Wednesday, October 10, 2012

Sins of Omission (Part 1)

Many successful investors analyze their past mistakes as well as their successes. In fact, they probably believe their mistakes teaches them more than their successes. Any investor will vividly remember his worst stock purchases, because the loss from the stock is real. These are the sins of commission. But an investor may not vividly remember the situations where he found a good stock but didn't buy. In this case the opportunity cost is really equally high. These are the sins of omission. I am going discuss several of my sins of omission.

Fairfax Holdings (FFH)

Fairfax Holdings (FFH) is a Canadian property and casualty insurance company. It operates similarly to Berkshire Hathaway, only smaller. It is run by an India-Canadian, Prem Wasta. Some have dubbed him the Warren Buffett of the north. One difference between FFH and Berkshire, other than size, is their volatility. Berkshire is a company with much more consistent gains than FFH. Prem Watsa joined Fairfax in 1985. It had a great run before hitting a bad patch in the early 2000's, which is when I bought in. I call this FFH a sin of omission because I sold it shortly after buying in, and missed out on the subsequent runup.

In 2004 when I bought in, FFH was just listed on the NYSE and it was receiving a lot of bad press. Many argued that a number of shorts were attacking FFH, and was responsible for much of the bad press. Shorts are people who borrow shares and sell them with the intention of buying them back when the share drops. They have a vested interest in seeing the stocks drop. I read the bad news on the message boards. There was primarily a negative spin on every piece of news. And the worst part was that FFH lost money in 2004 and needed a $300Mil transfusion through a private placement. I knew that there was a big short interest at the time but didn't know who to believe. The stock went up a bit and dropped to my buying price of $150 in late 2005. I sold then.

I was in the habit of reading financial reports but I wasn't as wise then. In their, 2004 shareholder letter, Watsa wrote:

Investment performance in 2004 was hampered by our very conservative position which included not reaching for yield, maintaining large cash positions and hedging a significant portion of our common stock holdings against a decline in the equity markets. The $81.5 million unrealized loss in our hedges flowed through our income statement as realized losses.

In 2004, FFH lost $17Mil, so all of it was due to an unrealized loss based on a bearish bet on a bullish stockmarket. I think I read their financial reports but probably didn't recognize the significance of that.

An in the 2005 annual report dated April 2006, Watsa gave an ominous warning:

.... we are very wary of the risks prevalent in the U.S. As we have mentioned ad nauseam, the risks in the U.S. are many and varied. They emanate from the fact that we have had the longest economic recovery with the shortest recession in living memory. Animal spirits are alive and well and downside risks have long been forgotten. Having lived through the telecom bubble recently and the oil bubble in the late 1970s and early 1980s (and perhaps again today), we see all the signs of a bubble in the housing market currently.

Two years later, the world learned that Watsa was right on. FFH profited handsomely in 2006 and onwards, in a lot due to credit default swaps (bets) against the US stockmarket. Today it is $380 / shr.

The following table shows the FFH annualized appreciation of its stock and book value over the years. After this experience, I am more grounded in what I believe. I am much more subjective when I choose who to listen to.

Since I sold
Dec 2005 — Oct 2012
Since Inception
1985 — Dec 2011
FFH Book Value23.5 %
FFH Stock Price14.1% 20.7%
S&P 500 0.1 % 7.9 %

DR Horton (DHI)

DR Horton (DHI) is my second sin of omission. DHI is the largest homebuilder in the US. Like all homebuilders it was very profitable in the early to mid 2000s. By 2008, the housing was a disaster beginning to unfold. But I thought this is a good time to take advantage. I bought DR Horton after it was already down 50% from its peak in early 2007. By the time the market really crashed in 2008-2009 DR Horton was down to $5. But still, this was much better than some banks, AIG, Fannie Mae and Freddie Mac, which effectively went to zero. But by 2011, DHI was hovering above $10 for 3 years. I threw in the towel and sold it at $12 in 2011. Now, with the beginning of a housing recovery it is over $20.

After these two investments, I have learned to pay more attention to stocks that I consider selling. It is true when they say selling is harder than buying.

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