First published in The Sunday Times on 16th July 2017.
I often fall for the allure of a false bargain and end up regretting it. Bitter experience teaches me that when it comes to investing, assets are usually cheap for a reason. Sometimes the worst deals seem cheap because you don’t pay a lot for the shares — but the problem rests with the liabilities you inherit.
Perhaps the worst example in recent history was the catastrophic purchase by Bank of America of Countrywide Financial in 2008. The bank paid just $2.8bn (then £1.4bn) in stock for the sub-prime mortgage lender, but the deal has probably cost $50bn in loan write-offs, legal expenses, settlements and fines — let alone the reputational damage and opportunity costs.
The timing of the purchase was awful — turning Bank of America into the largest mortgage lender just as the US housing market collapsed. The buyer did insufficient due diligence and market analysis and suffered the consequences. The chief executive who led that deal, and the terrible subsequent acquisition of Merrill Lynch, paid with his job — Ken Lewis retired a year later under a cloud.
One way to avoid false bargains is to know the country where you invest. A few years ago I bought a stake in an Italian company that appeared to be trading at a fraction of its balance sheet value. Unfortunately the figures were nonsense and the business was infested with litigation and fraud. I did not understand what I was buying and took at face value what I was told about the underlying subsidiaries.
My ignorance proved my undoing and I lost most of my money. I discovered too late why Italy ranks 60th in the Transparency International Corruption Perceptions Index, lower than countries such as Romania and Rwanda.
When assessing shares you should approach apparent giveaways with deep suspicion: what appears too good to be true probably is. And remember that the market is frequently better informed than you think.
Langbar International was an example. It listed on AIM in 2003 as Crown Corporation and supposedly raised $570m. But most of the money was never subscribed. The stock traded at a seeming huge discount to its liquid net worth — yet it was an elaborate swindle, with fake contracts and bogus certificates of deposit. Institutional investors lost as much as £100m.
The central conspirator, a man called Avi Arad, died before he could face trial. The chief executive, a former Baker Tilly accountant called Stuart Pearson, was something of a fall guy. He was sentenced to a year in jail after being found criminally reckless for issuing misleading statements to investors, although he was acquitted of dishonesty — he even lost money in the debacle.
Another form of self-deception is to buy an asset based on how much it has fallen in price, rather than judging it on its intrinsic merits. You can still lose all your money, even if a share has declined from £10 to 10p. By all means bet on a turnaround if you really know your stuff — but beware structural changes that have profoundly altered the economics of markets and technology.
Even though the shares of certain prominent retail companies appear cheap, the onslaught of online shopping is making many of them unviable in the longer run. They may well prove to be classic value traps. I suffered heavy losses wagering I could revive a store-based bookseller when I paid perhaps 5% of what had been invested in the business by the parent company. But Amazon, ebooks and high fixed rental costs defeated my ill-judged plans. I didn’t realise, but the business model was broken.
Small businesses frequently change hands for only three or four times annual profits, which sounds reasonable. But this reflects the difficulties one encounters with many micro enterprises — low barriers to entry, weak management and systems, underinvestment, high customer dependence and so forth. Companies that reach a certain scale have a degree of substance that small ones lack.
Occasionally I’ve backed an inexpensive, mediocre business and it has gone well, but mostly they destroy value. In these cases, almost without exception the management was poor — over-optimistic, unreliable, bad at controls and so forth. In hindsight, the warning signs were there, but the bargain hunter in me ignored the clues. Be it construction, recruitment, restaurants, food production, retailing or vehicle repair — what looked cheap turned out to be very expensive, demoralising and a big waste of time.
I suppose I like the idea of bargains because I see myself as something of a contrarian investor, not following the crowd but seeking out neglected opportunities. Ignoring general opinion and forging an independent view takes effort, a little courage and a willingness to be proved wrong — since such a strategy is inevitably higher risk.
A rock-bottom entry price should compensate for the dangers of unloved businesses, but if the issues of quality are so fundamental and the distress so serious, fixing the flaws can prove impossible.