What investors should do next after making a mistake

In investing, as in life, mistakes are inevitable. To err is to be human, after all. But what should you do next? Human psychology is an interesting thing. Some of us will hold onto our mistakes to the bitter end, hoping for a reversal which may or may not come. Others will cut their losses and move on. 

When you see a stock take a nose-dive, the correct answer could in fact be either of those options if you ask Forager Funds Management’s Steve Johnson. Often as not, when investors are burnt, they fear approaching companies with any similarities.

The famously transparent fund manager is open about his past mistakes – and equally happy to share the lessons he’s taken from these into his approach to portfolio management. And while many investors who are burnt by mistakes fear approaching comparable companies, Johnson remains open and flexible. When your bread and butter is analysing and investing in ‘unloved’ businesses with potential to change, you can't immediately write off all businesses with similarities.

“If you’re going to recognise whether you need to upsize or you need to cut, you need a really clear roadmap around what it is that you think is different about this stock from where the market is pricing it at the moment,” Johnson says.

He argues it is just as important to know when to exit a position as well as knowing when to hang on.

Johnson recommends starting small on new ideas so you have the ability to build up as your thesis plays out – or cut with minimal losses if you find you need to completely reassess your thesis.

It’s a lesson he applied to successes like Gentrack (ASX: GTK) and sees similar potential in sports tracking software firm Catapult Group International (ASX: CAT). On the flip side, it’s the approach he used to cut his position in Adore Beauty (ASX: ABY), recognising it was not growing as fast as he’d hoped.

In this episode of The Pitch, Johnson shares his own lessons for portfolio management and how investors can approach investment mistakes. He also shares the two attributes he thinks are most critical when it comes to portfolio management.

Please note that this interview was filmed on Tuesday 11 June 2024.

Edited transcript

To begin with, being transparent about mistakes is really important to Forager. Why?

It's not just important, it is a fundamental component of our business and I think there's a few reasons for that.

Number one, it's really important to make the right decision at that point in time, and I think if you can't recognise that you've made a mistake, the general approach is to either just hang on and hope that things get better or even buy more of something in the naïve hope that your original expectations around that business were right.

If you want to make the right decision at that particular point in time, you have to recognise that you've made mistakes. I'd say a corollary for us as a business has been that we've attracted some really long-term loyal clients that appreciate that transparency and have stuck with us through some difficult times. But probably most importantly, you have to learn from them.

And if you can't recognise mistakes, for me being public about them actually helps with the recognition and the transparency and then learning from it - what are we going to do differently next time to make sure we don't do this again.

Moving on to a bit of a curly one, what is the biggest investment mistake you've made and what did you learn from it?

We've had investments in both of our funds go to zero or close enough to zero. Freedom Insurance in our Australian fund and then Technicolor (now Vantiva (EPA: VANTI)) in the International Fund are two stocks that were almost complete wipeouts for us and we've talked about both of them publicly. It won't be a surprise to our investors, but they are two good examples of what I was talking about.

What lessons did you learn from this?

The easy lesson is don't buy that type of business again, don't invest in a business with a flawed product or with a management team that you don't trust. It's actually not the right lesson from those two investments for us.

We invest in unloved, underappreciated stocks. Often that business is going through some difficulties at the time we invest in it, and that's why it's cheap. 

And some of our most successful investments have actually been businesses that didn't look great and didn't have those attributes either at the time we bought them. So it's not just don't do that.

Our mistakes were portfolio management mistakes. We had too much of the portfolio in both of those investments. And the lessons for me therefore have been:

a) you've got time to upsize your really good ideas when they work out. Start with small positions and as you get evidence that your investment thesis is working, that the market's wrong and you are right, you've got time to upsize them. Even if you pay a bit more, it's stopping you making mistakes and losing big chunks of your portfolio on those things.

b) And then the second thing is if you're going to recognise whether you need to upsize or you need to cut, you need a really clear roadmap around what it is that you think is different about this stock from where the market is pricing it at the moment. That might be as simple as: people don't think this business is ever going to grow again - I think it's going to grow 5-10% per annum, and if it does that over the next five years, it's going to look really cheap. It might be it's not making any money at the moment, but I think it can make 4-5% profit margins a few years down the track. They can be as simple as that, but if I'm three years down the track and this business is not doing what I expected it to do, my thesis is broken and I need to completely reassess it.

They are the two things for us, a really clear roadmap of the investment and to work slowly into new ideas.

Can you share some examples of some investments that you've made that factor these lessons?

On the plus side, I'd say Gentrack listed here on the ASX is a business that was going through some quite difficult times a few years ago when we first started investing in it. That was at less than $2 a share.

We thought that business was going to become more profitable through cutting costs and improving its profit margins. It's a software company. Most software companies can usually cut their costs. They've been investing to grow and they can cut their costs and become profitable. So that was a good example of us starting small, but we really let that investment grow as the thesis played out, not just in line with what we thought, but it's gone better than we thought. And it enabled us to say we had 2.5-3% of the portfolio in this stock when we were uncertain about all of those things. As we got increasingly certain, we let it become 5,6,7% of the portfolio and that share price is now up near $9 as we record this today. We've since taken a lot of profits, but it's still in our portfolio in a small size as we sit here today.

Any that haven't worked out?

That's probably the thing that's most important from what I was talking about earlier, is to recognise those mistakes and move on. Adore Beauty, another ASX-listed stock, I think is a good example of us recognising that that business was not going to grow anywhere near as fast as we thought when we first bought it, and more importantly, its customer acquisition costs have gone through the roof. We had a plan there for that business to be able to keep acquiring customers for a certain amount of money, and it's costing three times as much. So, we cut that investment early and moved on, and that is as important a lesson as hanging onto the ones that do well.

Are there any unloved stocks that you're watching right at the moment?

One that I think is in that category like a Gentrack is Catapult.

This is a sports tracking software for professional teams and hardware as well. You see their vests in a lot of professional sports. I think they're on the tipping point, like Gentrack was a few years ago, of becoming a rapidly growing stock. It’s a rapidly growing business, but hopefully the stock price follows suit. But a rapidly growing business here, and I think that could last 10 and 20 years with the opportunity it has ahead of it.

What would you say is the most critical factor to success when it comes to portfolio management?

Really good portfolio management is a combination of two quite different attributes.

I think you need patience and you need aggression, and most people have got one or they've got the other. I think the really good portfolio managers have the ability to combine those two things.

The great opportunities are rare and you need to wait for them. And then when you see them, you really need to capitalise on it precisely because they are so rare. And putting those two things together I think is the key.

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