My biggest mistake in the last 12 months

It was a mistake of omission.

There is this startup with a promising but unproven technology. I spent weeks searching the business and the market. I got to point of pulling the trigger. It was at a price that I was comfortable with to put in a small stake based on my calculated risk/reward, knowing I could lose it all. I literally had my finger on the "buy" button when I hesitated, wanting an even cheaper price. The next week, price started running away from me and has never returned. If I'd bought it, it would've been a 3-bagger in less than 3 months and would've taken care of my 2013 return single-handed.

It's been really painful watching the price running further and further away from me on a daily basis. Trust me. It's painful. Even having reflected on the lessons learned, knowing probability plays a role here and drilling on it does me no good, I can't help agonising about it.

Emotion can kill an investor.

Another lesson: net-net mentality is sometimes wrong.

Update on RIMM

This is a long overdue update on RIMM.

Since I wrote my original investment thesis 9 months ago, the stock price has been acting like a roller coaster, falling from $13 all the way down to $6.30 and has since recovered and climbed to $18. I accumulated more shares on the way down. I have also reduced my stake on the way up.

Assessing RIMM now

RIMM's management has done many things right. If you are familiar with Apple's history as depicted in Steve Jobs' biography, you will see what RIMM has done was straight from Jobs' playbook when he brought Apple back from the brink of bankruptcy in 1997. At the time, Apple was 3 months away from insolvency. Jobs cut cost, rationalised the supply-chain and cobbled up a stop-gap product iMac G3 to buy time. RIMM did all these. (Granted that RIMM's stop-gap products are not as intriguing as iMac G3. But they did refresh a couple of their BB7 models.) Because of all these tactical moves, RIMM has been cash flow neural.


Besides, what RIMM has done shows also RIMM has a clear understanding of ecology of the mobile industry. In the mobile space, you do not deal with just the end users. Instead you have this entangled triangular relationship: (1) the carriers, (2) the application developers and (3) the consumers. In order to get one group on board, you need to get the other 2 groups on board.  This is a virtuous cycle, but going backwards when you don't have the base. To break this chicken and egg situation, RIMM has literally handed out free cash to court application developers. (If Alec Saunders can really pull it off to artificially build an ecosystem overnight and make BB10 a self-sustainable platform, it is destined to be an important case study at B-schools.) Besides, the restructuring of RIMM's pricing model revealed in their recent conference call is an evidence that RIMM is also buying carriers' support.

However, it's not all blue sky. RIMM has made a single most critical strategic decision that has fundamentally altered the value proposition of its turnaround. I'm not saying RIMM has made the wrong decision. They have no choice. They have selected the lesser of two evils.

What am I referring to?

RIMM has completely given up a pillar of its existing ecosystem. RIMM has given up their proprietary management protocol. Instead, both BB10 and BES10 will use the ActiveSync protocol.

The key issue here is old back-office BES can't manage BB10. Consider this: business users constitute a significant portion of RIMM's market. These existing users are still on BB7 only because their companies are still running the old BES. How to get them to buy BB10 phones? They won't buy the new phones unless their companies upgrade to BES10. But the upgrade cycles of information systems at corporations are notoriously slow. Businesses are inherently risk averse. They won't adapt new systems if the systems are not proven. Consumers will buy phones on an impulse. But it can easily take a company months or even years to evaluate a new system before committing to it. (Quick, is your company still using WinXP?)

So, RIMM has given up the lock-in power of their own franchise. It's not unlikely seeing Intel giving up their x86 architecture or Microsoft giving up their Win32 API. But as I said, RIMM has no choice. This decision to use ActionSync makes BES10 able to manage all other phones on the market. It makes BES10 a better value proposition to sell to CIOs.

If you remove this structural lock-in, for business users, what is left is RIMM's brand, its customer relationships and its history of delivering valuable solutions.  These are by no means worthless. But  without the lock-in, BB10 will be competing with Android and iPhone on equal footing, on features and prices.

(Well, I think one comforting sign is, there are reports that companies have shown up for BES10 testing and training. The uptake of BES10 can be faster than I foresee.)

On valuation and what to do next

At the current price of $18, the margin of safety has gone. Not only that. RIMM's break-up value has actually deteriorated as expected. The value of its BBM network and BES have both shrunk. Donald Yacktman aptly said RIMM's value was a melting ice cube.

RIMM was a net-net at one point. But it is now a pure turnaround story. Its P/B is back to 1.0.  So I don't have the downside protection I once had. However, on the flip side, if BB10 manages to become a sustainable ecosystem, the upside is huge. RIMM can easily get back to $40, $50 or $60. But this is a big "if". I have no confidence in myself to handicap it. I don't have much insights on the odds. And I don't much insights on the bull case valuation. If the PC history is a guide, it's winner takes all.

When I bought RIMM, my investment horizon was 3 years. I didn't expect such a dramatic price movement. I didn't expect the price would go up this quick before RIMM turned a profit. Without the downside protection, the possibility of a break-up and real profit, I now have my eyes on the exit. Weighting up all the factors, the odds and my edge, I will probably sell down my stake gradually. I may hold a smaller stake for a long time as the upside is still too good to ignore. The upside still has a good chance to materialise even though I'm not capable to put a figure on it with confidence.

Lessons learnt

In retrospect, if there is one lesson learnt in investment, it is that I was not aggressive enough when averaging-down. I run an already very concentrated portfolio. And this single stock has been (and still is) the biggest position. I was too concerned about the concentration in one stock. In hindsight, my emotion overtook my rational thinking. When the stock was below $7, the probability of losing money approached zero. This should've been the time to back up my truck to load up. But I didn't. But my averaging-down was too timid. (And this is not the first time I make sure mistake...)

By the way, here another interesting thing I've observed.

There was this analyst covering RIMM who was able to move the market. When he changed his target price, the market followed. At various times, this analyst came up with his target prices by weighting different scenarios by their probabilities. There is absolutely nothing wrong with this. But what I disagree with is that he assigned a high probability to the $0 case.

RIMM is debt free. Management shows they are rational, doing all the sensible things to keep its cash flow neural. It has a book value. It has tangible assets. Every single desk at its Canada HQ can be sold for some cash. Its patents can fetch some money. After all, it has cash in the bank. $0? You are kidding me.

This shows the general bias on the Wall Street. Undoubtedly there is a fair chance RIMM will fail and disappear as a company. But they mix up the collapse of an identifiable business entity with the complete destruction of value. They think that when a company ceases to exist, all the value embedded in it will vanish. They think value can only exists if the business is a going concern in its current form. This is the reason why so much emphasis is placed on the P&L's while balance sheets get very little attention. They ignore the possibilities of what Martin Whitman called "resource conversions". [Ed: Reading this myself again, I realise I implied the management wouldn't drive the company to the ground if BB10 didn't turn out right. The confidence comes from that we have a major shareholder on the board who would steer towards an orderly liquidation. An orderly liquidation is resource conversion.]


Resource conversion is one important way values can be released.

(Disclosure: Long RIMM)

Ships, hogs, dirts and the shipbuilder called Conrad

Ships, hogs, dirts and shipbuilders. What do they have in common?

Their economics.

Ships

A while back, the dry bulk shipping industry caught my attention. You can see why from the 3-year BDI index chart below. The BDI index is the barometer of the charter rates for dry bulks. The industry has been in recession since GFC.  It is severe. Besides, I remembered one of my role models, Mohnish Pabrai, described in his book how he scored a multi-bagger win in his bet on the oil shipping company Frontline when the industry was in recession in 2001.

Source: Bloomberg

Were there values among the dry bulk shippers? 

The initial look looked promising. Listed dry bulk operators like DSX and GNK spotted attractive ROAs, profit margins and P/B ratios. However, the more time I spent to understand the industry and its economics, the less sure this was a game I was capable to play.

Take a look at the supply/demand curve I reproduce from Martin Stopford's book Maritime Economics :

Source: Maritime Economics, by Martin Stopford

Let me point out the important bits:

• Shipping is essentially a commodity business. (You generally don't care too much who is shipping you stuff as long as your goods arrives in one piece.)
   
• In short term, demand is inelastic. (If you need to buy steel beams to build your Olympics stadiums, high shipping cost won't easily deter you.)
   
• At the same time, worldwide shipping capacity is finite, because it takes years to build a new ship. Thus, supply becomes inelastic once you reach a certain point. Hence, the "hockey stick" shape supply curve. Freight rates can go from $6,000 to $44,000 in the space of a few months.
   
• When freight rates skyrocket, shippers will decide to invest to expand their capacity. It takes 1-3 years to build a new ship. By the time the shipbuilders expand their shipyards and new ships are built, the demand is no longer there. We now have an oversupply of ships and freight rates tumble.

So, here we go. Boom and bust cycles. Because of the above structural reasons, the magnitude of boom and bust cycles is extreme. Consider this: BDI was at its highest 11,000 in mid-2008 before the GFC, tumbled to 700 in Dec 2008, recovered to 4,600 in Nov 2009 and is now hovering around 1,000. To get a sense of what this means in real life, just imagine bus fare tumbles from $110 to $7 and then climbed back to $40 in the space of months.

This means the usual metrics like ROA, P/E and P/B are all meaningless. Earnings and asset values are quick sand. They are extremely unstable. You can't rely on them to value dry bulk shippers.

I ended up not investing in any of them because I just had no particular insight into individual shippers. Nor had I any insight into the cycles and the macro environment surrounding them.

Hogs and Dirts

I've omitted a lot of details about maritime economics which contribute to the "hockey stick" supply curve. (e.g. Ship owners can slow down their voyage or lengthen their maintenance time in response to low demand.) But the above supply/demand captures the essence. Furthermore, there are 2 key factors underscoring this extreme economics: (1) The decisions to expand the supply (i.e. the fleet) take years to materalise. (2) Each player in the industry is making rational decisions, but only considers themselves in isolation. Some kind of prisoner's dilemma is at work here.

This pattern shows up in another industry that I'm been worried about for some time: the mining sector in Australia.

Professor Steve Keen at University of Western Sydney explained it the best in this Business Sepctator piece. He pointed out this is nothing new. This was long recognised in hog cycle, the volatile 4-year cyclical pattern of prices for pigs in the US. And there is a neat economic theory, the cobweb model, explaining it.

(This is a good example that knowledge is accumulative. You builds up your circle of competence organically over time. From time to time, Things I learned from one place would show up in another place in a slightly disguised form. Things learned from one domain are never wasted if they didn't lead to any investment idea.)

Conrad Industries

This brings us to CNRD, the shipbuilder that I'm investing in.

My original conservative estimation of CNRD's intrinsic value was $18-20 per share. The current share price has now fallen into this range. Isn't it time to take the money off the table? This is the question I've constantly had in my mind in the recent weeks.

The original investment thesis was essentially based on a single event, the oil spill, or the recovery from it. But I have since realised there is more with CNRD. CNRD's management is more competent than I initially thought. CNRD has also become less sensitive to the exploration activities in the Gulf region than it used to be as the management has diversified its client base. CNRD may not have any structural advantage, but it is a very efficient business. It has the appearance of a "hidden champion". It's more like Buffett's Nebraska Furniture Mart than his Coca-Cola.

The difficult question is: how to value it now?

CNRD isn't exactly Nebraska Furniture Mart. Even though CNRD's client base is more diversified now, the products it makes are still commodities. It is still at the mercy of boom and bust cycles. "When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact." More importantly, the longer I hold CNRD, the more important the cycles will become.

For a cyclical business, the concept of intrinsic value as in Ben Graham's way of thinking may not even be applicable. Even if it exists, it's close to unknowable. There is no stable earning. It will be dangerous to normalise CNRD's earning over many years to arrive at an artificial figure. If we do so, we will be like having one foot in a bucket of ice water and another foot in a bucket of boiling water and claim we feel good on average.

And it is equally dangerous to time the cycles. Stopford says in his book the average length of boom and bust cycles in the shipping industries is about 7-8 years. This is, again, just an average. These cycles don't come in as clock work. The constant changing macro environment has significant influences on the supply-and-demand.

Where does this leave us? Without an estimation of the intrinsic value, I don't have a rational basis to judge when to sell. And forcing an estimation may easily give me a precisely wrong figure.

I'll follow Keynes' doctrine: "it's better to be vaguely right than precisely wrong". Here is how I will approach it:

• I mentioned in a previous post there are a few catalysts surrounding CNRD: the BP settlement, full recovery of its repairing/maintenance segment and a small possibility of some kind of corporate action. So, instead of getting obsessed with figuring out a valuation, I will wait for one or more of events to play out.
   
• I will add one more event to my list above. There is an important observation from the discussion of the boom and bust cycles of the shipping industries: The length of the cycles is a directly consequence of the duration it takes to materialise the investment/expansion decisions made by the players. It is not precise and will never be precise because unpredictable macro events will push things around. But the general cause and effect is there. If it takes only one week to add capacities in an industry, you will  expect to see the length of cycles in the order of weeks, not years. And here, we see CNRD is also buying land and getting government grants to expand its capacities. We can reasonably expect other players in the industry are doing the same within a similar time frame. (This will be a good place to do more scuttlebutt.) When all of these new capacities come online, we have to be worried. So, if we work backwards from here, the completion of CNRD's expansion program will be a signal the industry has passed its peak.
   
• I will err on the side of being over-cautious. I will rather leaving too much money on the table than being caught in the downturn of the industry.

I mentioned in my previous post the Credit Bubble Stocks blog is an excellent source of intelligence on CNRD's industry. Credit Bubble has linked to an informative research piece Good Year for the Barges. Being a contrarian, I'm becoming more cautious, treading with my eyes wide eye...

(Disclosure: Long CNRD)

I am still the easiest person to fool

I thought I discovered a gem when I spotted a company called Ancestry.com (ACOM).

It eventually turned out to be a dud but I learned a few important things along the way.

Key points:

• Beware of rationalising doubts with superficial reasonings
• Pride can cloud judgments
• Don't ignore the market
• Use a checklist
• Scuttlebutt is important
• Reflect and improve

As its name implies, it allows people to trace and discover their family trees and connect with family members. According to its website and annual reports, not only it maintains world's largest genealogy database, it has also been building up a huge collection of user-generated content about their family histories. Another website states that genealogy is 2nd most popular past time behind gardening. Ancestry.com has a subscription model. Users pay a monthly fee to access its database and connect with discovered family members.

Immediately, the following phrases popped up in my mind: "recurring revenues", "network effect", "zero margin cost", "moats",... A quick scan of its financial results brought up something too good to be true: A fast growing business with a market cap of $1 billion and ttm FCF yield at about 11%. Wow, a business with Facebook-like quality at a cheap price!

How could it not been discovered? I couldn't help but decided to look deep.

Then, I spotted something unusual. Short ratio was 10! That was nothing ordinary.  What was going on?

I found a couple of bullish articles on Barron's. Nothing looked alarming. I found some writeups on popular investing websites. It appears some investors questioned how much further it could grow and how long the users would keep their subscriptions once they had found what they were looking for. Could these explain the shorts?

Brushing the concern of the shorts aside, I decided to do a search on review sites like Yelp.com to see how satisfied the users were. Here I found my first lead of the real issue. This subsequently led me to more user reports on the Consumer Affairs website. The gist of the issue is:

• Ancestry.com always charges its users upfront for the entire year even though its website implies fees are monthly.
• They make it very hard, if not impossible, for you to cancel your subscription.
• Subscription fee kicks in immediately right after the 14-day trial period. Again, it's almost impossible to stop it.

It also appears Ancestry.com has engaged in this practice for many years.

No wonder their receivable turns are that short. No wonder the platform is sticky. It handcuffs your credit cards to its cashier. This is at the borderline of being a scam.

What are the lessons here?

I am the easiest person to fool. When I re-trace my thoughts, I see a few dangerous signs.

When I initially read the claim that genealogy was the 2nd most popular past time behind gardening, I had a flash of doubt. Isn't family tree discovery an one-off thing? How can it be addictive like World of War Craft or Facebook? Is there really "re-play value"? But Ancestry.com's financials seem to indicate otherwise. And its publications paint a very rosy business. I treated them as "proofs" and suspended my skepticism.

Second, I was too eager to uncover "hidden gems". Now think about it, it's impossible Ancestry.com was  under the radar. It's sponsored popular TV show "Who Do You Think You Are" in the States as part of its marketing campaign. My pride clouded my judgments.

Third, you got to wonder why Barron's and other investors were not aware of this questionable billing practice. Probably the sell-side analysts with Barron's had the incentive to turn a blind eye to this...

What saved me from losing more than just a few hours of my times?

• I didn't ignore the market. The market is usually very efficient. Re-assess my edge.
• I went through my checklist.
• I looked beyond the financials. I tried to understand the business from the customer's perspective.
• I reflected upon my past mistakes. This post itself is a reflection. It's so crucial to learn and adjust.   

(Disclosure: no position)

A followup on GLG Corp

This is going to be a quick post.

I wrote about GLG Corp (GLE) last week. One thing that has kept me perplexed is: Why did they list in Australia? Australia ASX has arguably more strigent listing regulations than SGX in Singapore. (This was one of the contentions in the ASX-SGX merger talk back in late 2010.) Why the trouble? And what's the point of raising so little capital here? The CEO and founder still controls 75% of the company.  They were not in here for the money. But what?

Yesterday I met up with a Singaporean friend. He read my GLE post. He made this casual comment while he was cuddling his one-year-old daughter in his arm: "These people were here for the status in order to attract employees back in Singapore."

Wow, what a revelation! This makes a lot of sense. This fits the general mentality in Asian culture that status is important.

This taught me two things:

1. Local know-hows are all important.
2. Scuttlebutt is all important.

Lesson learnt from my mistake with Lakeland

LAKE (NASDAQ)

Not buying LAKE was one of my biggest mistakes in 2011. This has led me to rethink how to judge risk/reward balance in net-net investments.

Lakeland (LAKE) is a protective clothing manufacturer. It's a microcap with a current market cap of  $54m. I looked at on and off for nine months with a passing interest. In November last year, it traded below $7.00, that was 20% below its net current asset value (NCAV) and 50% below its book value. That got me very interested and I took closer look. Whopper Investments has a nice writeup of the investment thesis on his blog. I'm not going to repeat the analysis here.

To cut the story short, I was troubled by their Brazil VAT liabilities. I couldn't reconcile the figures disclosed in the cashflow statements with the details else where in the 10-K. Together with a few circumstantial facts*, I started wondering if there was fraud at LAKE. After some email exchanges with Whopper and some more thoughts, I dismissed the fraud idea because there wasn't much incentive for the management to do so. But I did conclude their VAT mess (resulted from an acquisition) was a result of bad management. I concluded their incompetency would destroy value and their good ROE in past years was pure luck. Later in their fourth quarter result, they shuffled the India money losing operation into "discontined operation". That further enforced my thinking. With no catalyst in sight, I was worried that they would bleed money in foreseeable future.

Fast forward to today. LAKE is now trading at $10.50. That's 40% return in less than 3 months. What has happened? In December before Christmas, Ansell, an Australian protective clothing company, took a 9.7% stake in LAKE.

What's gone wrong in my reasoning?

I always wanted an exit strategy or catalyst in place but there wasn't one. I forgot a net-net is a net-net because it has a few warts and no obvious resolution in sight. Otherwise it won't be a net-net. Buying a net-net is basically a calculated bet on some "positive black-swan" event, if you wish, that some positive event you have no way to anticipate or foresee will happen. At the same time, the backing of the assets gives you the staying power and downside protection.

p.s. If you don't know what a black swan is in the context of investing, read Nassim Taleb's Black Swan or Fooled by Randomless.

----

*  Other circumstantial facts I found: (1) the proxy-advisory firm Institutional Shareholder Services (ISS) has advised sharesholders to vote against director John Kreft (sitting on the audit committee) and Lakeland's audit WAKM in its Jun 2011 AGM, objecting the high non-auditing fee paid to WAKM. Kreft nearly lost his seat.  (2) Lakeland only switched to WAKM it the last couple of years. Switching accounting firm always raises concern. (3) WAKM was being sued for negligence in auditing of a bankrupt furniture maker.

First Anniversary of Japan 311 Disaster

I've just heard on the radio yesterday was the first anniversary of Japan's "311" earthquake and tsunami. And I found this entry I wrote in my own investment journal on 29th March 2011,

It's really scary. Really really scary.

After the Japan nuclear incident, most of my holdings went down and some went up. When I looked at those which went up, I found my confidence in their analyses went up and wanted to buy more. When I looked at those gone down, my confidence in them dropped and wondered when I could unload them.

My emotion is my biggest enemy.

If I can keep my head cool and be rational and methodological all the time, 80% of the work is done.