6 Lessons From the Bear
We learned the hard way that few companies' earnings are immune to a terrible economy.
Few would argue with the assertion that learning from our mistakes is a central component of self-improvement. To that end, savvy investors put a high premium on disciplined reviews of their gaffes. With one of Warren Buffett's favorite admonitions in mind -- "It's better to learn from other people's mistakes as much as possible" -- we've compiled six important lessons from our own and others' experiences during the recent market meltdown.
Beware of over-concentration. Having endured a humbling 2008 after several years of outsize returns, Mohnish Pabrai, of Pabrai Investment Funds, concluded that his previous approach of owning 10% positions in just ten stocks was simply too risky. He now aims for 5% positions for his most compelling ideas, and he keeps stakes in stocks with profiles similar to his biggest holdings and stocks with significant risk to 2% or so. "One needs to be ... willing to give up some of our best-loved ideas when the evidence suggests they are flawed," he says.
The big picture matters. Like many dyed-in-the-wool value investors, we have traditionally left economic forecasting to the pundits and focused almost exclusively on selecting individual stocks. As a result, last year we held companies -- such as Barnes & Noble and Target -- that we believed were resilient enough and priced cheaply enough that their stocks would perform well regardless of the environment. We learned the hard way that financial crises don't tend to be self-contained, that very few companies' earnings are immune to a terrible economy, and that even if profits hold up, investors are likely to reduce the amount they're willing to pay for each dollar of earnings.
Expect the unexpected. Few investors have more in-depth financial-industry knowledge than Tom Brown, who, after years as a top-rated Wall Street analyst, started a hedge fund in 2000 called Second Curve Capital and put up spectacular returns for six years. After financial stocks started to implode, his biggest mistake, he says, was assuming that everything would resolve itself as quickly as it did during previous credit shocks. Brown wrote of his 2007-08 performance: "I made the mistake of assuming that prior events always provide a good guide to what's in store for the future. Wrong ... The scale of the disruption might have been highly unlikely -- but it wasn't impossible."
Book profits. It's easy to be mesmerized as stocks you hold appreciate. Each uptick provides further confirmation of your wisdom and your assessment of a company's bright future. The result can often be that you build too big a position in a market darling that is likely to fall hard at any inkling of bad news or a more general market shock. As bear markets constantly remind us, taking profits is rarely a cause for regret.
Don't outsmart yourself. On two different Fridays in 2008, Timothy Mullen, of VNBTrust, the money-management arm of Virginia National Bank, bought shares of financial firms that were rumored to be subject to imminent seizure by the federal government. He assumed he'd sell on Monday when the rumors proved false. Neither institution -- Lehman Brothers nor Wachovia -- made it through those respective weekends intact. "I've purposefully started exercising much more in the past 12 months," says Mullen, "and one big reason has been to help avoid making stupid mistakes because I get all caught up in staring at the screen and overthinking."
Stay humble. "If the period from January 2007 to July 2008 taught me nothing else, it's taught me that disciplined self-doubt is a vital part of the investment process," says Brown. The markets never seem to tire of imparting the wisdom of humility.
Columnists Whitney Tilson and John Heins co-edit Value Investor Insight and SuperInvestor Insight. Funds co-managed by Tilson hold positions in Barnes & Noble and Target.