Before I attempt to analyze any potential investments, I think it would be helpful to review some of my biggest stock investment mistakes ever. I feel I should turn a critical eye toward these first in order to identify what I did wrong and to extract any potential lessons. Hopefully, I'll be able to avoid these mistakes the next time around. So let's get them out of the way.
1. Select Comfort (SCSS)- Oct '04: Bought 300 shares @ $10.64 (split adjusted)
- May '08: Sold 300 shares @ $2.54
This was my first stock purchase after getting a full-time job. I spent quite a bit of time examining it, and there was a lot that I liked. The company sold fancy high-end mattresses through several hundred retail stores. Because the mattresses were made-to-order, the stores actually carried no inventory. This made for a very efficient business model with a lot of free cash flow generation. Coupled with 30%+ sales growth driven by new stores and glowing product reviews, it looked like a winner to me. It helped that I was a regular reader of the Motley Fool at the time, and the stock was a top selection in one of their newsletters.
The stock performed very well almost immediately. By March 2006, it was trading at around $26. The performance seemed justified as everything looked solid: revenue growth, operating margins, FCF growth, stock repurchases.
But then I got lazy and made my first mistake: failing to keep up-to-date with the company. I figured with a return above 150%, my downside would be limited. I stopped keeping track of company news and failed to pick up on trends pointing toward signs of weakness: slowing revenue growth, reduced profitability and an increasingly negative economic climate that would impact large consumer discretionary purchases like high-end mattresses. I had passed by the Select Comfort store at the mall a number of times, and not once did I ever see anyone inside. Who would want to drop several thousand dollars on a mattress when they were staring at foreclosure, and where would they even scrounge up the money to buy it?
By the time I picked up on these trends in mid 2007, the stock had dropped and was hovering slightly above $15. This was where I made my second mistake: not getting out of a deteriorating company quickly. Even though I could see the operating margins and business prospects were weakening, I figured that I would cut it loose once it got back to $20. As the stock plummeted to $12 to $7 to $3, I made similar vows to sell, always at just a slightly higher price. When the stock dipped below my initial purchase price, I thought that there must be a rebound, and then I would sell and at least breakeven. By the time I finally sold at $2.54, I had lost about $2,500.
Ultimately, I had gotten too comfortable with the stock and had grown attached to it. It occupied a special place for me as my first true stock purchase. I grew complacent and didn't follow it. Even when I realized that the business had plateaued and had dim prospects, I didn't have the fortitude to act right away. Instead, I delayed almost a year. This was more than just simply buying for the long-term and trying to ride out short-term stock price fluctuations. As the price fell 50%, 75% then 90%, I didn't feel compelled to buy more, which should have been a telling sign. I was anchored to my initial purchase price and only wanted to breakeven. I didn't have a set of exit conditions.
When I did finally sell, the feeling was that of relief. I used to check the quote everyday, but now I'm happy ignoring it. It's currently trading at $1.50.
Result:- Down ~$7,000 in potential loss (peak to trough)
- Down ~$2,500 in net loss
- Down ~$2,100 in tax-adjusted loss (assume 15% offset of long-term capital gains)
2. Nautilus (NLS) - Aug '03: Bought 300 shares @ $11.45
- May '08: Sold 300 shares @ $6.45
Virtually a mirror image of my Select Comfort adventure. Yet another consumer company selling a high-quality, well-branded, yet ultimately overly expensive and discretionary product: fitness equipment. If you've been to a gym, you should be familiar with it. In college, you had to wait forever to get on the ellipticals. To this day, I've never gotten around to trying it out. They used to run those Bowflex ads on ESPN at practically every commercial break. The company had a sterling brand name, a strong operating record and cash flows, and even sported a hefty 4% dividend yield, which was very high back in 2003. The decision to buy was easy to make.
But as Mark Twain once said, "history doesn't repeat itself, but it does rhyme." This was another good investment decision turned bad after a few years of neglect. Similar industry, similar business, similar performance.
By June 2005, the stock traded in the $28 range. But operating margins were steadily declining. Flat sales growth in 2006 led to a 20% decline in 2007, as well as a high net loss. Once again, I resisted selling. I fell into the same trap of hoping that the brand name and historical performance would drag the stock back into positive territory.
The one saving grace was the $480 in dividends I accumulated over the holding period. It actually made a pretty large dent in my total losses.
Result:- Down ~$6,000 in potential loss (peak to trough)
- Down ~$1,100 in net loss
- Down ~$900 in tax-adjusted loss
3. Kintera (KNTA) - Feb '05: Bought 400 shares @ $7.10
- Oct '07: Sold 200 shares @ $1.74
- Mar '08: Sold 200 shares @ $0.84
At the time I invested, there were two main public companies that made software to help nonprofit organizations manage donors, reduce fundraising costs, and market themselves. One was Blackbaud and the other was Kintera. Blackbaud was definitely the safer choice, with a track record of solid cash flows, moderate revenue growth, and a traditional application software solution. Kintera was the flashier one, with huge growth prospects, a sexy software-as-a-service subscription business model, an impressive management team, and massive losses.
After much deliberation, I decided to go with Kintera. The huge opportunity to reach thousands of non-profit organizations seemed more feasible for a browser-based solution, which I believed to be superior (not that I actually knew anything about the technology). In any event, with the "land-grab" opportunity, I figured both would do well, but Kintera had the potential to do really well. Let's compare the results:
The divergence in this chart is almost comical. Clearly, I backed the wrong horse in this race. In fact, Blackbaud just
closed its acquisition of Kintera yesterday.
This was a bad investment decision all around. I strayed from an insistence on profitability, not to mention even the
hint of achieving profitability. Even the analysts covering the stock hadn't built in profits in their forecasts. They just didn't project numbers that far into the future.
Why I didn't at least apply a
Gorilla Game approach and invest in the whole industry is beyond me. With it's solid financials, Blackbaud really had only one drawback, and that was it didn't have the shiny veneer of Kintera.
The fact was that Kintera was already in freefall when I jumped in. At the time of my purchase, Kintera had simply never been that cheap at any point in its short history. I reached for a falling knife and got cut badly.
The lesson here: make sure you know the company can turn a profit. It's better to have a company that has already demonstrated that it is profitable.
Result:- Down ~$2,300 in net loss
- Down ~$2,000 in tax-adjusted loss
4. Arbinet (ARBX)- May '05: Bought 100 shares @ $13.51
- May '08: Sold 100 shares @ $3.58
I got caught up in the hype on this one and never truly understood their business. They provide a marketplace for trading communications capacity. In a nutshell, they're the eBay for trading long-distance calling capacity. The example from the IPO prospectus was for a 10-minute call from France to India, Arbinet allowed members to trade for the capacity to handle that call. They could monetize their excess capacity and also lower their own costs.
The exchange concept was seductive. eBay and other exchanges were trading at stratospheric multiples. And Arbinet had 8 of the top 10 global communication service providers. Have enough of the major players and everyone is compelled to come to you. Of course, just because they're on the exchange doesn't mean they're using it.
Enough people overlooked that little fact though to make the December 2004 IPO one very hot ticket. Trading on the first day leapt to $29 a share, up from the IPO price of $17.50 which itself was above the range of $14 to $16. When the price dropped below the $14 low end of the IPO range, I thought I was getting a bargain.
A falling knife if there ever was one. While the business was at breakeven at the IPO, I never really understood the model. I just didn't understand enough about excess calling capacity to make any reasoned judgment on the company's business prospects aside from what the company provided. It's something I should have stayed away from.
The lesson here: know the business model. As in exactly how they make money and why customers are willing to pay for it.
Result:- Down ~$1,000 in net loss
- Down ~$850 in tax adjusted loss
Conclusion:I wish I could say I learned my lessons. At $7,000, the lessons certainly didn't come cheaply.
My mistakes have mostly been on the selling side. But it's often difficult to determine when a once strong and attractive company has begun to decline. Often times, they are still riding on the wave of glorious past performances. Who knows if their competitive advantages are strong enough to allow them to rebound? As the financial sector has shown us, it doesn't take long for once stout results to turn sickeningly poor.
I'm facing the situation of what to do with Dell and eBay right now. Both are trading within 10% of my purchase price. Both were once undisputed leaders but now have hit difficult times. I'll need to re-evaluate these in a future post.
To summarize the key takeaways:- Know the company's business model and exactly how they make money.
- Avoid companies that have not proved their model to be profitable.
- Do not get anchored to the initial purchase price. The purchase price should not impact the selling decision.
- Keep up-to-date with the company and reevaluate whether or not to sell, hold or buy regularly.
- Have an exit strategy and know the conditions under which to sell.
- Once I decide to sell, act.
Labels: mistakes, philosophy
