10 easy mistakes for investors to avoid

They say you learn more from your failures than your successes. I’m not sure that’s true but one thing I am sure of is that if you can learn from the mistakes of others rather than having to make those mistakes yourself then you will save a lot of time and money.

In my previous wire, I shared 6 pieces of advice for private investors and SMSFs. In continuing with this theme I thought I’d discuss some common mistakes that those same investors would be wise to avoid.

 

1: Selling Quality Businesses Run By Impressive Management At Fair Value

Back in 2012, I bought shares in a business called MyNetFone (ASX:MNF) at around 30c. I’d done my research, spoken to management and was comfortable enough to throw a decent portion of my portfolio at this investment as the downside appeared limited.

 

Some 3-4 months later I exited the stock above 70c as I felt the price was getting closer to fair value and there were a number of other opportunities out there. I thought it was a great decision at the time.

 

I’ve spent the last five years watching the market reinforce the fact that it certainly was not a great decision. Today the stock is approaching $5.

 

You could argue that at the time I sold MNF the stock was still cheap, and you’d be right. But over the five years that followed there were a number of points where the stock looked fair value, even expensive at times, and yet it has continued its march upwards.

 

The mistake I made was underestimating the power of a quality business run by an impressive management team. The CEO, Rene Sugo, owned 25% of the company and was a very savvy operator. Every time the stock looked to be approaching fair value or a typical indication to sell appeared (a director selling, the retail business flatlining, etc) an acquisition was announced or the business would find a way to just keep going from strength to strength. So too did the share price.

 

I could have used a number of other examples of quality businesses run by impressive management teams that I made the mistake of selling at ‘fair value’ rather than demanding a premium price, but the point remains the same.

 

If you find a quality business led by an impressive management team and can buy it at a cheap price, don’t sell it until you are offered a premium. Fair value won’t do.

 

2: Seeking Massive Addressable Markets

Flip through any investor presentation and one of the things you’ll usually come across is mention of the market being measured in the many billions of dollars. Investors want hard figures on the size of the market in which companies are operating and they often prefer to invest in businesses that play in markets measured in the billions over those in smaller niches.

 

But looking only at the size of the market completely ignores the underlying dynamics. What are the typical margins generated by companies in this space? How intense is the competition? Who are the leaders and what do they do better than everybody else?

 

Gartner recently estimated that the global public cloud services market is worth US$250 billion dollars and is growing at 18% a year. That would provide some nice figures to put on an investor presentation and would read well to a potential investor. But how is an ASX listed micro or small cap business going to compete over the long term with the scale and near zero cost of capital of Amazon or Microsoft?

 

The size of a market and the accessible opportunity are two very different things. Your focus should be on what portion of the market the company actually has a good chance of winning. Try to figure out the immediate opportunity - the low hanging fruit - and why the company’s product or service justifies a customer switching from a competitor. Don’t just rely on the fact that the market is measured in the billions.

 

It is also a mistake to immediately dismiss companies operating in small or niche markets. They often present the best opportunity for small companies to grow without the threat of a multinational coming into the space. You can find some fantastic investments operating in niche markets provided that market is growing sufficiently and the company can build a sustainable competitive advantage.

 

By definition, if a market is measured in the tens or hundreds of billions the big winners and losers have already been decided and an ASX microcap company is going to find it tough going. But these same companies can thrive for a long time in growing niche markets where the bigger players can’t justify entering. You aren’t going to find Gartner reports detailing the size and expected growth rates of a lot of these niche markets, but that doesn’t mean the company won’t be a fantastic investment.

 

3: Ignoring The Macro

Value investors sometimes downplay the importance of paying attention to macro themes, and often for good reason. There is always something to worry about. We’ve been hearing that China is a basket case set to collapse for many years now. That Sydney property prices are in bubble territory. And that another crisis is around the corner. If you let any of those concerns keep you out of the market over the last few years you will have given up some attractive returns.

 

But there is no excuse to not be cognisant of the macro environment at all times. It may not directly impact your investment decisions but you should be aware of the environments the companies you own are operating in.

 

For the long term investor, the focus should be on structural macro trends, rather than whatever is making headlines at any given moment. Attractive investments can be found in sectors experiencing macro tailwinds and if you catch them early you can be in for an incredible ride. Some examples that come to mind in recent years are baby formula manufacturers, tourism operators and healthcare stocks.

 

Paying attention to the macro can also save you money by ensuring you aren’t invested in businesses facing structural headwinds. It is easy to have tunnel vision when all you do is look at the company but sometimes you are best served to take a step back for perspective.

 

4: Being Lured In By The Pipeline

A few years ago I was looking at a small software business that had a lot to like about it: sticky customers, insider ownership, a long history and trading at a decent price. But what really got me interested was management’s comments to the market around the rapidly expanding pipeline which was at one point quoted as high as $90m.

 

The market cap for the company was closer to $10m. It didn’t take a genius to realise that if they could convert even a small portion of that huge pipeline it would be transformational.

 

The problem with looking at a company’s sales pipeline is that it's difficult to know how highly qualified the opportunities really are. Has the potential customer signed a Letter of Intent or have one of the sales team simply sent an introductory email?

 

The size of the pipeline means very little without knowing the extent of qualification of that pipeline and, ideally, the company’s historic conversion rate. Whenever a company quotes a large or growing pipeline try to do a little more digging on what that actually means.

 

And that small software business I was looking at? It turned out that a new management team came in and decided that the predecessors were overstating how qualified those prospects really were. To the best of my knowledge, they converted none of the $90m pipeline and I sold the company at a loss.

 

5: Underestimating The Straight Talking CEO

In 2013 I walked into a meeting with Damian Banks, the CEO of a company called Konekt (ASX:KKT) which provides occupational health services and return to work injury management. I held a small parcel of shares based on some initial research and a call with Damian, but this was my first time meeting him.

 

The best way to describe the meeting was unremarkable. Konekt was operating in a highly competitive and fragmented market. Margins were slim and conditions were tough, and it sounded like they were going to get tougher as state based Workers Comp schemes were expected to reduce their spend. The company had started to turn a profit, but only just.

 

Damian provided the facts without any spin. He acknowledged conditions were difficult and competition was high. There was no emotive language or lofty targets. There was an opportunity to consolidate the sector but it was going to be a moderated, steady-as-she-goes strategy. This did not seem like a business with tailwinds and while Damian was clearly a smart guy it felt like it would be a hard road for KKT.

 

I bought those shares at 5c. I had to sell for reasons unrelated to the company, but I didn’t think I would be missing out on too much upside. Today they trade at 60c.

 

As an investor it is easy to be lured in by the fast talking, charismatic CEO that tells you how their business is going from strength to strength. You should be careful not to fall for the sales pitch. If you see a stock that's trading at a price that seems well beyond any reason without the numbers to justify it there is a good chance it does so because the management team know how to spin a good story.

 

If Damian wanted to he could of quite easily made the outlook sound a whole lot better. He could have downplayed the pressure on margins, given aggressive targets for their acquisition strategy or talked about how cheap his stock was trading. Most management teams try to put a positive spin on everything, and I was waiting for Damian to do the same.

 

But he didn’t. He just presented the facts as they were and shared his strategy for growing the business regardless of some difficult conditions.

 

There were two other factors that I underestimated. The first was obviously how skilled an operator Damian was which is easy to see in hindsight but had I done a bit more digging on his background I probably could have figured that out.

 

Secondly, Damian’s incentives were perfectly aligned with shareholders. Before he was the CEO he was an investor in the company and became an executive in order to turn the business around. By the time I came across KKT he owned almost 20% of the company.

 

Don’t underestimate the straight talking CEO that presents the facts as they are. Especially when they are skilled operators with incentives aligned with your own.

 

6: Following Stock Tips

A stock tip, broker report or endorsement from a well-known investor should only ever be an indication to look closer at a company. You should never buy or sell a stock based solely on the suggestion of someone else, no matter how highly you view their investing ability.

 

If you enter a stock based solely on the views of another investor, how will you know when to sell it? And even if you make a profit, how will you learn and improve your process for future investments?

 

There are some excellent reports and investment theses shared here on Livewire about companies that may well prove to be stellar investments. But they are only the start of your research, not the end.

 

This also applies when you are holding a company and someone outlines the reasons as to why it's a sell. It is easy to be swayed and think it might be time to lock in profits or cut your losses and run, just in case what the other person is saying turns out to be correct. And you should always be listening to opposing views and challenging your thesis, constantly looking for errors that are often easier spotted by an onlooker with a different perspective.

 

But to be a good investor you need to find the balance of backing your own convictions while always considering the possibility that you could be wrong. So listen to opposing views but don’t let them sway you emotionally. Consider the facts and either adjust your thesis if necessary or stick to your guns if not.

 

7: Not Striking A Balance Between Existing and New Investments

You should be regularly reassessing and testing the thesis for every investment in your portfolio. But at the same time, there is a need to constantly be scanning for new investments. Opportunity cost is not only very real but it sets the benchmark for all future investment decisions. If you can invest in a company offering a 100% return, then why are you still holding the one offering a 50% return?

 

Investors can become attached or absorbed in the companies they already own, either emotionally (“I’m not selling until it makes back my money!”) or intellectually (spending so much time on researching a new company that you let other opportunities pass you by). You need to do deep dive research on every investment you make and that research doesn’t stop once you’ve bought the stock. But you also need to continually monitor the market for new opportunities, compare them to your existing holdings without bias and decide which investments deserve your capital.

 

8: Not Paying Attention To Position Sizing

Position sizing is arguably amongst the most underrated skills of investing. It is incredibly important and yet gets very little attention.

 

In simple terms, you need to bet big when the odds are in your favour and pull back when they aren’t. It comes down to your level of conviction. The position should be large enough so that if you are correct it has a meaningful impact on your returns, but small enough that if the worst case scenario plays out you can live with the consequences.

 

Position sizing shouldn't be static and it is often wise to increase your position in a company as the thesis plays out and your confidence grows, even if that means paying a higher price than you initially paid. The inverse is true if the thesis starts to slip or something comes from left field that you weren’t expecting, at which point it is wise to start reducing.

 

9: Not Keeping It Simple

In investing you don't get any points for degree of difficulty. The best investments are often the ones that just make sense. It may take a certain amount of work to unearth the business or put the pieces of the thesis together, but once you do it should be a relatively simple proposition. The more moving parts involved the more exposure you have for something to go wrong.

 

With regards to valuation if you have to build a complex model to justify buying a stock chances are high that your margin of safety isn’t large enough. You should certainly work to build a deep understanding of the financial drivers of the business and that will involve modelling it out under a range of possible scenarios. But the best buy decisions can usually be worked out on the back of an envelope.

 

10: Not Putting In The Work

There is no excuse for not doing enough research on a company. Whether it is understanding the industry, doing background research on management, reading through current and past years accounts or speaking with competitors and customers. It all adds up and only you are accountable for getting it done.

 

Really putting in the work not only helps you build conviction in an investment, which allows you to bet big when the odds are in your favour, but it also puts you in a good position to know when to sell. If you have a deep understanding of the underlying drivers of the business you’ll also have a good idea as to when those drivers are accelerating, decelerating or stopping altogether. And chances are you’ll realise it well before the rest of the market.

 

Investing is a game of odds and you will never completely eliminate the role of luck. However, the one variable that is entirely within your control is the amount of effort you put in to researching your investments.

 

Make sure that you are doing everything you can to ensure your investments are successful. And that starts with putting in the work.