My investment mistakes 2021-2022

Reflections on the reasons for the biggest losses in my portfolio

We would all love to never make mistakes, especially when it comes to money and investments. I have seen recently that many people who invest and are active in social media hide their failures and brag about their successes. Maybe that's a good strategy to get followers, but it's not a good strategy to be a better investor.

My only goal in sharing my experiences on Twitter and Youtube was to improve as an investor. Actually, I had a lot more to improve than I thought at the beginning, and I consider that I have made quite a few mistakes that could have been easily avoided. As my goal is to improve my investing skills, and not to pretend that I am better than I really am, I am going to share with you all the investment mistakes I have made these last two years, so that you can learn from them as I did, and maybe avoid big losses in the future.

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1. Buying without a margin of safety

This investment mistake could probably summarize all the ones you will see below. One of the most important pillars of value investing is to trying to limit your losses by buying assets at a price that gives you a good margin of safety. If your losses are limited, then everything you gain will be an addition to your wealth, and you will be able to compound. If you buy thinking only on the potential gains, and not the possible loss, you will find that your bad decisions will weigh heavily on your profits. It is necessary to invest thinking about limiting losses.

During 2021 it was difficult to find quality company stocks at a price that offered a good margin of safety. One of the most common forms of self-deception to justify the prices paid for many stocks was to use overly optimistic growth estimates (either your own or analysts'). Another form of self-deception was to compare one of your stocks to a bubble stock and conclude that since yours was not as over-priced it was not a problem (for example: “since Square is at P/E 300 my stock at P/E 30 is a good buy”).

Personally, I made quite a few purchases without sufficient margin of safety (we will talk about specific stocks in the following sections of the post). Perhaps with my mind clouded by the great returns I obtained in 2020, I took risks that were not necessary, that if I had not taken, surely my wealth would be higher.

And this brings us to the second investment mistake:

2. To always be 100% invested, unconditionally

I no longer consider it necessary to always be 100% invested.

My idea of always being 100% invested was based on the fact that in the long term, FIAT money (euros, dollars,...) will lose all of its value, and therefore, it makes sense to get rid of FIAT money to buy assets that generate cash flow that can increase with inflation. The problem is that in the short term the money is not going to lose all of its value, so you should not rush into buying anything to get rid of it, since the possible loss is higher than the inflation of a couple of years.

Does it make sense to be 100% invested? Yes, absolutely yes, but only if we can buy assets that offer us a margin of safety and good appreciation potential. If we do not find anything, we should not force an investment and pay too much for our assets, it is better to wait until we find good opportunities.

In my defense, in early 2021, interest rates were at 0%, the Fed was in infinite QE mode, and it didn't look like they were going to change, so I think at that time it was hard to see the current situation. There are many stocks that did offer a margin of safety at 0% rates, but did not offer a margin of safety at 4% rates. Probably those stocks have suffered a 15-30% fall, but the errors we are talking about in this post are drawdowns equal to or greater than 50%, they are mistakes that did not depend only on the change in interest rates.

One of the good decisions in 2021 was to accumulate cash or short-term bonds (even though they paid close to zero) while everything was in a bubble, that was the way Warren Buffett opted for with Berkshire. If you can't find anything to buy, better wait until you find something. This is what I should have done.

Another good decision was to invest in more unknown stocks (even cyclicals), abandoned by the market, which did offer a good margin of safety. I can think of two examples of Spanish managers who did this with very good results: Gabriel Castro and Edgar Fernández (follow them on Twitter, I recommend it). For this you had to have a great knowledge of unconventional sectors that I did not have at that time, as well as a huge discipline and confidence to avoid participating in the euphoria of the market and trust in their own value investing ideas. From here I congratulate them both for their profitability.

3. Paying too much when political risk is high

Let's start talking about specific stocks, starting with the one that has generated the biggest losses for me: Alibaba (those of you who follow me already know that it was the top 1 position in the portfolio).

If you are going to invest in China, or other emerging countries, you better make sure that the share price gives you such a high margin of safety that it compensates you for the enormous political risk you are assuming (not negligible), in addition, I consider it vitally important that the company's management has a good policy of capital allocation and shareholder compensation (taking into account the Stock-Based Compensation, as we will see in section 6). I consider that my mistake was not to buy Chinese stocks, but to buy them without a margin of safety taking into account all the risks and without paying enough attention to capital allocation and shareholder compensation.

The only Chinese stocks I have invested in are JD, Alibaba and PAX Global Technology.

- JD I bought it in 2019 at ~22 USD and was selling it at ~44 USD in 2020 when I needed the capital for the down payment on my apartment. I consider the price I paid did have a good margin of safety, although nothing like what we will see below:

- PAX Global Technology I bought in 2020 at 3.5 - 4.5 HKD when the company had virtually all of its market capitalization in net cash (EV = 0) and 0.57 HKD earnings per share (2019, P/E 7). I think this is the perfect example of the prices to be paid in China. In fact, despite the black swan that was the FBI raid on PAX's US facility (share price down 50% overnight), I still hold more than half of my shares with capital gains in excess of 50% excluding dividends. The margin of safety was huge, combined with a management that does reward the shareholder, even though it was Chinese, it was a very good investment (and still is in my opinion, it is the only Chinese stock I hold, the fundamentals have improved a lot).

- My first purchase of Alibaba was in 2020 at ~280 USD (Degiro is in maintenance today so I don't have the exact prices) at a Market Cap/FCF above 25x, and if we subtract the SBCs from the FCF, even higher (I explain in section 6). As you can see, these prices have nothing to do with the prices I paid for PAX. What went through my mind to pay those prices for a Chinese company, when I could pay a much lower price for PAX? The truth is that I don't know,... I always thought that being a big known company it deserved a higher multiple. Now I am starting to think that in China, being a big company makes you more susceptible to the Government and really what you deserve is a lower multiple. Anyway, surely Alibaba will recover, but what is clear is that the prices I paid did not offer any margin of safety to compensate for the high political risk. Couple that with the company diluting shareholders heavily through SBC, and allocating its capital to money-losing projects for many years. I consider PAX to be a better investment with a higher margin of safety, although the prices at which Alibaba is trading right now are much more attractive than before. Alibaba was the perfect storm: political risk, VIE risk, bad results for several quarters, competition getting stronger (JD), government intervention....

4. Ignoring a fundamental change in an investment thesis.

When we buy a share, we are buying the cash flows that the company will generate in the future, and paying a price for them. Moreover, if the company decides to reinvest these cash flows instead of distributing them to its shareholders, it will be of great importance that it does so in order to earn a higher profit in the near future.

When Facebook announced its rebranding to Meta Platforms , Zuckerberg explained to shareholders that he planned to allocate a large portion of current profits to Reality Labs. That moment was a fundamental shift in Facebook's investment thesis. At over $300 per share, there was plenty of time to decide whether to stay on Mark's boat or sell and look for a better alternative. With increased competition from TikTok and the hit that Apple's privacy change had taken, coupled with the fact that earnings were going to decline for a few years due to the heavy investment in Reality Labs, I believe there was plenty of time to sell at high prices. In fact, I thought about selling, but did not. People always talk about investing for the long term, at least as long as the fundamentals remain intact, I think this is a clear case where the fundamentals were strongly deteriorated and I did not know how to react.

In an environment of declining sales, we have seen how Meta has oversized the company by increasing employees by 32%, SBC by 31% and increased Capex by 63% (Q2 2022 results). I consider that at this price it is no longer worth selling, and furthermore, we see the company starting to be more conservative (better late than never), but I consider that bad decisions were made.

In the long term (say 2030), maybe Reality Labs will eventually pay off, but it is clear that this investment was not made conservatively and protecting shareholder returns in the medium term. The company talked about the investment being made in a balanced way, and I don't think they have delivered on that. Personally I prefer that the capital allocation is not so speculative and can generate profits in the short term (see Berkshire, the capital allocation is always to acquire new cash flows at good prices).

5. Buying a company with low profit margin in a period of high inflation.

This was a small position, but I made some purchases of ASOS Plc at 2600-1500 GBX with no margin of safety and in a period of high inflation that was almost certain to affect its profit margin. It did. I also feel that at this price there is no point in selling it, plus I believe it is recoverable as international shipping costs have plummeted and the new management wants to recover the profit margin. Even though it is a small position, percentage-wise it has been the biggest drop.

6. Not substracting Stock Based Compensation from Free Cash Flow

Technology companies have a lot of Free Cash Flow, and that is because they pay a large part of the salaries of employees and management in shares instead of paying them in cash, and Free Cash Flow does not include non-cash expenses. To compare them with other companies that don't carry out this tradition, you have to subtract SBC from Free Cash Flow. Always.

It is well known that Alibaba has a program of 25B in buybacks for 2 years (12.5B per year), but SBCs are 7.6B (2021), so in the end, the net buyback is much lower. They buy back shares, but they also issue new shares. Is it good? Is it bad? Personally I consider it doesn't matter, just subtract SBCs from FCF to normalize it.

The same goes for Meta, Google and other techs (there are blatant cases like Snapchat). In both Berkshire and Markel (two of my new stocks), the SBC is zero every year, so one less problem to worry about, all buybacks end up being shares that won't be back in circulation.