The school of hard knocks

We learnt a lesson painfully. You can learn it vicariously.

Last December I wrote that ‘the risk of Specialty Fashion going under is uncomfortably high’.

I’ll save you the trouble of looking it up. Specialty Fashion has not only survived but its price has since risen tenfold. As far as looking stupid goes, this is world class.

If you’ve ever carefully rejected a stock to watch it tenbag in six months, you’ll know the feeling. But now I’ve come to terms with the pain of missing out it’s time to salvage a lesson.

Let’s start with the quality of information, which is probably the right place for every post mortem. What did I miss that would have improved the analysis and eventual decision?

My biggest mistake was in assuming that all Specialty Fashion's brands were tired and suffering from underinvestment. In so doing, I overlooked the value of City Chic. I also underestimated the company's capacity to offload its weaker brands.

How did I overlook this? The truth is that City Chic's success wasn’t easy to spot, as management kept each brand's revenue and earnings figures to themselves. They had little incentive to highlight its success as this would have drawn attention to how poorly Millers, Katies and the other brands were doing. But now they've sold the dud brands they've got every incentive to paint City Chic in the best light.

It takes imagination to pull on loose threads and spot earnings power that other investors have missed, but it takes x-ray vision to spot things that management are hiding. So even though I missed this I'm not kicking myself too much.

Next on the list is cognitive dissonance. When I valued Speciality Fashion at the time, I assigned a 50% probability to failure, 40% to a muddle-through scenario and a 10% weight to it tenbagging.

Even though the latter is what transpired, it's still hard to know whether my initial assessment was wrong. It's here that investing gets murky.

As much as anything, Specialty Fashion's surge may actually reflect how close it was to bankruptcy, as it's only the stocks that escape death's clutches that go up this much this quickly. 

But 50% may have been overdoing it. OrotonGroup had just entered administration when I made my initial assessment, so it's possible that I got caught up in the retail pessimism because of this.

The trouble with trying to fine tune these things, though, is that the outcome says nothing about the initial prediction. Even though Donald Trump is now President, it's impossible to say for sure whether Nate Silver's 70% estimate for a Hillary Clinton win was incorrect. Was the chance of Specialty Fashion ten-bagging about 10%? We'll never know for sure, and that makes it hard in our quest to improve as investors.

If you've got a view about my initial probability guesses, or the approach in general, I'd love to hear it in the comments section below.

Which brings us to the question of portfolio management. Even though I thought there was a small chance of a fantastic result, I steered clear because I considered the risk of a total wipeout to be too high. Doing so even when the weighted value was far in excess of the price at the time. An alternative approach could have dictated a small position size to counter the risk of failure. A 1% investment in a bankruptcy candidate has the same downside risk as a 10% investment that can fall by 10%.

Overall, this experience has reminded me of the importance of flexible thinking. I used to think that ‘conviction’ was essential for success but I’m increasingly appreciating its shortcomings. Like Richard Feynman says, a better approach is probably one of 'strong opinions, weakly held'. That way you can quickly adapt as things change.

Oh well. All in the name of improvement eh.

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