Some of the best investment decisions an investment manager can make is choosing not to buy a particular stock. Those decisions probably do more to improve long-term performance than any investment decision we make.
As I indicated in my last blog post, I’ve made hundreds, maybe even thousands of decisions over my 25 years as a professional investor – some good and some bad. I’m not afraid to highlight my lousy investment decisions because there’s always a lesson to be learned that makes me a better investor. A few weeks ago, I provided an example of a great investment decision that also turned out to be one of my worst investment decisions (see Netflix – The Best and Worst Decision I Ever Made).
And, since I’m not the boastful type, I don’t often use this blog to toot my own horn when I make a good decision unless it offers some instructional insight (see Apple’s Epic Stock Decline Turned Out to be an Opportunity). However, not all great decisions involve investing in a stock. Some of the best investment decisions an investment manager can make is choosing not to buy a particular stock. Those decisions probably do more to improve long-term performance than any investment decision we make.
That’s the value of having a proven investment process – to keep us from falling in love with a great company that looks solid on the outside but might have exposure to hidden risks. When based on in-depth research and analysis, decisions not to buy become teachable moments, so I thought I’d share a couple of those along with the thinking behind the decisions.
Buckle Inc. (NYSE: BKE)
You don’t have to be a financial analyst to know that the retail industry is really struggling right now. In recent weeks, some stores, such as Macy’s, are starting to reopen following the economic shutdown, while others, such as Neiman Marcus and J.C. Crew, are filing for bankruptcy. Either way, consumers aren’t flocking back to the malls. The retail space as we knew it might never be the same.
Before the COVID-19 crisis, we really liked Buckle, which shares the same space of American Eagle or Aeropostale, selling trendy clothes. They operate hundreds of retail stores, primarily in a traditional mall environment.
At the time, Buckle appeared to check all the boxes for what we look for in a great company – a cash-rich balance sheet, huge profit margins, a nice dividend, and no debt. As I do with all my ideas, I passed it along to my esteemed financial analyst, Frank Corbett, to run it through the cleaners to see if it was as great as I thought it was.
What he found was that the company no longer had the capacity to grow its revenue base – an essential characteristic we look for in a great investment. With its strong cash position, low debt, and the fact that its share price had fallen about 25 percent off its recent high, it had many of the earmarks of a great value stock. But, when a company can’t grow its revenue base, it’s nothing more than a value trap. There was risk lingering within that didn’t come out until Frank dissected the annual reports and management statements.
Since the end of 2017, when we made the decision not to buy, Buckle has underperformed the stock market significantly. While the stock market is up about 6 percent since then, Buckle is down more than 15 percent. That’s a 20 percent performance gap.
Southwest Airlines (NYSE: LUV)
Over the longer term, the airline industry has had its troubles, struggling mightily to squeeze out any meaningful profits. The industry had mostly been running at a break-even. But, over the last decade with operational changes, fee increases, and a general overhaul of their business models, the industry managed to turn things around, pushing out billions in profits. The airlines even caught the eye of Warren Buffett, who purchased significant stakes in all the major domestic airlines. Not just one, but all of them.
I liked one, in particular, Southwest Airlines, which many industry experts regarded as the cream of the crop. It was the most popular brand, the most well-managed, and they were perpetually profitable, even as most other airlines continued to struggle. Again, it checked most of the boxes as a great company. But, when Frank looked under the hood, he found that the company had been taking on an enormous amount of debt to buy its planes and fund its operations. We determined that, while it was a great company, it was not sustainable as a great investment. Eventually, the debt would catch up to them. So, even as Buffett was buying, we decided not to.
Since then, Southwest’s stock price is down 44 percent, while the stock market is down about 1.4 percent during that time. And, Warren Buffet, who typically buys when the market is down, has been unloading most of his airline shares.
Avoiding Catastrophe
Now, you could say that these particular companies were doomed as a result of the COVID-19 crisis – the retail and airline sectors have been hammered due to the economic shutdown. Who could have known that the pandemic would hit and obliterate these industries?
No one could indeed have foreseen these events. However, by following a research-driven investment process, you can know where there is an underlying risk that can make any company vulnerable during periods of severe economic distress. You want to avoid those companies because you can’t know when the next economic calamity will strike.
