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Being an obvious idiot is the worst part of value investing

Being a contrarian can be a lonely existence. It involves doing nothing for long periods of time. And then when you do something, you are usually going against conventional wisdom at the time. But loneliness is not the hardest part of the job. The hardest part is being an obvious idiot when you get things wrong.

All investors make mistakes. Most successful investors say the best you can expect is to get six or seven out of 10 right. That’s been consistent with our experience over the past decade. The difference as a value investor is that you get things wrong in ways that are obvious, seemingly stupid and embarrassing.

Into the face of Jumbo concerns

Online lottery ticket reseller Jumbo Interactive (ASX:JIN) is a darling growth stock these days. But it wasn’t always that way.

We first bought into the stock at around $2.50 a share. From there it fell more than 60% and we added significantly to the holding at less than $0.90 per share. As a value investing opportunity it was simple. Its market valuation was just $39 million. It had $17 million in cash, a pile of franking credits and an Australian business making $8 million of pre-tax profit a year.

But the issues with the business were well known in 2015. Jumbo was wasting money on international expansion gambles in Germany, the US and Mexico. It had one critical supplier, Tatts Group, that could terminate its distribution agreements and kill the business overnight. And, perhaps most worrying long term, Jumbo sold exactly the same product as Tatts for a 10% premium. Why did anyone even use it?

When the share price was getting hammered, everyone was focused on these flaws in the business model. Blind Freddy could see that this business didn’t have a future.

Taking a contrarian view involved coming to terms with just how much money would be wasted, how profitable the Australian business could be and what the chances were of losing that big supplier.

Jumbo turned out well — the stock is up from $1 to $6.50. But imagine if Tatts had pulled the pin soon after we bought it. It would have been easy for our investors to turn around and say: “You guys should have seen that coming — everybody else did.” Which, of course, is why the opportunity was there in the first place.

Wrong on Freedom and looking stupid

The Forager Australian Shares Fund owns funeral insurance company Freedom Insurance (ASX:FIG) in its current portfolio. Freedom’s share price is down more than 60% over the past two weeks after being called before the Royal Commission into Financial Services and the release of an ASIC paper condemning its business model.

Forager made the investment knowing that Freedom’s sales model was potentially flawed. Here’s what I wrote in our research document in November 2017:

“The direct sales business model could come under threat. Regulators could require personal advice to sell life insurance products, for example. There’s something ugly about phone sales of insurance product and I can imagine it getting a lot more scrutiny if it continues to grow. I would put the probability at low but meaningful and the impact very high.”

A probability assessment of 'low' can be debated. The point is that we made the investment knowing full well that there was a chance of something very bad happening. We thought there was enough potential upside to compensate for that risk and that there was some downside protection in the company’s existing customer base (the latter part of that thesis is about to be put to the test).

In Freedom’s case, unlike Jumbo, that risk has become a reality. And when a risk that everyone was worried about comes to the fore, the nuance of chance and probability gets lost. It simply looks like we failed to understand something that was blatantly obvious to everyone else.

Making mistakes is something you get used to quickly in this business. Regularly looking like an idiot, though, is something I find much tougher. For me, that’s the hardest part of being a value investor.

 

Steve Johnson is the Chief Investment Officer at Forager Funds Management, has a monthly column in the Australian Financial Review and regularly appears on Sky Business, the ABC and CNBC. To find out more about Forager Funds Management, please visit www.foragerfunds.com. Some of the comments below were posted on the Forager website.

 

12 Comments
Max Williams
September 25, 2018

Steve, your ability to admit the failures and not be daunted by the negative outcomes is exactly why we invest with Forager. I retired in 2008 with a nest egg and very little knowledge of investing. There were many predators out there wanting to get their hands on our funds and with the GFC closely following my retirement it was a very testing time.

It was II and your advice that saw us through that difficult time. I want to congratulate you for having the courage to hold the line!
Well done!

Brett
September 20, 2018

I want to pick up on this ethical investing thread some commenters have latched onto.

I had the pleasure of attending the Forager Investor presentation this year in Brisbane for the first time. I was there early and the first person I saw when I walked in the room was Steve and I spoke with him one on one for 10 mins or more. (I thought, gee, high net worths typically get that access, not someone like me)

Then I sat down and after a bit this guy sits next to me. If I am completely honest - and this really doesn't reflect well on me at all - I actually thought he may be a homeless person who had come up for a free lunch. (Sorry if by some chance you are reading - must continue to work harder on not judging!!) Anyhow he proceeds to tell me how he'd been coming for a few years when they were held away from the Queen Street Mall. The guy told me about how one year he was walking down the street after the meeting and was getting saturated in the rain when Steve pulled up in a car and asked if he wanted a lift. Steve then drove him home.

I'm about as far away from Martin Place - or Collins Street for that matter - as anyone can be. I'm a stay at home Dad.

But I have been observing business and economic commentators for over 20 years now. And for the first time, just recently, for a few reasons, I've had the funds and opportunity to invest with the managers I want to, and that is Steve and Roger M. I (actually we) are invested with them not just because they have outstanding track records and because their investing values and attitudes relate well to my own, but because I have been assured over the years by the way that they carry themselves that they are people of the highest moral integrity. (As the RC has made excruciatingly clear, you don't have to go far in the financial services industry to find people who are not.)

When it comes down to it, that is what I believe most people miss in the debate about active versus passive funds. What is usually talked about when Buffett's bet is discussed is the pure numbers but I believe Buffett's main point is that the managers that underperform still become wealthy from clipping the ticket regardless of their performance. He is most pissed that money managers become wealthy Irrespective of whether their Clients become wealthy, rather than Because their Co-investors also became wealthy. (All you have to do is understand the Buffett partnership and Warren and Charlie's remuneration from Berkshire Hathaway - genuine shareholder alignment - as well as how they remunerate others within Berkshire.) I have also noticed over the years that much of their decision to invest in/with companies is based on their estimation of the calibre of the person in charge.

It's true that, with the shifting of retirement saving risk onto the masses, many who have much to lose will not have the interest, time or energy to develop the capacity to make informed decisions.

For others that have made the effort, if it's good enough for Warren and Charlie... And the humility shown by Steve in this article just underlines what I already know...

Graham Hand
September 20, 2018

Thanks, Brett, fascinating insights into Steve. I also attended a recent presentation and he does come across as genuine and down-to-earth, with few of the traditional trappings. G

Keenan
September 18, 2018

The best investors, including Warren Buffett, have never worried about how they will look after outcomes are known. But some are prone to money outflows so they must manage the expectations of those who invest with them.

Lyall
September 13, 2018

Adele – what is ‘ethical’ is too subjective for an investment manager to decide. What is ethical/unethical is often a matter of perspective and political beliefs. Is selling alcohol unethical? Some people would think alcohol is a destructive social force, while others would see it as something relatively harmless that adds value to peoples social lives, etc. Is coal mining unethical? Yes it promotes global warming. But it also provides affordable energy to poor people in developing country, without which they would not be able to afford electricity. Is providing affordable electricity to people unethical?

I’m not trying to defend coal mining – I’m trying to make the point that drawing ethical lines is complex and should not be the domain of the investment manager. That should be up to society & its regulators. Companies & investment managers should comply with all government regulations, which reflect society’s overall assessment of what is moral/allowable and what is not. But investment managers should not be in the business of forcing their politics onto their investors.

Lyall
September 13, 2018

Karin,

The future is always uncertain and subject to risk. The wise investor doesn’t try to avoid risk, but to underwrite it at sensible prices, just like a well-run insurance company does (forgive the FIG pun). What is important is asymmetry, not the ability to predict the future. You’ll note that Forager made a lot more % profits on JIN that it has lost on FIG. That’s what matters in the long term.

It’s like playing poker. You will suffer bad beats. That’s part of the game. What is important is that you calibrate the odds correctly enough, ex ante. That’s within your control. Outcomes are a function of luck. Probabilities are not. The challenge with investing, of course, is that unlike poker, we never know what the actual odds are/were. When we get a bad outcome, did we just get unlucky, or did we estimate the odds incorrectly? Not always easy to tell! Cheers

Andy
September 13, 2018

In spite of Steve calling out ‘hindsight’ bias that we all suffer from, I can see many responses displaying such biases.

Only if Steve (you or I) would know about the outcome of Royal Commission beforehand… then Steve wouldn’t be managing money for a living… you or I won’t bother putting in comments on this blog or any investing blog for that matter and instead sipping Margarita in the Bahamas.

Only if investing is that easy (with hindsight)

Yong
September 13, 2018

To be fair to Steve and the Forager team, they had to make an investment decision based on the available information that they had at the time. The Royal Commission has uncovered the dirty laundry of Freedom Insurance Group. If anyone had this particular information available to them at the time, then they wouldn’t have touched the stock with a 10-foot pole. It would’ve been difficult to predict late-2017 that an inquiry with the widespread powers and scope of a Royal Commission would have occurred. In addition, the level of malfeasance on the part of the banks and financial services sector has been a shock to everyone including some industry insiders (see Marcus Padley’s wonderful tirade on ABC News Breakfast). I think it’s fair to say that, in the long term, no one wants to invest in publicly listed companies that have a reputation for dishonesty and the exploitation of consumers.

I also agree that the direct sales business model pursued by FIG is not unethical, per se. But it is no surprise that when this business model is coupled with an aggressive commissions-based reimbursement structure and an organisational culture of ‘get the sale no matter what’ – that we hear stories of people with intellectual disabilities getting sold products that they don’t need/comprehend. The Royal Commission is a wake up call to all Australian citizens not to be complacent and to ensure that we lobby for governments and institutions to ensure that private firms are acting in the public interest.

Steve and the Forager team. You have my sympathies (as much as it pains me to see the value of the Australia fund drop so much in the short term). Then again, we were warned of these risks in our Product Disclosure Statement. We invest in your fund, not because we are paying you to be correct all the time. We invest in your fund because we want to see you outperform the market in the long-term.

As a side, I’d be interested to hear your thoughts in the next Quarterly Report on where the investment thesis now lies with FIG. Will they be able to reform their business model and practices to become a profitable business again, without the unnecessary sales of life insurance products to people who don’t need/want it?

Mark
September 11, 2018

Without wanting to get into a debate on ethical investing, in regards to Freedom I think you need to put the numbers aside at some point and question the merits of backing a business that essentially looks to hard sell insurance products to people that didn’t ask for them in the first place. Royal Commission or not, doesn’t sound like a sustainable business model to me.

Karin
September 11, 2018

The successful outcome achieved with Jumbo is surely just as subject to hindsight bias as is the downside from Freedom. When you have no way of controlling the actions of executives in charge of a company, nor any way of knowing for sure if they are telling you their true intentions, surely these possible value situations become little more than a roll of the dice, with the investor looking like a genius if they get it right, or an “obvious idiot” if they get it wrong.

At what point too do you take the ethics of a business into account? Laughable I know in light of recent finance industry revelations, but some business models really do look a bit too dodgy to be taking a punt on.

TN
September 11, 2018

Ahh… the value investing life. You look for situations where the probabilities are stacked your way, “Tails I lose, heads I win – a lot more”. When it comes up heads you are a hero. When it comes up tails you look like a fool, because everyone has hindsight and no one takes the time to see the risk-reward play before it happened.

“A probability assessment of “low” can be debated.” Yep. That’s the only thing I would debate you on here. It of the banks and other financial institutions were looking at getting rid of the parts of their business that sold this very kind of product, partly because it looked bad, but also perhaps because they thought the likelihood of it becoming regulated was very high.

Watching the RC go through junk insurance policies should have rung alarm bells, I found it hard to believe that this was not going to get clamped down on hard.

Tom
September 11, 2018

I have some sympathy for you Steve, I have had similar experiences in my investing life. Here’s a question I ask myself constantly – is it better to be a value investor or ignore valuations and just buy the highest quality stocks and hold them long term?

There are 8 stocks that I regard as the highest quality stocks on the market. My definition of high quality is consistently high return on equity over many years (i.e. 10 years or more) and increasing profits in most years.

The annual yearly return over the last 5 years for these 8 stocks is : ARB 13%, BKL 43%, COH 31%, CSL 29%, REA 19%, REH 21%, RMD 24%, TNE 25%. The 10 year return is also very good.

You could argue that those stocks are currently at very high prices compared to their valuations and their prices may drop in the future, but it is a good return for virtually zero effort and a high “sleep at night” factor.

Who knows what the next 5 years will bring for these stocks, but these long term returns do make me question my value investing process.

 

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