A little investment test

 An Interesting Little Test

When I was an analyst/PM at times I worked for weaker investing institutions. The consequence of this was that there would be a steady turnover in investing people. Working with new people constitutes a large risk in investing because you are unaware of their strengths, weaknesses and biases and probably will not know those for a couple of years or even until there is a market crisis and see how they react. That can be a costly exercise I found.

To help speed up that process of analyzing the analysts I devised a little test. The test has no right answers. The test was to help me characterize the people I was working with. Of course, there is no substitute for years of watching and talking to people through different market environments to assess their mental processes, how they believed markets worked and what were their processes or philosophies.

The test starts with a story, it’s a real story but I didn’t want to get into a stock-specific rabbit hole, which people love to do, so I generalized the story. Its 1998, the internet is becoming a “thing” in investing around the world. Almost everyone alive realizes this is going to be huge. The issues for me were the difficulty in identifying winners or even winning business models. I was pretty sure the ultimate winners would be global, probably US-based since the internet was global. Possibly with some local variations.

The stock market went strong bull on any story associated with the internet. Companies that for years had been speculative mining stocks, changed their names to something internet-themed and the stock prices went up, a lot! Crazy times we had never seen before. Only the late 1980’s deregulation boom was as close as I have seen to that one.

As a valuation-based investor at the time with a strict discipline on calculating a company’s valuation on a stock that I could have faith in and buying and selling accordingly, this was an amusing event, but not something I believed was sustainable, and importantly, did not fit my process. The process I was following was working extremely well.

Against this backdrop, I was offered an allocation in an internet float (back when IPO investing was allowed by investing staff).  I read the prospectus end to end. The company named a lot of celebrities, Greg Norman etc who would be the face of an array of initiatives to carve out a space in the new emerging world. All very exciting and although there was a possibility of the company achieving a business, there was no business in existence at this time. There was also little in assets, there were letters of agreement to redo stuff on the net etc. This business was very speculative in what the market perceived as an exciting new dawn. There was a chance it could be worth zero.

What happened? I took an allocation and sweated. The company was outside my investing style, outside my competence circle and I realized this was a huge valuation bubble and fretted that it would collapse before the listing date. Usually, I don’t fret about my investments.

The stock was listed at a 30% premium, I sold and congratulated myself but felt relieved and a bit dirty as well. As if I had gotten something I didn’t deserve. The stock went on from its $1 ipo price it would peak around $4 later that year. When the slide started in March 2000 this company went if it. I can't recall whether it went under or was taken out at a few cents in the dollar. It doesn’t matter it was a disaster for those who held to the end.

Then I relate this story to the analyst and ask what you think I should have done. The responses fall into four categories. Again, there is no right answer but it helps me classify what type of investor I was dealing with (IMO).

Type one is the Process disciple. You betrayed your investment philosophy and process, luckily you got away with handling a live grenade before it went off but that outcome does not forgive the poor judgement you showed by taking on the risk.

Type two is the pragmatist. You did the right thing, although it was outside your style and competence but the market was crazy at the time and you may as well have profited from it. It’s a sideshow but if there is a coin on the floor, pick it up even if it is not supposed to be there.

Type three- the hindsight expert. You did the right thing but obviously you sold way too early, this market was hot, and everyone knew that it would go higher, what you needed to do was judge when the game was up and get out. You left too much money on the table.

Type four is the True believer, yeah I was in those stocks, I still can't believe how they collapsed when the internet was the biggest thing that had been invented since writing. The opportunity was huge and these companies were placing themselves at the forefront of a new era. There will be big winners here. I was going to call this category the dreamer, but that is unkind.

There are others but these categories cover most people. What did I do with that information? IMO it tells me a lot about how the person invests. I fall in between types one and two. Type three I find the most dangerous because they believe that the markets are much more forecastable than they are, or their belief in their abilities is just unrealistic. No one rings a bell.

The fourth category is interesting. Not my bag at all but these guys are the ones out on the edge of the risk/return spectrum. If they can keep their capital intact and not get obliterated, their next pick could be AMZN or some other moonshot that comes in. The base rate of success here is too low for me, but the corresponding payoff on success is very high. Some of these guys will win big.

Hope you found that interesting, where do you fit?