Portfolio management is both a science and an art. The science can be learned from finance professors and investment books. The art part, however, comes from years at the school of hard knocks.
Like every grizzled money manager who's attended that particular school, I've developed rules to protect me from myself. Some of them have a fundamental basis, some work for inexplicable reasons, and some are just plain superstition. All are hard to quantify and yet can often be more important than the data that's provided each quarter - revenue, profit, market share and management guidance.
Here are a few of my hard-earned lessons.
When a company makes a major acquisition in an unrelated business, it's time to reassess. Numerous studies have shown that such deals lead to lower profitability. And even when a newly diversified company executes successfully, the market often struggles with how to value it. Ultimately, the stock gets weighed down by the dreaded "holding company discount."
I think back 20 years to Imasco, which was considered to be a successful conglomerate. If it had stuck to its original business, Imperial Tobacco, it would have made a pile more money for shareholders. And if only Molson had stuck to beer.
When a retailer announces that it's expanding into the U.S., or has just made an acquisition south of the border, I start to squirm. One of the highest-profile debacles was Canadian Tire buying White Stores in the 1980s, but there have been many disappointments since, including Jean Coutu's disastrous purchase of Rite Aid.
Retailers that are building a state-of-the-art distribution centre or installing a new inventory management system also warrant caution. Getting products to the shelf is a complicated process and one that requires years of refinement to get right. Loblaw, which suffered from stocking issues for a number of quarters, is the most recent addition to a list of companies that stumbled badly during conversion.
I watch out for companies that report a pattern of earnings that is steadier than their underlying business. The longer that management smoothes the bottom line to meet Street expectations (yes, it still happens), the greater the risk of explosion. That's because when the news turns bad, the chief financial officer's hidden reserves are tapped out. The closet is full of skeletons, but the cupboard is bare.
Bombardier is a good company with a wonderful legacy, but when it was riding high in the eighties and nineties, its business, which is lumpy and erratic, didn't match up with its smooth earnings. Bomber's fall from grace in 2001 was harsh. Loewen Group, Laidlaw and Enron, all masters of managing their earnings, were also tough lessons.
When the commodity cycle is roaring and profitability is high, it's a good idea to avoid the empire builders. I'm referring to companies that use their bulging coffers to make large acquisitions. Nobody knows when a cycle will end, but we know for sure the buyers are paying fancy prices and will be carrying too much debt when the downturn hits.
I also steer clear of resource companies that are in that awkward stage between discovery and startup. When the focus shifts from proving up reserves to bringing the mine into production, the only news is bad news - delays, cost overruns and technical difficulties.
I'm also wary of companies in industries that are deregulating (a wide open field brings with it increased competition and lower margins), that are selling to low-quality customers that are losing money, or whose leader has recently been named "CEO of the Year." And I shouldn't forget to mention companies that put their name on sports arenas.
There are certain management behaviours that warrant close attention.
When the CEO of a company gets into a fight with an analyst or short seller, I get uneasy. During my analyst days, I had a mixed record on "sell" recommendations, but when management protested too much, I knew I was on the right track. If the C-suite is overly sensitive (think Biovail, Enron and Timminco), then there's probably something to be worried about.
I follow management departures very carefully. Over the years I've covered Extendicare from both sides of the Street and made good money on it. But when the CEO and CFO, for whom I had a high regard, retired within a few months of each other, I should have sold. The company subsequently went through a rough patch due to challenges in its U.S. operation.
In revealing my list, I have to acknowledge that it's hard to act on these warning signs. That's because art is less concrete than the science of formulas and spreadsheets. And in the back of our minds we know there have been exceptions to every rule.
But the older and more sensitive I get, the more weight I put on the soft stuff, because as the old proverb says, "Fool me once, shame on you; fool me twice, shame on me."
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