I Can Admit My Mistakes - Can You?

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Includes: ACFN, EMES, GPRO, HCLP, PM, SLCA, SODA
by: James Melvin

Summary

An examination of my worst investments over the last 10 years.

A case study of the commonalities or biggest themes that led to a loss.

I share the major red flags I either missed, ignored, or rationalized.

I share my philosophy on loss and growth.

Investing has been an obsession of mine since I first learned about the compounding effect when I was in 7th grade (big ups to Mr. Stankovich). This curiosity transformed once I got a job at age 14 and saved my first $500 (thanks, mom and dad, for paying for everything).

I wanted to play an active role in choosing where my first investment capital went, especially because it was an enormous amount of money for me at the time. I went to my parents' broker at Merrill Lynch with my $500 bank check and told him I wanted to invest it. I began asking questions about my various investment options, and I questioned the choices he gave me. The broker laughed at me, giving a clear indication that he should not be questioned, especially by a 14-year-old who could barely pass for 12.

This was one of the most important moments in my investing career: It pissed me off to no end, and I became determined not only to continue questioning other expert advice, but also to keep my investing fate in my own hands.

My first intuition was the recognition of the strong addictive nature and sticky business model of the cigarette industry. I ended up choosing to go with Philip Morris (NYSE:PM), as it seemed to have an incredibly powerful brand. Fast-forward many years, and it turned out to be a great investment, an outcome that served as a critical confirmation of the value of independent research.

Fast-forward further, to my college years, and there was rarely a day I missed reading investment analysis on Seeking Alpha or the Motely Fool, or browsing Yahoo Finance for investment ideas. This passion led me to pursue a dual degree in business and an economics, and eventually work for an investment firm, where I really began to understand the business.

Here I am, a few years later; I have been investing for roughly 10 years and publishing on Seeking Alpha for two and a half. I have tried many styles of investing over this period, including focusing on blue-chip stocks; innovative, high-growth companies; growth at a reasonable price, or GARP; hyped stocks with no earnings; and many companies that fell somewhere in between.

I have allowed myself to try new styles, as I want to make the inevitable mistakes early on in my investment career and use those lessons to find an investment strategy that really works for me. Embracing a mistake as an opportunity to grow, rather than pushing it out of your memory, has been one of the most valuable lessons I've learned. Reviewing these investment mistakes before putting money into a new investment is even more valuable.

The ability to sell out of a losing position where my investment thesis has been disproven has been the hardest lesson of all. The need to be validated or difficulty admitting error is a fundamental human flaw most of us have and it is important to overcome this. This has been especially difficult as I help family members with their investment decisions. I felt a need to write an introspective article evaluating my many choices. Recognizing failures lead to growth and keeps an investor humble no matter how successful. Evaluating my investment history has also led to a couple of trends that my winners have in common and help to validate lessons I have learned my investing greats.

Oops, I missed something — or many things.

  • Acorn Energy (NASDAQ:ACFN)

The worst investment I have ever made was investing in Acorn Energy. I was introduced to Acorn while working at the investment firm and it was my job to research and present a report on my findings. CEO John Moore is a magnificent storyteller by my account as he was great at conveying potential in the 4 business segments and spinning the red flags. The supposed gem of this holding company was US Seismic systems segment. This company promised development of 4D seismic technology that would process seismic waves continuously to give oil drillers a more accurate picture of where the oil was located. The potential if proven successful was enormous and was partly validated by a couple of field tests with supposed industry leading players. The inefficiency of the oil drilling industry is well known and a small player providing a disruptive technology would create massive upside potential. The simple error here was if it sounds too good to be true, don't invest — especially if the product is not being sold in the market.

The first red flag the president of the investment firm I worked for pointed out was Acorn paid for research of US Seismic Systems. Gaining coverage for micro caps is difficult as there is little incentive from any major firm performing due diligence. Paying a company to perform research has a clear conflict of interest and any investor reading this type of report should take the article with a grain of salt at best and perform their own due diligence. The next major red flag was that the company continually had negative earnings and was world class at burning cash. Management continually uttered their need to reinvest in their companies, but the continual negative earnings and cash burn necessitated the company issuing shares to pay for operations. Remembering that cash flow dictates long-term value would have saved me from a painful experience.

Continual shareholder dilution was the next red flag. Management issued a significant number of shares after the company had dropped roughly 40% and this was the final straw for holding Acorn Energy. Any company willing or forced to issue shares (cash burn) after significant drops in their share price should be scrutinized closely as it tends to lead to a self-fulfilling prophecy of poor returns. The biggest lessons I learned from this was not to buy a company that's main appeal was based on technology that is still in development no matter how big the supposed pay off could be and cash flow is king in the long run.

  • SodaStream (NASDAQ:SODA) and GoPro (NASDAQ:GPRO)

The common thread of these companies is the majority of sales are dependent on a single product line or ancillary items that are directly tied to the growth of the main product. GoPro has virtually all of its revenues coming from its sports action camera line through the various Hero camera models. SodaStream's revenue comes from selling their various soda machines and then making money on the flavoring and carbonation. SodaStream overall revenues still derives from the primary growth level of selling the machines, which makes it makes the fate of the company come from a single product. The retail industry is notoriously cut throat segment to operate in and often falls victim of fickle consumers, steep discounting, and excess inventory.

Threats to the retail industry are greatly magnified when all of your sales are derived from a single product line and often lead to punishing stock returns. The risk becomes even more pronounced when the value proposition is not extremely compelling. GoPro may have the best offering in the camera space, but there are numerous options that are much cheaper making the value proposition for customer difficult to make. SodaStream's high cost of machines relative to the low cost of buying premade soda makes the value proposition relatively weak.

Low market penetration does not mean that the real market isn't saturated. One argument for SODA and GPRO was that there are millions of potential customers in the US market alone and there is a huge market to sell into. The US consumer market is massive and can be a major engine growth for companies. The important caveat is finding the real addressable market that is reasonably going to be interested in the product or will find the value proposition compelling enough to purchase the product.

Most people in the US are not extreme sports athletes and therefore are not the real core market where GoPro offers the best value proposition. There is a market for those trying to capture their day-to-day life or various events, but the value proposition is relatively weak as the high cost compared to competitors and often these customers do not necessitate the highest possible specs to capture their events.

One of SodaStream's investment opportunities is the low market penetration in the US and the huge domestic carbonated beverage market. There is a growing trend towards healthier options thereby decreasing the overall market on a large scale. The proposed "convenience" of the being able to make soda at home turned out to be a major limiting market factor as most people have no interest in putting in the extra effort or lose interest relatively quickly (fad product). The key here is to make reasonable assumptions on the actual size of the market rather the looking an individual company's sales relative to the total industry and saying the company has low market penetration.

"Cheap shares" can always get cheaper. I made investments into both of these companies after they had dropped over 50% and investment valuation seemed to indicate that both SODA and GPRO were extremely cheap based on previous growth rates. There are many reasons why negative trends can persist longer than expected. Remembering that negative trends are often hard to reverse and can take significant time if ever to reverse is important in catching falling knives. Companies with downward trajectory are unusually susceptible to extreme emotional buying or selling and typically cause high volatility causing many investors to sell after a major loss. Having the emotional stability to deal with tumultuous share price changes is key in these types of investments. Remembering that deteriorating results can make "cheap shares" become relatively expensive very quickly is an important consideration.

  • US Silica (NYSE:SLCA)

US Silica is a producer of sand that has uses in various industrial purposes as well as fracking. The high level of innovation in the fracking industry caused the cost of drilling to significantly decrease. The drop in cost of fracking production led to a boom in US oil production. US Silica was one of the main beneficiaries and performed extremely well until the recent oil crash. One of the major advances in fracking was the discovery that increasing the amount sand per well led to significantly higher production yields. The more sand being used per well and high oil prices created strong market dynamics for sand producers causing US Silica to be one of the fastest growing companies in the world.

Oil prices began to decline quite rapidly from the $110 per barrel peak creating massive drops in stock price for anything related to oil. Cyclical stocks typically get crushed when the tide turns against them. I watched SLCA drop 50% and I though this created a great buying opportunity given their massive growth over the past few years. I underestimated how far oil could drop and how much that drop would absolutely decimate the stock price of oil related stocks. This was my first investment in a true commodity product company. I knew the value of companies with economic moats, but the destruction of value SLCA showed over a few months made this clearer than I ever expected.

US Silica does have an industrial sector that has is not nearly as susceptible to the cyclical nature of the frack sand industry, which was why I chose them over pure plays such as Hi-Crush Partners LP (NYSE:HCLP) and Emerge Energy Services LP (NYSE:EMES). The industrial segment has performed extremely well helping to mitigate the huge decline in the frack sand segment, but this segment is far too small relative to the size of the frack sand at its peak to truly smooth results. Companies that are highly reliant on cyclical industries create often create a binary outcome in the short term. Both EMES and HCLP are even better examples of the binary outcomes inherent with cyclical stocks as can be viewed by their 5-year returns. Investors with a long-term investment horizon may be able to weather these major downtrends, but it is important not to underestimate the emotional rollercoaster that follows these types of investments.

Sand production has lower barriers to entry than my typical investment choices. Arguments over regulation or difficulty on obtaining licenses to produce frack sands have some validity. Logistics is an important part of being a successful sand producer and scale certainly helps more timely results. These combined factors lead to a small moat at best in my opinion though. A low economic moat industry seems to be validated by the high level of fragmentation in the sand production industry. The importance of barriers to entry will be further discussed in my next segment on my successful investment choices and the common themes these companies share.

Conclusion

I strongly believe that facing and regularly reviewing investment mistakes has immense value for growth (applies to life as well). Investment mistakes are far more emotionally charged than successful investment choices. Reviewing investment mistakes therefore is more difficult than thinking about the companies that have appreciated in value. Preparing material for this article was particularly painful, as I scoured my investment spread sheet to find my worst investments over the last 10 years.

The difficulty in facing these investments and plainly looking at the mistakes is the exact reason that it is so valuable to investors. The willingness to do what other investors will not is the key to outperformance over the long run. I highly suggest every investor perform this exact exercise, and write down the results. I find that writing down the results both clarifies my thoughts as well as reduces the likelihood that I will repeat these mistakes. I plan to publish a second part to this series on successfully investments and their common themes to hopefully stop the continual weeping I experienced while writing this article.

Disclosure: I am/we are long GPRO.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.