Prior to starting Deep Knowledge Investing, I was one of two portfolio managers at Silver Arrow Investment Management. I was fortunate enough to have Raji Khabbaz as my business partner. Raji is a first-rate stock analyst and a fantastic investor. The best part of running Silver Arrow was the constant discussion and debates Raji and I had when trying to figure out whether a particular investment thesis was correct. He’s now a member of the DKI Board of Advisors and we talk about investing on a near-daily basis.
On September 12th, he’ll be the featured guest on the DKI subscribers-only webinar to talk about how to figure out if you’re wrong about an investment. It’s a complicated topic because sometimes, the right thing to do is to exit a position. At other times, the best move is to add to a position you like at a lower price. As a way to get the conversation started, I’m presenting three case studies from our time at Silver Arrow; one where we correctly exited quickly, one where we made the wrong decision and lost money, and one where we added at lower prices.
Skechers makes leisure and athletic footwear. By using backlog information and publicly available scanned sales data, we determined that analyst estimates for the company were far too low. In addition, Skechers was expanding into the huge performance running shoe market. I ran competitively for Warren Street, and the team was sponsored by Skechers. As a team member, I had been receiving Skechers’ shoes delivered to my apartment every time they introduced a new product line. The first few generations of running shoes weren’t great, but by 2014, Skechers was delivering high-quality product. It also helped that Meb Keflezighi won the Boston Marathon that year wearing Skechers. I was on the course “with” him. Ok – full disclosure: We were on the course at the same time, but I was miles behind the winners.
We were correct about the backlog and increasing demand, and as the company started to beat estimates and raise guidance for revenue and earnings every quarter, the stock became a huge source of profits for us and our investors. Because retail is a fickle business and the Skechers position had become large, Raji and I spent a lot of time talking about what it would look like if our positive thesis became wrong. We decided that the signal to sell was when growth slowed.
The day that happened, we were ready. Skechers announced earnings after the close one day, and we were glued to the screen. We instantly saw that growth had slowed and immediately sold the stock. Because we had the conversation on what to look for earlier, we were able to act quickly when our thesis was no longer correct. By the time the stock started to fall, we had already exited the position.
While we didn’t “top tick” the stock, we made several times our money in the name, and exited before the stock reflected the coming downgrades and reduced estimates. By knowing in advance exactly what we were looking for we preserved $SKX as one of our most profitable positions.
The TLDR version: We had a huge position when our thesis was correct and exited immediately when the thesis was no longer valid.
Brookdale Senior Living ($BKD):
The US is facing a demographic problem. The country is aging with a huge cohort of senior citizens entering the years when they are no longer able to safely live alone. Because the US tends not to have a lot of multi-generational adult families, more people are starting to enter assisted living facilities and nursing homes. Brookdale has a huge network of these facilities and we invested based on our belief in the company’s ability to grow earnings.
Despite a few quarters of excellent results that seemed to confirm our positive thesis, the stock kept declining. We looked into it and found that there was significant short-selling in the name on the thesis that pricing was falling. We looked into it, and Brookdale’s pricing for the prior quarter hadn’t fallen. In addition, we found industry-wide data showing that pricing in the US was stable.
While both of those facts were true, we were still wrong. Like most real estate, nursing homes and assisted living facilities are highly location dependent. Families prefer that their parents and grandparents are located within 20 minutes of their home. Even another few miles away could make the commute to see family members increase by another 20 minutes each way, and not everyone has an extra 40 minutes to allocate to a visit. While Brookdale’s pricing looked stable, that was historical information, not a guarantee of future revenue. While national rates were also stable, that turned out to be too general a metric to track. Brookdale was facing new competition in its specific markets, something that our analysis didn’t uncover.
The shorts were right and we were wrong. This became apparent during a quarter when Brookdale beat earnings estimates and didn’t raise guidance for the year. The company was implicitly reducing its guidance for the second half due to price competition. With proof that our investment thesis was incorrect, we did the only thing we could do; sold the position and took the loss. Almost a decade later, the stock still hasn’t recovered.
The TLDR Version: You have no way to know if you have a good or bad investment thesis if you’re tracking the wrong data.
Digital Realty Trust ($DLR):
We uncovered Digital Realty as an idea when a prominent hedge fund manager spoke at a conference and accused the company of being a fraud and management of conducting a Ponzi scheme. Digital Realty builds and manages data centers. The speaker was convincing, and it sounded like the stock was an excellent candidate for a short position.
When we started to do more work on $DLR, we realized the criticism was incorrect. The big fund manager claimed the company should be depreciating the computer servers in its data centers on a 3-5 year time-frame rather than the 25 years it was using for most of its depreciation schedule. He had made a huge error. Digital Realty doesn’t own the servers its tenants use. It owns earthquake resistant buildings made of concrete and the steel shelves where the short-lived servers owned by others sit. Some of these assets have useful lives of over 100 years.
Regarding the accusation of management running a Ponzi scheme, that relied on incorrect assumptions of how real estate investment trusts (REITs) are required to finance their businesses. DLR’s practices were both consistent with proper REIT accounting, and also standard industry practice. The entire short case was wrong.
Once we realized that, instead of shorting the stock, we bought a large position. Because the speaker was so prominent, he was able to do multiple media interviews, and each time he spoke, it took the stock down further. His efforts were further aided by the SEC requiring the company to restate earnings. Digital Realty was expensing a lot of small items instead of capitalizing them and recording future depreciation. Many investors sold immediately on the announcement of the restatement, but we understood the management team had been conservative in their accounting practices and would need to show higher earnings in the future. Still, both the negative accusations and the restatement scared investors and the stock continued to fall.
In this situation, we understood why the stock was down and the reasons the negative narrative was incorrect. We kept adding to our position at lower prices. After a couple of years of excellent fundamental performance, the stock rose by well over 150%, and Silver Arrow owned more shares because we’d been buying on the way down. Because we exercised a little patience, it became one of our top performers.
The TLDR Version: If you understand why a stock is falling AND you know it’s for reasons that are incorrect, the right move is usually to increase your position.
There’s a time to react quickly, and a time to be patient. There’s a time to double the size of a losing position, and a time to accept a loss. Either way, it’s crucial to understand what the narrative on a stock is, and know how your view differs from current conventional wisdom.
GB@DeepKnowledgeInvesting.com if you have any questions.
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