Two mistakes we made as portfolio managers – and what we learned from them

Is it easy for investors to predict the next winner consistently? We think not. That’s why we prefer to bet on the winner only after the race has started. That is, we only invest in a company after it has proven its business quality – the ability to generate superior business economics like high returns on capital.

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This approach has not only helped us land on some long-term compounders such as Constellation Software, Microsoft, and Games Workshop, but also led us to step into some quality traps, occasionally. Below, we are listing a few mistakes we made regarding quality-focused investing over the years.

Consumer brand in a crowded category

Premier Anti-Aging is an asset-light beauty product business based in Japan. With a clean balance sheet and a simple business model, the company generates most of its revenue from DUO, the #1 cleansing balm brand in Japan with 20%+ market share (vs. only single-digit held by #2) when we started to buy the shares. However, DUO’s success didn’t last long enough for us – very soon, competitors, big and small, initiated aggressive advertising budgets, which stole market share from DUO. To fight back, Premier Anti-Aging could do nothing but join the advertising war, which hurt profitability, while seeing revenues decline.

Thanks to the increasing prevalence of direct-to-consumer model and supply-chain outsourcing, the entry barrier for consumer goods has been significantly lowered – great for consumers, not so much for investors. Also, with the high penetration of social media in our daily life, consumer taste can evolve more rapidly than ever. Consequently, it becomes easier for “hit” products to turn out to be fads, meaning it becomes difficult for the next “Coca-Cola” to build a durable competitive edge through its brand alone.

In hindsight, we probably prematurely assumed the existence of any economic moat in a crowded consumer-product niche like cleanser. Notably, DUO built its top mindshare among Japanese consumers primarily through paid advertising, which is hardly sustainable. Meanwhile, the cleansing balm category was expected to grow at 15% to 20% a year, thus inviting competition.

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When investing in consumer brands moving forward, we would require a greater margin of safety and avoid crowded categories. Peter Thiel notes “Competition is for losers.” Partly due to a similar concern, we sold our investment in New Zealand-based A2 Milk – another consumer-product business lacking a solid moat in our opinion.

Cyclical business with high financial leverage

You may not have heard of Endor AG but its Fanatec brand is a household name among sim racers for game peripherals. Fanatec is the only enthusiast-grade brand focusing on a EUR 500 to 1,000 price-tag range, where very few competitors exist. Therefore, we did not face the competitive issue of Premier Anti-Aging or A2 Milk. However, the business model relies on selling expensive equipment that is high quality and durable, implying low purchase frequency even among the most loyal customers, and hence, a high degree of cyclicality.

We are not against cyclicals, but the management decided to lever up its balance sheet to endure supply-chain disruption and build a new headquarters (with a go-kart track on the roof!). High cyclicality plus high financial leverage turned out to be a perfect formula for disaster. A chip shortage lasted longer than expected, which led to a massive corporate crisis for Endor AG in the end.

In hindsight, we probably should have paid more attention to the management style and should have waited for additional evidence in the regard of capital allocation before buying shares. Even with a top-notch product, any business can fail without disciplined management. Warren Buffett muses ‘I try to invest in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will.’ This was not that.

Going forward, we decided to become even more conservative when it comes to cyclical businesses and financial leverage. In general, we would like to see the ability of a company to pay down its debt within one to two years using its operating cash flow. Along the same lines, we sold our investment in RH (RH-N), which had been aggressively levering up its balance sheet to fund share repurchase and expansion initiatives.

Fortunately, when we have been wrong, we have been wrong small. That is to say, the above scenarios were all generally sized as 1% positions in our portfolio – our lowest conviction weight. This is a conversation for another column, but we have two levers to pull when allocating capital: what to buy, and how much to buy. While we accept that striving for 100% success on either front is not realistic, we do wish to point out that when a given opportunity sports more yellow, orange or red flags, one should pay particular attention to sizing the position commensurate with the risk, valuation and upside/downside proposition in mind.

Jason Del Vicario, CFA, is portfolio manager at HillsideWealth | iA Private Wealth Inc. Steven Chen, MBA, is global analytics associate at the firm.

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