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Friends,

Because confession is good for the soul, each of us should review our biggest investing mistakes of the last year and then share the ghoulish details on this discussion board.

No need to write the Great American (or in Jim G's case, Canadian) novel; just identify the company, your initial thesis, what went wrong, and how you intend not to repeat the mistake again.

Sometimes, of course, problems come out of left field. But I think we cause most of our own problems. ("The fault, dear Brutus, is not in our stars, But in ourselves, that we are underlings." --from Shakespeare's Julius Caesar)

In looking over my bad decisions, for instance, each resulted from veering away from my well-defined process of 1) vetting earnings power, 2) making sure there is a durable competitive advantage, and 3) buying at discount to intrinsic value.

Buying and selling stocks is not for people who are afraid of making mistakes. On the other hand, there is no glory in making the same mistakes over-and-over. So let's see if we can improve our game by making a few investing resolutions for 2006.

My portfolio autopsy will appear on these pages in the next few weeks. I hope you will consider doing the same.



Hewitt
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buying at discount to intrinsic value.

Does this imply you bought above your calculated intrinsic value or you miscalculated. If the stock goes below the calculated intrinsic value do you buy more or sell?

making sure there is a durable competitive advantage

We both apparently own AEOS, however, I can see no competitive advantage whatsoever for this company when compared to ANF, URBN, CHS, just to name a few. I just think its cheap. Where do you see a competitive advantage?

As for my mistakes, the biggest problem I had in 2005 was straying from my methodology which had been producing 30% CAGR. I bought a stock on one of the newsletter recommendations and blindly trusted the opinion of the picker that this reinsurer was a great company, with Buffett-related management and its moat was growing. Blind faith led to thousands lost when I knew in my head this was not my type of company. I'll make my own mistakes from now on.

ab


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I made 2 mistakes this year that I feel I should not have done.

1.) In January I sold covered calls on my ADBL position when the stock was at $28. The call expired worthless and the stock now trades at $13. In addition to this, I let ADBL become a huge position in my portfolio. I sold 40% of my position at $20 in December, but the rest became as much as 35-40% of my portfolio in January. Instead of trimming the position, I sold the calls to get income, which, yay, I made me $1.40 while losing $15 on the stock. This single position accounted for a huge hit to my portfolio, and I had been in the red all year until yesterday when I finally crossed back into the black!

2.) In November 2004 I found a very interesting small company, recent IPO, in a "hot" space. The company was cash rich thanks to the IPO, and growing pretty quickly. I bought an initial position. In February I doubled my position. I ignored things I should not have ignored like concentrated customers, high churn among subscribers, shareholder unfriendly management, and a fairly large acquisition which seemed to be moving the company in a direction they had no experience in. They reported not so bad numbers in April, but decided they were no longer going to talk to analysts between calls, so don't bother calling. They refused to answer questions. Analysts on the call were speechless. The stock plummeted about 40% in a day, and I sold right near the bottom. The company is Intersections, INTX. They do Identity Theft Monitoring. I originally bought at $12 and $14, I sold at $8.75. The stock then proceeded to go back to $12+ before their most recent earnings announcement which included the loss of their number 1 customer, and it's back to $9. I should have 1.) not gotten frustrated and sold at the bottom, but really 2.) not bought in the first place as the signs were pretty evident with high churn rates and renegotiated contracts. It might be worth a "trade" here if they're able to renegotiate the lost AMEX contract at a lower rate, the stock might get a small pop. But I'm done with it now!

Off my chest!
Cameron
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Hello Gents,

Well if confession is good for the soul, then I suppose this is to be cathartic.

Actually, I'd consider a 'macro' issue of mistakes, in which I can tie back each one to being too cute with the timing. Or, as TomG is fond of quoting Buffett - "I would have made a lot more money if I never sold a share."

To whit:

1) Very similar to Cameron's story. Company is CryptoLogic (CRYP). Bought a good chunk of the stock when it was dirt cheap (long before it was an HG recommendation). Won't regale you with the story, but, if interested, it's written up at the following link (you'll need to be an HG subscriber to read it): http://boards.fool.com/Message.asp?mid=22558878

When I loaded up on CRYP, I bought about 1/3 in my RRSP (Canadian retirement account - grows tax-free until retirement or age 69 - but you pay full taxes upon withdrawing any money - no capital gains tax credits) and 2/3 in my $US cash account. Flash forward to earlier this year. My upper valuation on the stock was $35, a 10-bagger for me, but it was now an unwieldly 35-40% of my portfolio. I decided that would try to rebalance a little, but, to avoid taxes, I targetted the portion in my RRSP for pruning. Like Cameron, I chose to sell calls on those shares (in a bit of humour - I sold the $35 Oct05 calls for $3.50, when I'd paid $3.35 for the shares...) rather then sell the shares themselves. Stock got hit on the threat of a customer defection, and a $35 stock tumbled as low as $15, although it's back over $20 today. I still own the shares, although they're not as much of an overhang on my portfolio, for obvious reasons.....


2) Conversely, I sold calls on a company that I thought was looking overvalued, and that had already been a near 5-bagger for me in fairly short order. Company - Quality Systems (QSII). Purchased for $13 in July 2003 (all numbers post-split), then paid special dividend earlier this year of $1.50. Stock then goes on a tear. On Dec 31, a $29.90 stock doubles by May. In valuing the stock, I can't get a value > $55 under but the most optimistic of assumptions. Sold $55 Dec05 calls for $4.40, figuring that, if I do get called, I'm getting more than my high valuation.

Only problem is, the stock didn't listen to me....

Now flirting with $87, the fact that it's now grossly overvalued (or would someone like to spin a P/S of 11, a P/E of 58, a EV/EBITDA of 33, a EV/FCF of 60 and an P/FCF of 64 in a more postive light) doesn't change the fact that I'm smarting from leaving a further near 50% on the table.

The message here is, don't get cute Jim, and let your winners run (and employ covered call strategies as simply that; an income strategy, not a finesse strategy for high flyers. Remember, you can lose your shares...

Original 'overvalued' thesis written up here:
http://boards.fool.com/Message.asp?mid=22527883



3) Sold AWGI and NVR on days when I shouldn't have (I'd like to say emotion didn't play a factor, but I'd be lying). NVR I sold too late, as I'd put together a write-up on why it was time to get out (ironically, before I put together my IETC write-up up-board). And yet, I didn't sell; told myself I'd wait for the next earnings release.

Moral of the story - when you've made a well-reasoned decision, act on it, don't get greedy.

3a) Sold AWGI because they got a less-than-clean auditors opinion, which is one of my immediate red flags. Turns out it was new SarbOx related, and not a big deal. Should have held for another few days. Opportunity cost-wise, I'm actually further ahead here, since I redeployed the AWGI money (sold at $12) into more GRMN (bought at $42), but I just hate that I sold for a trigger-happy emotional reason.


Mea Culpa.

Cheers,

Jim
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Jim,

there seems to be a contradiction in your post that I struggle with as well. We want to let the winners run but at the same time lament not selling after stocks have come down. I think I can live with this confliction as long as the winner has not become such a huge portion of the portfolio. I think I need to employ a more structured approach and start trimming if a winner gets to 25%. I did this with ADBL but then it went up another 50% from where I sold and and I didn't want to sell any more in case it continued to go up. The alternative is to sell in the money calls, perhaps $20-$25 ADBL in my case and $25-$30 CRYP in your case.... thoughts on this?

Cameron
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Hey Cameron,

Yeah, I realize it's sort of a riff on Will Rogers' "Buy stock that goes up. If it doesn't go up, don't buy it."

I think a quick-and-dirty solution might be to divert some of the money received from the call sale into a long put, out-of-the-money, but not too OTM (maybe $25-$27.50 for my CRYP). It least you've collared your downside (and I say this as someone who hates the idea of buying 'protection', since, theoretically, I should sell outright if I trust the courage of my convictions).

Selling the ITM calls - $25-$30 in my CRYP case would have given me a higher payday, but, looking from today's perspective (the calls expired in October) I'd still own the shares, though I'd have a few more dollars in my pocket. Why did I not sell ITM calls, versus ATM calls? I think (entering Hewitt's confessional again) that there was still some greed there, and, at least a part of me, was hoping that the shares weren't called.

I work at cross-purposes apparently. Something to address in 2006.

Cheers,

Jim
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I didn't do much this year, mostly maintained a holding pattern.
I had invested in a couple school stocks and sold them in the first part of 2004, because they seemed really expensive and the charts looked dicey. They had been selling for 40-50 x earnings for quite a while, and that game seemed played out.

The group came down quite a bit and several of them were in the headlines for all the wrong reasons.
In May I bought EDMC (not one I'd owned previously) after it had drifted down to 28 from 35 and was selling for about 25 x. It went back up to 35 but then started to drift down so I sold it at 33 after waking up one day and realizing that the school stocks were so 1999 (or '95-. if you had APOL) to 2004, and it was 2005, so get out and wait for the trend to change.

The one thing I got out of Michael Covel's book Trend Following is that trends last longer than you think they will. The school stocks ended in 2004 and buying EDMC was one of my Big Misteakz. The other was not buying GOOG. Which was also a misstep in 2004.

VS
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My 2 cents, fwiw......my mistakes almost always fall in the category of holding onto losers too long. I have not learned to cut and run. Fortunately, I have seldom added to a losing position.
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my mistakes almost always fall in the category of holding onto losers too long.

Echo that -- APOL (went from way up to even now).

Have you ever calculated what holding those losers cost you v. what letting winners run gained you? Although I'm a serial holder, I think I've come out ahead because of my inability to pull the sell trigger either way.
Fool on!
Tim
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good thoughts, thou I have a different take. On the covered calls, I've learned the hard way that it's critical that I keep reminding myself that the two positions are seperate and distinct from each other. I've often said most of us treat a covered call like we just nailed our foot to the floor. If it starts looking like you should get out of the stock then get out... and either roll with a naked call write or close it too. The trick is to focus on the equity as if the call didn't exist... if I'd sell the equity absent the call I need to sell inspite of the call.

On the letting losers run thing... I wrote a short time ago about the importance of buying more at lower prices.
http://boards.fool.com/Message.asp?mid=23049200
All those "I let my loser run" stories have a common thread. It's the "it went up after I sold" thread. Just think if you'd averaged down on an equity. When they're back to even you're a big winner. One of the biggest mistakes I've made over the years is not having faith in my valuation when the short term winds blow cold. The best moves I've made this fall were buying like a wild man into the late Oct weakness. BSX was one and HMB was another... and buying into the weakness with faith in the valuation makes both positions winners right now.

The biggest mistake I made this year... and most every year is anchoring in on a price. Either it's the price of my initial buy and I'm unwilling/unable to buy more down the road when a get a second chance at a somewhat higher price (witness GRMN twice this year)... or... it's refusing to begin buying or selling because I have too specific a price target.

happy T day
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Mistake 1, I lost a bit on Agilent. This was a holdover from buying based on a strategy I didn't properly understand and then not following the sell signal. It was a more of a momentum approach that didn't fit me well. It worked well for my friend, but it is not for me. I finally saw the light and understood I did not know the value of this company and sold it for a good sized loss. It immediatly went up but I felt good about it as I didn't understand the value of the company.

Mistake 2, I don't know if this is a mistake or not, but BMW port is doing badly. But I believe this will require patience. I will buy more when I get more money in that account. I don't believe I have done badly because I did improper analysis yet. I think it will just take time to turn the ship around. I own KO, WMT, PFE, BUD and not exactly BMW stocks like DRL and NYB. I have a lot of patience and I think it won't be a mistake to hold.

Mistake 3. I bought into BRK and sold at a fairly small loss soon after realizing I wanted to be more active in picking my own stocks. Silly thing to do. It was a great value, but I think the BMW method will do better.

Mistake 4. Became impatient with QCOM and ARMY, sold too early. I feel justified with ARMY because the earnings were dissapointing to me. But here I through the baby out with the bath water and didn't pay enough attention to good earnings QCOM had.

Mistake 5. Bought QLTI without very little research and it is down big. I seem to have to learn this lesson every year. Maybe I have to cut losses here or devote more time to understanding the company better.

Overview:

Philosophy needs to be followed and worked on.

I am patient with BMW stocks (overconfident?) but not as patient with my own buys as I have less confidence in my reseach.

It has been a great year though! If things hold I will have done well for two years. So far it seems worth it to do my own

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Interesting thread--maybe after a few more confessions we can start some discussion on the patterns reasons and cures of the various investing sins

I think of them as sins of commission and sins omission.

A sin of commission


The long sad tale of Boston Scientific or never bet against the shorts

In the summer of 2004, BSX ran into some manufacturing problems and the stock price went down rather dramatically. My sad history with BSX extends even further back than that, when I bet on the JNJ stent and passed on purchase of BSX. BSX grew rapidly on the promise of Taxus and JNJ treaded water at multiyear lows. As Taxus gained market share, BSX shares reached all time highs and my JNJ shares stopped treading water and did the dead man's float. I was bitter and primed to jump on BSX shares at the first sign of weakness.

That miracle happened in the summer of 2004 as BSX had a recall due to manufacturing problems in Ireland. The manufacturing problem appeared to be easily fixable and it was. The shares had dropped into the $30s from the mid $40s. I decided to open a synthetic long, anticipating that the resolution would send the shares back to the mid to high 40s and my $37.50 calls would soon be in the money and the put writes at both $37.50 and $35 would never be exercised.

I was right for a week or two and the stock went up, my calls were in the money and nicely appreciating and the profit from the puts was in the bank. Life was good.

A talking head from CNBC was telling Maria and Joe and Ted that he was happily shorting BSX at the time and looking forward to big returns. I couldn't and didn't believe it. Here was a great company, experiencing rapid growth with an incredibly successful product recovering from a temporary problem and he was shorting them? What an idiot! Well, he was right and I wish I could remember his name. It was brilliant move in retrospect

BSX was a company undergoing a massive reversal of fortune from a mediocre medical device maker to a glory growth stock all due to huge saled of the Taxus stent. But it couldn't last. At $46-- an all time high-- they were priced for perfection. What Mr. Short realized that I did not, is that any sign of weakness in Taxus would send them back to more realistic prices that reflect the nature of the lackluster catalog of medical devices and the weakening growth of their one wildly successful prduct. They were in essence a one trick pony and I didn't see that. Taxus had doubled the revenue and as such, Taxus would be the downfall. I was not careful about considering the competition from a powerhouse like JNJ and incursion into the market by well respected companies like Medtronic. Taxus' hold on its market share and its ability to sustain the BSX price per share were tenuous.

The puts at $35 were exercised (thank the gods the $37.50's had expired) and I paid a basis of $34.70 for 300 shares of BSX--a stock that later became famous for reaching new 52 week lows on a daily basis. Its hard knowing you paid $34.70 for a $22 stock. The calls of course expired and I did not sell in time while they were in the money. The expense of the calls left me with only 30¢ in profit from the puts.

But the sad story doesn't end there. Seeing lowered guidance and admission that Taxus would continue to lose share from management, I decided there was no catalyst to drive the price much higher in this fiscal year. And I sold $25 November calls for 60¢. Couple that with the really gloomy market in October, and I felt these were safe--safe from exercise I mean. Because in spite of the poor performance of BSX, I think the company has some promise of recovery and I am not going to sell. I just want some cash for holding since they pay no dividend.

Things were going swimmingly right up until the day before expiration. BSX was at a high of $24.95 the Wed before expiration. Cutting it close but that's all I needed. Then on Thursday, there was an inexplicable jump on heavy volume--no news, no new guidance--just a jump. Short squeeze? Buying shares to cover naked $22.50 calls? BSX went up to $26.10. I didn't get exercised on Thursday, but Friday brought more upward price movement and I grudgingly closed the position and bought the calls back for 25¢ more than I sold them for. More heartbreak.

The only way it would have been worse is for the damn company to drop this week. So far they are up to $26.45, so buying back the calls has been profitable. Didn't care to sell it for $25. With my luck with BSX, I am positive they will drop back to $22 soon.

The lessons? Never pay a premium for a one trick pony that has world class competition nipping at its heels
Don't sell puts if you don't want to own the company
Don't let in the money calls sit and wait for expiration--jump on reasonable gains
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I bought a stock on one of the newsletter recommendations and blindly trusted the opinion of the picker that this reinsurer was a great company, with Buffett-related management and its moat was growing. Blind faith led to thousands lost when I knew in my head this was not my type of company. I'll make my own mistakes from now on.

That company would be Montpelier Re, which I also own. Although my position in MRH is down as well, I am not sure that the verdict on the company has yet been delivered. While certainly the loss of a huge chunk of the company's equity in a single storm puts managment's approach to risk diversification in question, the nature of re-insurance will always be that even in a well run company many years of profits will be periodically interupted by a horrendous year. Thus, the owner of a re-in company stock must be willing to ride out the business cycle. What Katrina hammered home to me is that the relatively low P/B for MRH existed for a reason - the risk of the business and the risk that the company could be driven out of business.

Even after Katrina, MRH is still up from its founding in 2002.

Rog
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Hi Hewitt-

Perhaps it's because I'm afraid of the Montpelier Re folks that I've been reticent to post here.

My biggest blunder, bar none, this year, was one that I actually got off relatively clean on. I owned DNT, which was a subordinate class of debt paying 8.25% face through 2039 for ..... Delta Airlines. Par for DNT was $25 per share. I bought it at a little more than 7, so my yield to maturity was...29%, payable quarterly.

I bought on the day that the pilots union agreed to all those billions in salary concessions, after the security had risen 75%, from 4. In the next few months the shares rose as high as 14 following the refinance from GE, and I got 3 separate payments of $0.51 per share, which helped. But I failed to consider two things.

First, even though I was clear on the fact that I was betting that the price offered overstated the chance of bankruptcy, I still was very aware that Delta was a pretty unhealthy company. But I did not count on oil prices rising as they did, and staying high. Oil prices destroyed Delta's chance to recover. Of course, this is the equivalent to the small cold that kills the cancer patient. I started playing speculator with oil prices, rather than recognizing that I had no ability to predict and cash on the line in a security that would be impacted badly if I were wrong.

Second, and more damning to my own analytical skills, I completely failed to consider the entire capital structure of Delta. It has two senior classes of debt to which DNT was subordinate. But more importantly, all of Delta's assets are pledged as collateral to bank debt and other financing tranches, so the second part of my investment in the company -- to get in line in the event of bankruptcy, was completely off. DNT holders are likely to get something when Delta emerges from chapter in, oh, 2 years, but the value of that is something like $3 per share, not $5-6 like I originally calculated.

And most of all, recognizing that I had gotten it wrong and knowing that I didn't have a clue what oil prices were going to do (they were at $50 and the company was saying "we can't meet our costs at prices over $43), I didn't sell. Rather, I watched DNT drift from 14, through 10, down to 5, where I finally unloaded it. Including my coupons, my losses didn't exceed 15%, but I earned every penny of them.

Interestingly, the security still trades as DNTNQ, is accruing its coupons, and trades...at $4.65.

Best regards-
Bill Mann
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I bought Sandisk after their initial slide at right around $25. I hadn't done a lot of research but my thesis was simple, they owned all the patents and such for flash memory, it was a huge and growing industry and they had a wide moat. The controlled their own pricing and were growing well. I sell their product all the time, understand it front to back. Buy what you know right? I know this product like the back of my hand.

But at that time I didn't have a lot of faith in my ability to chose stocks, and from the articles I'd read it looked like they were being overly generous on stock options. Also I was a new member to the hidden gems community, and didn't want to own stocks that I couldn't talk with other investors about.

So I sold at break even at about $25, a couple of weeks before they started their ascent. The funniest thing about it is how now that the stock has gone up so much people are calling them one of the world's great companies, a growth blue chip where the sky is the limit.

Wish I heard more positive reinforcement when the stock was going no where.

Oh well live and learn. I'm still young in the investing game so I forgive myself some mistakes.

Moving on, is it just me or do most of the mistakes that have happened in the last year revolved around over complicating the game of investing? Covered calls and puts and options and whatever else are starting to seem to me to be a game that people play when they are too smart (not being sarcastic) for their own good. I have the utmost respect for most of the posters in this thread.

Why make it so complicated when we can just wait for fear to drive down the prices of good stocks to a point where even I can figure out in five minutes that the numbers look good? (I.E. Tom E helped us located a watch list stock, MTLG that was down 50%, growing at above 15% and selling at a P/E of 8 when I bought.) Buy and hold, lather and repeat.

I say this not to rub salt in wounds, but to try to get to why I think Buffett has been so successful. He is incredibly intelligent, but doesn't allow his intelligence to over complicate/ over analyze things.

The ideas that have worked out the best for him he infers were the most obvious. I'm trying to be patient and wait for the obvious, which is is the simplest, but also hardest thing to do. The smarter we are the more we want to constantly play the game. The hardest thing I've had to learn is to wait for the fat pitch.

For me the lesson I have learned is to be patient for appreciation, and to believe in myself enough to not sell just because the stock isn't going anywhere and the crowd must know something I don't.

Jeremy
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I think understanding the domino potential of the quality of debt is extremely difficult. One has to be willing to read through a lot of 8-K's to get whether the company teeters on it's debt-to-capital fulcrum or has reasonable and safe leverage, even though the debt/equity or cash ratio may be identical. Standard price, income, earnings, cash flow, economic ratios and earning ladders fail to account for or display the consequences of missing criteria for staving off the dogs of debt calling in obligation.

Katrina's effects on Montpelier Re include not only the loss of equity but also the financial obligations incurred by the company to maintain capital/reserving ratios in order to be able to borrow at reasonable prices and to hold off lenders who could have otherwise forclosed.

US based airlines go bankrupt with such regularity that I have to believe there is virtually no scenario in which I would invest in one, directly or otherwise, including Southwest and JetBlue. What will happen to oil prices if Iraq's civil war spills into Saudi Arabia or Hugo Chavez decides Venezuela isn't going to sell oil to the US for a year? Doesn't seem worth the risk.

Rog
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Bill -

1. Case study #462 is why selling is much tougher than buying.

2. Henceforth this is a "Montpelier Re-free" discussion board. Feel free to visit again. You are among friends here.

3. I really am working on "My Mistakes of 2005" list and will post it soon.

Best,


Hewitt
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Well put, Jeremy!


Hewitt
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This year has been (thankfully) pretty mistake-free for me. Yay! The one big mistake was buying a small float pink sheet issue (STHJF.PK)and not checking the price history. Almost immediately, it tanked over the next several weeks to between a 30-40% paper loss. It's purely a small, speculative investment that may still pay off, so I'm not sweating it, but it annoys me that I missed this factor.

--Anthony
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Not buying more Blue Nile when it dropped to $25-26 earlier in the year when rising diamond prices weighed on investor confidence. I didn't pick up on the fact that engagement ring buyers would spend the same, just select a smaller diamond.

Mike

p.s. I don't entirely agree Hewitt on the valuation now

Consider this: If Blue Nile grows 29% a year for the next 5 years (matching analysts' forecast), 15% a year during years 6-10, 5% during years 11-20, and then 3% during the terminal period, its real, or intrinsic value, is just $44. At a current price of $41-$42 a share, this leaves you little margin of safety in case of miscalculation or bard luck (Ben Graham's words.)

I think DCFs don't work too well in the case of rapidly growing small/mid-cap shares. Tom Gardner has pointed to a couple of reasons why ( on the MPX and QSII boards ):-

(1) These type of companies are investing in their future and hence current FCF is depressed due to currently high capex. FCF may grow faster than earnings in the future.

(2) Terminal rates of 3% may not be valid. The high growth period could be much longer. Clearly Blue Nile could grow faster now if they invested more in advertising, but they choose not to opting for long-term sustainable growth.
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Hi Mike,

It's a cold, Ontario night, and I'm writing this during play-breaks in a Toronto Maple Leafs/Dallas Stars game, so apologies if it comes off as a little disjointed....


I think DCFs don't work too well in the case of rapidly growing small/mid-cap shares. Tom Gardner has pointed to a couple of reasons why ( on the MPX and QSII boards ):-


Yes and no. The dirty little secret with DCF's is that you can obtain any value you wish to, simply by altering the inputs. In the case of Hewitt's NILE valuation, he's not going terminal 3% until 20 years out. I don't recall his discount rate, but from a present value perspective, 20 years out is not greatly contributing to the overall valuation. (And we'll ignore the fact that it's often a mugs game to forecast beyond a year or two, since errors multiply upon errors).

But DCF's work great in helping you avoid silly investing mistakes with the caveats of: Their use is simply as another (rather powerful) tool in the arsenal, and employing ever-more enthusiastic assumptions in the DCF to justify current or marginally higher stock values is done at the modeler's peril.

The problem with DCFs exhibited very well in 1998-2001, is that people kept on justifying those assumptions higher. I know that you read the exchange between Tom and myself over on the Stock Advisor QSII board, so I'll refer you back to the discussion of CSCO and sustaining high valuations over a long period of time as proxy for justifying QSII's similar high current valuation. Forgetting the crazy years of 1999 and 2000, if you simply go back to CSCO's July 1998 fiscal year-end and measure from there you've made roughly 2% annually for the last 7 years. Why? Because a rich valuation of around 70x FCF for even a 'premium' company such as CSCO was simply too much, even as they delivered (and continue to deliver) stellar returns. You can go back to 1998, 1999, and 2000 and find DCFs showing why CSCO was overvalued at that point in time. You can also go back and find a lot of justifications that "this time is different" and "value is more than a DCF".

Although I know little about NILE, I consider myself (perhaps erroneously) to be very well-versed on QSII. And when I have to assume 35% growth for 7 consecutive years to justify today's price - well then I don't think there's any serious fashion in which I can claim a margin of safety.

Another perspective is to consider the return you're seeking from your investments, and then to consider what your company must do to justify that return. Hewitt does this with his Croesus Test, and I've put together what I call a Reverse Thumbnail. Again, not to highjack a NILE thread, but looking at QSII in this light, assuming you wish to achieve a 15% annual return over the next five years, and that QSII will deserve a 35x P/E, you need to grow earnings nearly 29% per year.

Much like changing your assumptions in a DCF, you can, of course, start to equivocate; saying QSII in 5 years will surely justify a 40x or 50x P/E, or that you'll be satisfied with only an 11% or 12% annual return. But the end point is the same. I see with QSII what I suspect Hewitt sees with NILE; a tremendous company firing on all cylinders, but a company that must have so many things fall right, that there is little potential for market-beating returns from today's share price.

Cheers,

Jim
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No. of Recommendations: 4
Mike,

Some of life's lessons:

1. Avoid hotel rooms near elevators and ice machines

2. Never ask a woman when she is due

3. Do not overpay for growth

To learn more about lesson #3, I call your attention to this excellent article by Morningstar's Haywood Kelly:

http://news.morningstar.com/doc/article/0,1,143859,00.html?_QSBPA=Y&pgid=seo

In a sentence, few companies are able to grow at high rates for long, Kelly finds. Therefore, do not habitually pay a high multiple of future earnings.

You are welcome to share your assumptions on Blue Nile (NILE). This discussion board welcomes variant perspectives, and it also welcomes opinions supported by sound analytical reasoning.

A few weeks ago I read a story on the culture at Google (GOOG). One item that made an impression was how new hires quickly learn that saying "I think..." is the equivalent of asking a woman if she is pregnant. Don't do it. Instead, say, "The facts suggest..."

Let's all try (me especially!) for lots of "the facts suggest..." comments on this site in 2006.



Hewitt


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Let's all try (me especially!) for lots of "the facts suggest..." comments on this site in 2006.

How about "the reason(s) I think...."

RWS
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Jim writes, between power plays:

The dirty little secret with DCF's is that you can obtain any value you wish to, simply by altering the inputs.

Exactly. If you want to have some fun, go to www.valuepro.net and check out whatever stock floats your boat or bails out your goalie. You can change the growth rate and recalculate the intrinsic value. You can't alter the discount rate (wacc) and I don't think you can alter the nopat, although I could be wrong on this last point.

Some of the default growth rates are quite high, often 30% or higher.
I think it was Buffett who said that companies just don't grow faster than 15% for long.

The default growth rate for QSII is 30% (Jim--is this reasonble?); for NILE it's 31.5% (Hewitt?).
I keyed in 20 and 15 for both and got IVs of 82 and 59 for QSII, and 45 and 32 for NILE. So 15% has them undervalued; they are more or less fully valued at 20, if you think they are currently correctly priced, as Jim and Hewitt evidently think.

The wacc for QSII is 7.52%, which seems a bit low to my untutored mind in this case. The program's input for its nopat is 28.6%.
NILE's wacc is 8%, which also seems a bit low. Its nopat is 9.25%.

In addition to the late 90s mantra "this time it's different," and others, remember also the endless refrain that stocks are no longer valued on their earnings, now they are valued on their revenues?

Of the various factors that led to the overvaluation of stocks then, one of them surely was the absurdly low discount rates investors used (implicitly, if not explicitly) to value (imagined) cash flows. There was a certain peculiar method to this madness though, for as James Grant pointed out several times, the Fed's easy money policy contributed to the stock euphoria, particularly when it hit the monetary gas pedal in the first half of '99 in anticipation of the y2k problem that never happened. One of the effects of easy money was to lower the cost of capital, which paved the way for all those dodgy IPOs, "friends of Frank" allocations, etc.

VS












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No. of Recommendations: 10
Hi VS,

check out whatever stock floats your boat or bails out your goalie.

Ha!

I've "spoken-out" against canned DCF's like ValuePro on several venues around the Fool. I think it rather 'f'oolishly misleads people into focusing on a certain value per share as if that is the be-all and end-all of the process, rather than on spending enough time and effort on considering the inputs to the model where the real art lies. It also incorporates erroneous numbers into the model, and makes financial errors of a rather disturbing nature (a couple of which, you highlighted).

Looking, as you did, at the default screen for QSII on ValuePro, it shows an intrinsic value per share of $161.23 But look at the assumptions that lead to this value:

Growth Rate: 30%

Excess Return Period: 10 years

You asked if the 30% is reasonable. I say yes, it likely is, perhaps for two-to-four years. But assuming 10 years of 30% growth is foolish (note - small-f). Better to assume slowing growth as the firm gets larger (law of large numbers). Plus, given the strong growth over the past few years, and what I believe is reasonable evidence suggesting that management is having difficulting collecting these rapidly growing sales (receivables growth rate is 1.6x sales growth, DSO growing quarterly, cash flow from operations less the tax benefit from stock option exercises is less than reported net income) I'm not sure the company could do sustained 30% if they wanted to.

Net Operating Profit Margin: 28.6%

Good enough, but the firm has been growing this margin, from 9.9% in FY2000, to 28.6% in the TTM ended today (30.6% in most recent quarter). They've been able to grow this margin because of their early lead and good product in their space. But success breeds competition, and this margin will certainly be coming down over the 10-yr period built into ValuePro's model.

Tax Rate: 36.8%

Low end of historical range. From FY2000 to FY2005, effective tax rates have been: 42.6%, 41.7%, 38.0%, 36.6%, 38.9%, 36.8%.

Depreciation Rate (% of Revenue): 3.37%

Investment Rate (% of Revenue): 1.91%

First major error on the part of ValuePro.

Most of QSII's 'investment' is in the form of capitalized software development (appropriate for their business). However, the 1.91% is only Capital Expenditures, it ignores capitalized software. BUT, the 3.37% depreciation rate DOES include the subsequent amortization of the capitalized software. To defenders of ValuePro I say, you can't have it both ways. If you're going to recognize the amortization, you need to recognize the capitalization that creates the amortization. More correctly, the Investment Rate should be raised to 5.07% (the TTM figure for capital expenditures + capitalized software).

Working Capital (% of Revenue): 36.07%

Another error inherent in Valuepro. For them, working capital is A/R + Inventory - A/P. But QSII's major working capital item is the current liability of Deferred Revenue, which matches against the higher and higher A/R balance. Ironically, inclusion of Deferred Revenue actually raises the intrinsic value as calculated by ValuePro, but it's a gross error nonetheless.

Company Beta: 0.84

Wrong. QSII's beta, calculated using the last 60 month-ending prices and regressed against the S&P500 is 1.224. I showed a beta calculation for QSII in this post: http://boards.fool.com/Message.asp?mid=23203754, although that ended in September 2005, so you can see that beta has risen in the past couple of months. You can also review the criticisms of beta as a determinent of cost of equity.

One thing I'll draw your attention to is the concept of Confidence Interval for a beta calculation. For the current calculation, the 95% Confidence Interval is 0.482 to 1.966. So we can say with 95% certainty that the 'true' value of beta is somewhere between 0.482 and 1.966. Really inspirational, isn't it.

Equity Risk Premium: 3%

Company WACC: 7.52%

Quite simply too low. Arguably, laughably low. Humourous if it wasn't dangerous for a prospective investor who isn't as well-versed in the financials as others, but who might have wandered by ValuePro after seeing how well TomG's done with QSII in Stock Advisor. Seeing an intrinsic value double today's stock price might have him quivering with greed.

But because the beta is wrong (and arguably useless at the best of times), and because the risk premium is too low, and because it explicitly ignores that things like beta, cost of equity, and discount rates are fluid (and will not be stable throughout the life of the valuation), our investor is being misled.

In all things regarding valuation, we need to ask 'Does This Make Sense?' When I see a low discount rate like this, I always like to play a 'bottom-up' game. I've written this somewhere up-board, but I'll regurgitate for this example. A classic discount rate (K) should be the compilation of risk-free-rate (RFR), inflation premium (IP), and risk premium (RP).

(1 + K) = (1 + RFR)*(1 + IP)*(1 + RP)

So, if we choose the 10-yr T-Bond as our RFR, we have 4.51% (and again, we'll igore that this number is going to rise in the future, most likely, as the Fed continues to tighten rates)

For the IP, we'll be generous and say 2%.

Since ValuePro has calculated 7.52% as WACC, we'll input that as our K, and back out a calculation for our risk premium RP.

(1 + RP) = (1 + K)/(1 + RFR)/(1 + IP)
(1 + RP) = (1.0752)/(1.0451)/(1.02)

RP = 0.86%

Point-eight-six-percent.

Is that the risk premium that an investor should be demanding from a company like QSII? How about if that RFR goes up, and IP is 3% or 4%? In deference to Hewitt ( ;-) ), I'll say that the evidence suggests that discount rate is far too low. Go to ValuePro, change the Beta to 1.224 and the risk premium to 6% (in the ValuePro world, their risk premium is a compendium of the IP and the RP listed above) and see what that does to their calculated value....

Other problems with Valuepro (bullet points):

* Ignores off-balance sheet forms of financing like operating leases (try doing a valuation of
FedEx without considering its off-balance sheet loans).

* Ignores executive stock options. This has been a well-publicized problem with QSII.

* Ignores any growth whatsoever after the explicit forecast period. Their terminal value is a
unrealistic perpetuity (NOPAT/WACC).

Other than that, I guess it's a fine website.

Cheers,

Jim
(Who promises this is the last time he'll beat up on ValuePro...until next time probably....)
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Jim
(Who promises this is the last time he'll beat up on ValuePro...until next time probably....)

Thanks, Jim, but after your demolition job, there's probably not much left to beat up.

Other than that Mrs. Lincoln, how was their website?
I'd post a note at the message board at valuepro citing your essay, but don't feel like being the bearer of bad news.
Besies, the more curious folks there who burrow under the surface will discover some of Jim's insights on their own, I think.

I used to hang out on the CANSLIM board when I was younger and even wetter behind the ears; and I once had the temerity to criticize its methodology, which got me flamed more than once. CANSLIM, for those who are unfamiliar with it, is the investment methodology of William O'Neil, founder of the newspaper Investor's Business Daily and author of a few books expounding the theory.
Btw, his website, www.investors.com, is free this week (or at least for a few days).

I am curious if you or anyone else have done a similar demolition job
on the CANSLIM method?
There's a market out there for a book doing a chapter-by-chapter demo job on these books/investment methods/gurus/websites--and I'm not even talking the newsletter writers, who are in a class by themselves.

VS
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No. of Recommendations: 3
And in case anyone was wondering why I nominated Jim for the Feste award, I think that post was a perfect example.

here's my nomination:

http://boards.fool.com/Message.asp?mid=23358693

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Jim:

Thanks for the great post on ValuePro. I know the 1.5+ metre shelf of investment reading has done something for my brain that can't be packaged and put into a can. One question though - do you still cheer for TO when they are playing the Canucks?

rp
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