An investment figure and author works through a series of errors that he sees people make in trying to build wealth. Not all of the mistakes are particularly large, so he also mentions a few of the less damaging errors that arise.
What sort of classic errors should wealth managers and investors avoid, and what are the red flags they should be alert to? In this article, author and investment industry luminary George J Schultze walks through some of the terrain. (More details about him below.)
There’s an old adage that says there are three rules for investing. The first is, “Never lose money.” Rule number two is, “Never forget Rule #1,” and the third rule is the same as the second. It’s a corny line, but it resonates. It’s also a series of rules that are difficult for investors to follow because human beings, being human, have a hard time admitting when they’ve made a mistake.
But an advisor who is unable to acknowledge when they have misjudged a situation and made a bad call can cost their clients a lot of money. Too many investors are unwilling to cut their losses because they have what behavioral finance calls “anchoring bias,” which causes them to wait for the price to return to their purchase price before they can bring themselves to sell. By the time they are emotionally prepared to pull the trigger on a losing position, their losses can be much greater than necessary.
This tendency to anchor on a losing position isn’t limited to individual advisors or their clients. It also happens on a much grander scale. Just a few years back, Pershing Square Capital lost almost $4 billion by holding on to its shares in Valeant Pharmaceuticals, long past the point where the holding made any sense.
Pershing had purchased over 27 million shares of Valeant at an average cost of $196/share, and held onto them before finally selling at around $11 each. I’m sure the initial investment fit the asset manager’s thesis at the time, but there was absolutely no rational reason for continuing to hold onto those shares as the price continued to drop ever lower. Fortunately, Pershing’s returns rebounded the following year.
Speaking as an asset manager with over 25 years of experience managing other people’s money, I can honestly say that our best return years have not been those when we had one or two positions that dramatically outperformed the market. Instead, our best years were those in which we got out of losing positions more quickly than other investors, cutting our losses very quickly; this strategy gave our more profitable holdings the opportunity to flourish. Whatever an advisor’s investment philosophy, the biggest mistake they can make is not having a system in place to cull losses and the discipline to abide by it. The next two mistakes I will discuss relate more to my own specialty, distressed investing.
One of the biggest errors an investor can make while investing in distressed securities is buying an overly leveraged company. This can lead to tremendous losses as the economy progresses through a complete business cycle. A company saddled with too much debt might look attractive when times are good, and the leverage may amplify those returns. However, the outlook may worsen considerably as the cycle inevitably turns and the enterprise struggles to meet its fixed commitments.
Right now, with interest rates so low, just about any company can borrow money cheaply. If they’re using that borrowing to keep the lights on and the doors open, but not doing anything to strengthen the underlying business, that’s almost certainly a recipe for eventual disaster. Money may be cheap right now, but it’s not free. Companies need to keep making monthly or quarterly interest payments, and eventually the principal on the loan will also be due. When that happens, the eventual turn of the business cycle may make repayment even harder, since customers, suppliers, and other counter-parties will likely be tightening their purse strings at the same time.
The unnaturally low interest rate environment that we’re currently experiencing is unique in the history of corporate finance. It has distorted the financing picture for most firms and, as a result, some buyers are increasingly willing to take on extraordinary balance sheet risk through borrowing. As someone who has spent their career looking for investment opportunities in companies going through distress, I know first-hand that many of these borrowers will eventually be rendered insolvent at which point their owners will face the risk of complete loss of capital.
Another common mistake in distressed investing is buying companies with hidden leverage. By that, I mean financial obligations that go by any other name (like tort liabilities, underfunded pension liabilities, leases, or other fixed contractual obligations) but which aren’t easily identified as leverage without further analysis. It’s very important to carefully study any company before investing significant capital, since there are a number of accounting tricks that may be used to mask hidden leverage.
Fortunately, recent changes to accounting rules have made masking lease liabilities more difficult. Previously, it was common for firms with huge lease liabilities to maintain them as off-balance sheet liabilities. Starting this year, that’s no longer allowed. However, some unscrupulous firms with substantial lease obligations are now employing aggressive asset accounting to mask their newly-disclosed lease debt; they do this by marking up corresponding lease right-of-use assets on the other side of the balance sheet.