Bank of America (BAC) and Research in Motion (RIMM) were two of the worst performers in my portfolio this past year, but more importantly, they each taught me a valuable lesson. Neither business had the cornerstone of a successful investment - a durable competitive advantage.
I first invested in RIMM between the 60 and 45 price level, when the company started experiencing a serious fall in its share price in response to competition in the smart phone market. I thought the incredibly cheap price quotation relative to earnings presented an easy profit opportunity, but I neglected to analyze the strength of the underlying business's competitive advantage.
RIMM failed the critical test of durability for two reason. First, the company's loyalty ran thin. It doesn't matter how much people love their Ford (F) Model Ts if someone can produce a Ferrari for less money. Similarly, Blackberry lost its following in a large part because the iPhone & Droid provided many services - notably much faster internet speeds - that RIMM could not manage to replicate. Investing in technology driven industries is always dangerous for this reason. When your company is on the cutting edge, a competitor could actually produce a competing product that is objectively better than your own. This is very bad news for shareholders.
RIMM's other weakness was the nature of the business itself. It is a durable goods producer that receives most of its revenues when consumers buy new phones, but it does not then receive much in the way of recurring revenue from those consumers. In order to make more money, RIMM would need to sell new phones. Of course, this places the company in a position where it is constantly fighting to sell more new phones faster and faster. Since RIMM's phones were not the latest and greatest, consumers had no reason to trade in their existing phones. And since every time a customer's phone comes up for renewal he or she has the chance to exchange it at very little cost, RIMM's market share is constantly under attack. In the cell phone market, consumers expect turbulence, and they embrace it because it promises a constant deluge of newer faster better products. But as an investor, this is not the place to lay down your hard-earned dollars.
I made my investment in Bank of America for the same general reason that I had made my investment in RIMM - because the company was undervalued. Buying fear often makes sense because when fear pervades the market, as it is much easier to come upon bargains. Certainly for Bank of America in August 2011, there was much fear to be had.
The problem came though from a different angle. Bank of America was and still is a mediocre business. I knew this at the time of course. But my logic was that in spite of this, the company was still undervalued relative to its assets, and therefore, especially for a financial, the purchase made sense. It was simply a case of buying a dollar for eighty cents. But what I neglected to take into account was the fact that I could not just liquidate my shares and exchange them for the company's assets. Rather, the company would continue to operate its mediocre business to the point where it could actually impair the asset base further. I had no control over management, and regardless of the loan losses, bankruptcy seemed unlikely. As time ticked by, I began to realize how little control I had over the investment. No matter what I did, EPS could fall, and management could continue to operate a declining business. Suppose the business did go bankrupt in five years, how would I know what the assets would be worth relative to the price then? And, if I had bought a dollar for eighty cents, and it took five years to realize the difference, my return would have been absolutely paltry.
Mr. Market spared me too much frustration in Bank of America by allowing me a gracious exit in a period of relative optimism at a price of 7.80, not much below what I had paid. For RIMM, this was not the case, but I was still able to see my error before the damage became too severe. I got out of RIMM around 30, and the shares now trade close to 12. On the whole, I consider myself lucky to have been able to exit each position when I did.
Sometimes you have to learn things the hard way and this was certainly the case for me. In spite of having read Warren Buffet's insightful quotes before, I did not fully take them to heart. Now I can look back on them with some scars and truly internalize the messages.
"Time is the enemy of the poor business and the friend of the great business. If you have a business that's earning 20%-25% on equity, time is your friend. But time is your enemy if your money is in a low return business." -Warren Buffet
"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." -Warren Buffett
"The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage." -Warren Buffett
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
