_gell_mann-chapter-19-plectics for more information.

[2] The company took on $150 million in long-term debt thereby violating another core requirement in my investment selection process. 
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Graham's Four Vital Elements

11/11/2016

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“One of the most demanding times is when you underperform. Whether it’s an individual stock that drops by 30% in one day or the entire portfolio grinding down month after month, stress can reach an intolerable level. Nobody said this would be easy. I always think these are times to really review your process. Is there something you are missing? Are there inputs that might give slightly different or better insights? I also see this time as a teaching moment for my clients. Do they understand why I am underperforming? Am I explaining it well enough. Most importantly, do I understand why I’m underperforming?  
 
 - Ted Regina, PhD
 
One of the most overlooked sections in great value investing writing is Chapter 2 in Benjamin Graham and David Dodd’s classic “Security Analysis[1]”. Entitled “Fundamental Elements in the Problem of Analysis. Quantitative and Qualitative Factors”, the chapter is filled with insights on both an investor’s approach and views on data/information about possible investments. I think many investors prefer Graham’s “Intelligent Investor” because of its length (575 vs. 733 pages) and Warren Buffett’s very vocal support of Chapters 8 (“The Investor and Market Fluctuations”) and 20 (“Margin of Safety as the Central Concept of Investment”).
 
During times of underperformance I generally turn to the investment classics to clear my head of the worries, doubts, and emotions that come with it. And boy have I been reading a lot over the past quarter. Nintai and Dorfman Value holdings Novo Nordisk (NVO) down -36.4% YTD, Hargreaves Lansdown (HRGLF) down -38.4% YTD, Manhattan Associates (MANH) down -24.5% YTD, and T Rowe Price (TROW) down -11.6% YTD. Just a solid wall of red across the board.  
 
Returns like this can make you question your investment process[2]. The pressure can get immense to tweak the system or make hasty changes to try to stop the losses. I know I’ve spent many days listening to quarterly earnings calls, reading through 10-Qs, and talking to customers of our holdings. But I think one of the more important things is to go back to Chapter 2 in Security Analysis and re-read it after taking a deep breath (and maybe pouring yourself a wee dram if that kind of thing works for you). 
 
In this chapter, Graham and Dodd start out by discussing four fundamental elements necessary to answering this question: should security (S) be bought, sold, or held at this price (P) at this time (T) and by this individual (I)?
 
(S) The Security
Here Graham and Dodd look to answer three questions. First is defining the business. Do we understand how it makes its profits? Second, what is the price of the security? Are the terms offered going to provide us with an adequate return? Last, define the security itself. Where do we stand as share holders or debt holders? I would add one additional item - corporate financial statements. Investors should know these to an in-depth degree for each of their holdings.
 
(P) Price
Price is what you pay, value is what you get. How many times have we heard this phrase (far too many times in my view)? Graham and Dodd point out the danger of paying the wrong price is equal to buying the wrong issue. They end this section by saying, “…the new-era theory of investment left price out of the reckoning, and that this omission was productive of most disastrous consequences.”  I couldn’t agree more. Which is what makes such significant price drops in my holdings so painful.
 
(T) Time[3]
Graham and Dodd point out that an investment can look vastly different depending on the time. Tech stocks certainly looked different in March, 1999 versus March, 2002. It’s important that your models work in most settings - such as 1999 or 2002 - and can adapt to new information. The authors state, “security analysis, as a study, must necessarily concern itself as much as possible with principles and methods which are valid at all times – or, at least, under all ordinary conditions.” Being able to adapt with the times is essential.  
 
(I) The Individual
Before any investment is made, it should be assured it meets the investment criteria of the potential holder. I have been remarkably fortunate in having investment partners that have extremely long time horizons (such as the Nintai Charitable Trust) or individual investors with great patience. It is during periods like right now - when underperformance is a very real concern - that you find whether your investors’ needs are aligned with your investment approach.
 
Breath in Patience, Breath out….Profanity?
I’m not a real proponent of checklists. I understand their value to some – just ask any airline passenger flying with a captain who hasn’t done his pre-flight checklist. In general I’ve found that a structured process is better for me than the list. With the latter, too many times I became focused on one particular item at the expense of several others. Process looks at the process more holistically while the checklist is driven by data. I generally look for a process that keeps emotions in check allowing for a more integrated and objective look at the data. An old friend of mine said that problems begin when you don’t let the profanity out. This is what makes Security Analysis’ Chapter 2 so vital. In its own way it allows investors to expunge the fear and terror as they watch their investments drop in price (along with a steady stream of epithets).    
 
Conclusions
Every investor will go through a dramatic period of underperformance in his/her career. It’s just a question of whose turn it is to be - as John Dorfman and I say– “in the barrel”. It’s safe to say the past 30 days it’s been this humbled writer’s turn to go over the falls. It isn’t very pleasant for me as an investment advisor and even less fun for my investors. The key is to avoid making any hasty decisions that assure locking in bad decisions through uncontrolled emotions. Each time I read Chapter 2 it allows me to reel these in and get back to basics. By answering Graham and Dodd’s question, I can feel comfortable the smartest move might be to do nothing at all.
 
As always I look forward to your thoughts and comments.
 
Disclosure: Nintai Charitable Trust is long NVO, HRGLF, MANH and TROW, as are some individual accounts at Dorfman Value Investments.


[1] “Security Analysis”, Sixth Edition, Benjamin Graham and David L. Dodd, McGraw Hill, 2009

[2] We can take heart in the fact 60% of all funds that outperformed their bogey over a 15-year period (1998-2013) underperformed in 7 of those years. See here for more information.

[3] Graham and Dodd are addressing more “timing” than “time”. Utilizing time as risk mitigation is an entirely separate concept deserving it’s own article. 
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    Mr. Macpherson is the Chief Investment Officer and Managing Director of Nintai Investments LLC. 

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