The long-term success of an investor is largely consequent to his/her decision making process. Developing a strong process is no easy task and even the best minds cannot perfect it a priori. It requires countless iterations with brutally honest reflection. As I am on a 14 hour flight to Beijing, China, this is the perfect time for me to update my process. I will begin by sharing my process improving methodology and show it at work through analysis of mistakes I have made in my investments. Along the way we will uncover some ubiquitous errors and provide insight into an effective method for improving one's investment process.
Process improving methodology
Regardless of an investor's skill or success there is always room to improve. The method detailed below is a step-by-step guide for improving one's process.
Honest reflection: Includes determining what worked what didn't and whether or not it SHOULD have worked. It is absolutely critical to disambiguate results from decisions.
Identify what caused the error: Once each bad decision has been identified, ascertain what the failure in process was that allowed the bad decision to go through.
Correct that portion of the process to block that error.
As a list, the method is rather vague but it should become clearer once we see it in use. Over the past 6 months I have made some mistakes, three of which I have been able to identify through honest reflection. Below are each of the errors and how I used this method to improve my investment process.
Stategic hotels (BEE)
On 11/05/12, I shorted BEE at a price of $6.39 and covered on 11/07/12 for $6.16/share for a profit of 3.6%. In reflecting upon this series of decisions, I nearly glanced over them, assuming that the profitability was indicative of an intelligent choice. However, upon rational analysis it became clear that the profits were consequent to an unforeseen event and that I SHOULD have lost money on the short. In other words, the average risk adjusted returns of such a short are negative, I just got a lucky outcome.
On the day I shorted, BEE's former CEO, Lawrence Gellar, had just stepped down and the market price rose nearly 15%. I believed the spike in price to be due to the investment public's perception that Gellar was going to attempt a takeover. Having been familiar with Gellar and BEE I felt the chances of such a takeover were slim to none and that once the rest of investors caught on, the price would return to where it was before the announcement: I shorted in anticipation.
Fairly soon, Gellar's severance agreement was released and it contained a non-compete clause which confirmed that Gellar could not initiate any sort of takeover. I had correctly predicted this, so why did the price not drop back down to pre-resignation levels? Well, I had misattributed the resignation as the sole cause of the price gain. In reality, much of the movement was from an analyst announcing a buy recommendation on BEE with a lofty price target as well as the fact that BEE traded below its NAV. Fortunately, I got bailed out of my bad position when the market crashed in response to Obama's re-election.
Once I disambiguated the profitable results from the decision it became clear that I had made an error. The flaw in my process which allowed the error to make it through to action was obvious - a lack of due diligence. Correcting this flaw, however, proved to be a more difficult task.
When fixing an error in one's investment process, it is critical not to introduce a new one. In many cases, there is no clean fix and we must choose the lesser of evils. For my BEE short, performing due diligence would have risked missing the window of opportunity. Time sensitive situations will always come down to intuition as to whether it is more important to act quickly or to wait and act more correctly. While I was unable to fix my methodology in this regard, actively considering the tradeoff enhances intuition for future time-sensitive opportunities.
In November, CapLease unexpectedly launched a large offering of common equity. Given the lack of warning and the low trading volume of LSE it caused the market price to plummet. I quickly analyzed the offering based on what the proceeds were used for and determined that LSE was massively underpriced. As most of my money was invested in fairly illiquid positions, I took on leverage so as to buy a large chunk of LSE at $4.72. This was not the mistake. Instead, the mistake was that despite knowing LSE was worth far more than its market price, on 12/04/12 I sold nearly half of my position at the embarrassingly low price of $5.04 (compared to $6.20 today) so as to cover the margin. It was a quick profit, but I failed to let it blossom to its true potential.
At the time, covering the margin felt like an intuitive decision as it captured the profits while reducing risk. However, one of the most difficult aspects of reflection is to understand the difference between intuition and emotion. Both are well intentioned, attempting to accomplish a goal, but emotional decisions create waste while intuitive ones are optimized. In my case, for accomplishing the goal of delevering my account, there were much better options. I could have transferred in funds from a lower yielding account or sold a position that was closer to its potential. With this information, identifying the error in process was clear - allowing emotions, specifically my discomfort with leverage, to affect the decision. Such an error can be corrected by adding a step before executing. One must not only consider whether a choice accomplishes the desired goal, but if it does so with the greatest efficiency among the spectrum of choices. Such an addition to the investment process reduces the emotional impact on decision making without inhibiting intuition.
Missing a golden opportunity
In analyzing the fundamentals of countless REITs, companies tend to fall within a certain range of the norm. Those which have attractive valuations tend to be balanced with extra risk or weaker operations. Through most of 2012, Ashford Hospitality (AHT) was anomalous; desirable in every parameter. It had excellent valuation, trading at an earnings multiple as low as 1/3 the market's average, supreme management, intelligent use of leverage and operated in an industry with a phenomenal outlook for 2013 and 2014. It was the golden egg. Having thoroughly researched AHT, I felt confident in this assessment and I even wrote numerous articles on it. Ashford surged late in 2012, gaining nearly 50% in just 3 month, but I failed to seize the opportunity. Despite my certainty, I had only allocated a small portion of my portfolio to AHT. The mistake was excessive diversification, deleterious to maximal expected returns.
Opportunities of this magnitude are rare occurrences and it was regrettable to let it pass by unexploited. A more correct process regarding such opportunities would be to engage in very thorough research, double check it and invest as heavily as your risk tolerance allows.
The Bottom Line
The investment process is always a work in progress. Taking the time to reflect upon and improve it is a sure step to becoming a better investor.
Disclaimer: 2nd Market Capital and its affiliated accounts are long LSE and AHT. This article is for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the writer.