There are two important reasons why an investor should take asset diversification seriously: One, in the event that something out of the range of normal probabilities occurs. This is something like BP, General Electric, or Wells Fargo. Two, to act as a safeguard against yourself in the event that your analysis might be wrong. Two companies that, even with the benefit of hindsight, would have succeeded in fooling me? Worldcom and Wachovia.
The difficulty in catching Worldcom is that…the company lied. If you curled up and read the annual report, you would have seen numbers reported as assets that were, in fact, liabilities. When the providers of the data lie to you, it’s difficult to mount a successful defense. How perilous is this stuff? When Benjamin Graham was asked in an interview if there were value investing opportunities that he would never pursue, he only came up with one example: Insinuations of bad numbers. If a company was involved in some type of accounting scandal, or if there was a meaningful accusation of an accounting scandal, Graham would stay away altogether because investments can only be justified based on the numbers, and if you have no numbers you can trust, you lose the sound basis for making the investment.
This will, sometimes, mean that you miss opportunities. I remember when Diamond Foods fell to $13 two years ago after the CFO committed suicide and the investment world became unsure of the true debt obligations. Anyone who looked at the company could see that it owned decent, profitable brands: Diamond of California (nuts), Pop Secret (microwavable popcorn), Emerald (snack nuts), and Kettle (potato chips). The trailing P/E ratio, at the worst point in the scandal, was 7x earnings.
The stock is now over $30 two years later, and the profits are the climb. The risk of the investment was that CFO suicide could have corresponded to debts that would drive the company into bankruptcy, and the profitability of the brands would serve as a slap in the face while the shareholders got wiped out during some type of reorganization process.
Critics were right, the debt is absurd: Diamond Foods makes $33 million in profits while carrying a $638 million debt burden. That’s why there is no dividend. Even though, from 2013 through 2015, a lot of money could have been made with Diamond Foods, I don’t feel bad about missing out because: (1) the debt situation at the time of the unknown could have been even worse and shareholders could have gotten wiped out completely, and (2) the debt is still going to drag down business performance in the years ahead.
The other example of a company that would have gotten me into trouble? Wachovia in the early stages of the financial crisis. Wachovia did everything like a blue-chip stock. It had a 50+ year excellent track record. All the people that owned and got rich in Winston-Salem from the rise of R.J. Reynolds tobacco poured their profits into ownership interests and general banking at Wachovia. It was a bank that historically was well capitalized. It raised the dividend every year. It had a book value of nearly $40 per share in 2008.
Everything about it looked good–the downfall of the stock appeared very similar to GE at $6, American Express at $10, and Wells Fargo at $8. For someone truly patient, it seemed to offer once-in-a-generation total returns.
The distinguishing characteristic that made Wachovia doomed for failure while the other financial institution companies recovered without excessive dilution is that Wachovia made the Golden West Financial Mortgage acquisition in 2005 for $24 billion. The deal, which gave Wachovia a $122 billion portfolio in the California lending market, would not have caught my attention because Golden West only had a 0.18% default record during the savings & loan crisis of 1991.
But the business culture rotted with the times. Golden West created that $100+ billion portfolio by giving its associates mortgage sales quotas each month, rewarding employees not on loan quality but on loan quantity. When you compensate someone for the amount of widgets, rather than the quality of widgets, the net result tends to be crap. In Golden West’s case, the company pioneered the “Pick-A-Payment” strategy with homeowners.
Here is how it worked: If Golden West owned your mortgage, you would receive a bill giving you four options of mortgage payments for that month. You might be able to pay $750, $830, $980, or $1,120. Human nature being what it is, most people would choose the $750 option. What Golden West did not make clear to homeowners is that this involved “negative amortization”, a scary word with a scarier implication: Even as you make payments on your loan, the balance for the next month actually goes up because you didn’t pay enough to cover the interest. Golden West referred to this as the “deferred interest” option. Really, it was the no principle option.
Worse yet, the terms of the Golden West deal had contained an unheard-of term: Golden West executives got to impose their will on Wachovia’s other lending divisions. Usually, the culture of the acquired company gets consumed by the culture of the acquiree. That is not what happened at Wachovia. The Golden West executives spread the Pick-A-Payment strategy across all of Wachovia’s remaining lending operations in time for the 2008 recession. Even worse, the steep price of the $24 billion acquisition meant Wachovia was low in liquidity with a dividend payout ratio over 60%.
When the financial crisis hit, the mortgage payments stopped coming in, and Wachovia sustained an $11 billion loss in the third-quarter of 2008 alone. By comparison, Wachovia was a bank making $8 billion per year, or $2 billion per quarter. In one quarter alone, Wachovia needed to come up with $8 billion in cash to cover losses. It could not do so, and the stock fell below $1 before Wells Fargo picked it up at a garage sale.
I’ve written before that you can deal with poor earnings quality, and you can deal with low liquidity, but you better not do them both at the same time. If the earnings are incredibly predictable, even in recessions, you can get away with minimal cash on hand even if it is not wise. And if the business is like the hotel REIT industry, subject to sharp swings in profitability, you can get away with it if you are sitting on large piles of cash. The trouble with Wachovia is that it had just finished lowering its earnings quality at the same time liquidity was at an all-time low, and the second-worst economic crisis in the past century was arriving.
The lesson, I think, is that people should always ask themselves one question when deciding what percentage of a portfolio should be in a given stock. Ask yourself: Can I afford to lose this if the stock goes bankrupt? Sure, no one would find it pleasant to see a particular holding disappear, but if the loss of a particular investment would seriously affect the quality of your lifestyle, then you should engage in what Benjamin Graham called “horizontal risk shifting” and do the equivalent of a large Coca-Cola owner buying up Pepsi and Dr. Pepper stock. That is the only limitation I would put on the general presumption that you should buy-and-hold and let the winners like Visa and Nike run.
Originally posted 2015-08-25 22:20:41.