I’ve started an experiment where I’m keeping a public portfolio of large cap stocks via the Motley Fool CAPS system- you can view it here. I would like to see if I can generate value on the long side… something that I find much, much more difficult than shorting.
My criteria are:
- Pick only the quality businesses in a particular sector. For example, Dollarama is the clear leader among discounters.
- Not overpriced. For that reason, Amazon and Netflix don’t make the cut (just look at what happened to Amazon during the Dot-Com Bubble).
- I avoid industries where there are no clear industry superstars. Oil and mining stocks simply don’t make the cut as none of them are quality businesses.
- Lastly, I avoid dying or shrinking industries. Profits ultimately don’t grow in dying industries and therefore those stocks almost never do well.
Human beings are wired to hold self-serving beliefs about the world regardless of the accuracy of those views. While it is easy to see these tendencies in other people (e.g. flat earthers, Donald Trump’s anti-vaccination views, conspiracy theories), all human beings are wired to have blindspots when it comes to the inaccuracy of their own views. Why? Ideologies are often arbitrary but they serve social and political purposes. Nelson Mandela was once on US terrorism watchlists; nowadays, he is celebrated as a freedom fighter and human rights activist. Clearly, it’s not possible for Nelson Mandela to be both a terrorist and a hero. Yet, society conveniently ignores conflicting evidence when it distorts history to fit a particular political agenda. My theory is this: human beings participate in the mainstream ideology when it benefits them. When it doesn’t, social outcasts and misfits band together to form their own alternative ideology that benefits them. In both scenarios, the ability to ignore, downplay, and dismiss conflicting evidence lessens the mental burden of upholding a particular ideology.
The most disappointing thing that I’ve learned about short selling is that identifying frauds and scams is not as consistently profitable as it “should” be. Identifying frauds actually isn’t the hard part. The real issue is that fraud isn’t symmetrical. While fraud reduces returns on the long side, actually making money by betting against fraud is much harder than it seems. Here are some reasons:
- The wealth isn’t exactly transferred from the longs to the shorts. Short sellers have to pay money to borrow shares. Much of the profit from short selling ends up in the hands of brokers, who earn large fees from lending shares to short sellers.
- Short positions tend to be correlated because of the way they are marketed. The parties lending out shares tend to be institutional investors who fall prey to the marketing tactics of small investment banks. Being unable to ride out market conditions can cause short sellers to lose money.
- Worthless companies often get taken over. There is always some rich person or misguided CEO that will throw money at a fraud.
I’m aware that there’s information on mining stocks from guys like Angry Geologist, Exploration Insights (Brent Cook and Joe Mazumdar) and investment bank analysts with mining degrees (P.Geo, P.Eng, etc.). The danger is this: just because they CAN perform due diligence doesn’t mean that they ACTUALLY perform due diligence. I don’t mean to be disrespectful to these people. (*I do understand that I am attacking their credibility.) However, they often come to conclusions without having access to key technical data. For example, Simon Dominy and Strathcona have unique views on Pretium’s Valley of Kings deposit. They had access to all of the sample tower data, including the sample tower data on the Cleo vein. Strathcona had access to the drill core so they could make their own interpretations about the lithology (Wikipedia) of the rocks and therefore the appropriate geological controls. If you don’t have access to accurate lithological information (e.g. pictures of all of the drillcore), then you cannot build a reasonable resource model. Insiders have this information. The investing public doesn’t. When mining professionals make conclusions without access to key technical data, you should take their opinion with a grain of salt.
Secondly, one should question an analyst’s optimism about deposits. With the benefit of hindsight, we can figure out that mineral exploration has been a disaster since 2000. Past optimism about exploration stocks seems quite dubious with the benefit of 20/20 hindsight.
While I haven’t spent the time to piece together all of the data points, it is clear that high-risk mineral exploration stocks have found very few profitable mines since 2000. The only reason why junior exploration stocks haven’t been a complete disaster is because senior miners have thrown away money by acquiring uneconomic projects. The majority of “value creation” in high-risk greenfield exploration can be attributed to poor investment decisions from senior miners rather than the meagre cash flows from mines like Arista, Bloom Lake, and Legacy (potash).
The conventional investing wisdom is that owner-operators should outperform since management has a lot of skin in the game. In the case of WWE however, that’s not the case at all. Vince McMahon, the CEO, does what he wants with his company and has left a lot of money on the table by interfering in his own business. WWE’s shows are fairly cringeworthy because Vince McMahon insists on micromanaging the creative, sometimes even writing dialog himself.
But it’s not just Vince McMahon who does this. One reason why Vince ended up with a quasi-monopoly in the wrestling business is because his competitors were even more poorly managed. The lesson is that some (but not all) human beings will interfere in their own success. It’s like hiring a brain surgeon and telling him/her how to do brain surgery. Some people will engage in dangerous meddling rather than stepping aside to let competent people do their job. These behaviours are likely hard-wired (nature rather than nurture). While the detrimental effects of counterproductive micromanagement will eventually become obvious, some owners will repeatedly continue their mismanagement regardless.
US health insurance stocks have performed extremely well. Even if you had bought the worst ones, performance would have been similar to the S&P 500. Why?
While the overall US healthcare system is dysfunctional relative to those in other developed countries, a broken healthcare system doesn’t explain why insurance stocks have done better than hospital stocks. While hospitals engage in abusive practices such as surprise out-of-network medical bills (balance billing), hospital stocks have been mediocre investments. A better supported explanation is scale. One manifestation of scale is in dialysis treatment, a unique market where Medicare is the biggest negotiator with at least 90% of patients. Commercial payers, with their lack of scale in this situation, are charged many times what Medicare pays. SIRF’s analysis puts it at roughly $1,050 per treatment versus $250. Of course, no health insurer enjoys 90%+ market share so their scale advantages are smaller.
Here’s a look at how market cap (a proxy for size) correlates with return on assets: