- Everyone makes mistakes, but few try to learn from them.
- Marijuana stocks have been poor performers, but they've retaught Kass valuable lessons that can be applied to any investment.
- Celebrate wins, but don't ignore the value of learning from mistakes.
It’s simpler and ego-friendly to focus on your successes, but ignoring your mistakes means missing out on a great opportunity to become a better investor. Failing to take the time to understand what went wrong with a losing trade is like only doing half your homework when you were in school. You may get the gist, but you’re unlikely to understand the concepts well enough to master them.
In his Real Money Pro diary, Doug Kass demonstrates the value associated with openly and honestly evaluating your mistakes by sharing a set of lessons that he (and you!) can use to make better investments. Kass writes:
“One of the reasons my Diary is helpful to me is that when I make investment boners (which, in some periods, occur with frequency), I can go back and evaluate why - in the hope that I won't make the same mistake again…My unprofitable sojourn into cannabis stocks is a good example of employing some discipline in a bad investment…But today's opening missive has broader implications beyond weed…Learn from my mistakes, I try to.”
12 investing rules
The 12 investing rules Kass shares are so good that I include all of them, followed by my comments. A quick note, though. The rules aren’t in a particular order, so don’t weigh the first rule more than the 12th rule in your process.
1. “Be Independent In View: Pool all your resources and come up with a series of probable scenarios and weight each scenario by probability in order to develop a calculus and range of "values" in seeking a realistic upside reward vs. downside risk and in an attempt to ascertain a "margin of safety" in each investment you make.”
Adopting others’ convictions is easy. Crafting your own thesis is harder, but it makes determining how much reward there is for your risk simpler. To figure out your margin of safety, keep an open mind to contrary opinions, and carefully consider what could go wrong if you’re thesis is incorrect.
Remember, spending all your time in echo chambers makes you feel ‘smart,’ but it adds little value to you.
Instead, create upside and downside targets after considering all the information available and, ideally, aim for a risk to reward of 2:1, like Market Wizard Mark Minervini, or higher. Famed investor Paul Tudor Jones suggests a 5:1 ratio, but 3:1 is likely more realistic for most investors.
2. “Be Realistic: In establishing the exercise (above) of evaluating an industry or company's prospects, avoid the hyperbole and exaggerated outcomes of others. Use common sense and logic of the argument. At the very least, be objective - at most, cynical when evaluating their input.”
This rule reminds me of the proverb, “if something sounds too good to be true, it probably is.” Beware claims of others. Often, they tout the edge case, not the most likely outcome. Tempering enthusiasm isn’t easy, but it can keep you from making an outsize bet with disastrous consequences.
3. “Fundamentals Trump Everything: While investors were starry-eyed about the longer-term promise of cannabis (and the large total market, TAM), the fundamentals were steadily deteriorating in 2021-22.
Analysts and investors steadily ignored these eroding fundamentals - I was late too but started expressing concern in late 2021/early 2022 in a series of negative columns - focusing too much on their perception of the potential treasures of the too distant future.“
The numbers matter. If the thesis doesn’t align with the financials reported, then at a minimum, you should stress test your thesis to ensure nothing has changed and you’ve crafted it objectively rather than subjectively. Too often, investors extrapolate rapid growth into the future and dismiss disappointing financials as a temporary phenomenon when faced with a disconnect between financial performance and perceived opportunity.
4. “Evaluate The Orbit of Your Outside Resources: Avoid the confident of view in a world of uncertainty and with a wide range of outcomes, stay away from conflicted and biased paid "advisors" to companies, as they typically have an agenda that differs from yours. Keep these "types" away from your children and from your portfolios.
The value of the "insights" of paid consultants, in particular, is inverse to the number of their tweets or comments that they make on social media! To this day, they are still confidently tweeting out their bullish pablam with frequency! With the benefit of hindsight, there might have been more tweeps and tweets about cannabis than any other market sector extant. I and others should have recognized this earlier!”
One of the more insidious aspects of social media is the use of paid promotion under the guise of honesty. Always ask, “how does their stance benefit them?” Don’t take it at face value that they aren’t conflicted, professionally or personally. They may have been paid as part of an orchestrated publicity campaign, or they may have their own vested interest in an outcome that you don’t fully understand. As a result, avoid rosy-colored glasses when the masses promote eerily similar messages.
5. “Analysts Are Notoriously Bullish - Take Their Views With A Grain of Salt: I have run several sell-side research departments and one buy-side research effort - so I know of where they come.
There are exceptions, but in the main - and partially to maintain company relationships - brokerage firms (and the sell-side) exist to sell you merchandise. Their estimates are too often "group stink", gathered in a herd of closely gathered forecasts that essentially mirror company guidance.
Over time, analysts have universally presented the cannabis industry as a ticket to high returns with low risk - they were woefully inaccurate. Not surprisingly, they are still unrepentant about being so wrong-footed and still mostly bullish!”
Wall Street analysts aren’t bad people -- I know many from my days running an independent research shop -- but remember, they’re beholden to their employer. And those employers may be beholden to the companies the analyst is covering because of profit-friendly investment banking business, including stock and bond offerings.
The reality is most analysts avoid sell ratings like the plague. Their close contact with senior management contributes to the “group stink” Kass previously mentioned. Their desire to maintain friendly relationships for access to the C-suite can lead to stubbornly bullish outlooks despite contradictory evidence.
One hack for measuring an analyst's confidence? Look at their official “buy, hold, and sell” ratings and how their earnings estimate and price targets are trending. If there’s a buy rating on a stock with a declining estimate and price target, it’s probably best to focus elsewhere or do more homework to understand the disconnect.
6. “Seek Out Competitors' Input: Try to speak to competitors to better and more objectively assess the lay of the land as they can often tell you more than analysts, stock brokers and/or management.“
The average investor likely doesn’t have the CEO of a competitor on speed dial, but they do have access to their financials and earnings conference call transcripts. So use the available resources to ensure there aren’t divergences. For example, be wary if one company blames market trends or the industry supply chain for poor performance, but another competitor is executing well and doesn’t reference those industrywide troubles.
7. “Talk to Managements But Don't Take Their Bullish Views as Gospel: In the extreme, Warren Buffett once said that corporate managers sometimes lie like Ministers of Finance on the Eve of Devaluation. The Oracle's words have some substance. “
Chief executives are often “chief cheerleaders.” Unfortunately, they’re far more likely to paint a pretty picture than not. Especially since their compensation, including options, can be tied to stock performance.
8. “(Almost Always) Seek Out Superior Managements With Solid Accountants/Auditors and Financial Controls: Again, in retrospect, many cannabis equities failed to fulfill this characterization and recommendation. Remember when an accounting problem is revealed more quickly, as there is never just one cockroach!
“Shoot first, ask questions later” isn’t a bad approach regarding concerns over the integrity of financial statements. Often, the company will reveal more lousy news in time, suggesting, at a minimum, that selling gets you a more favorable entry later and, at a maximum, the potential to avoid a disastrous loss.
Also, remember investigations are costly and can distract senior management, increase resignations of key talent, and open the door for competitors to steal market share.
9. “Be Cynical With Regard To The Timing and Anticipation of Regulatory Change: Our representatives in Washington, DC, are not a group you can count on to produce timely and effective legislation - regardless of how compelling. With our political leaders' growing party bias, things have worsened. Change comes even more slowly, if at all, as cannabis investors have learned with regard to the steady promise of federal legislative initiatives (SAFE Banking, uplistings, etc.). As Gretchen was told in the movie Mean Girls, "stop trying to make fetch happen, it's not going to happen."
You must be careful if disruption requires regulatory change because embedded political relationships are forged around existing laws. Unfortunately, the desires of lobbyists and political gamesmanship to win votes often get in the way of progress, given how often politicians must campaign.
10. “The Three Worse Words in Investing Are... "Total Addressable Market (TAM)": TAM is a crutch and often hard to refute because it is an abstract or conceptual factor many years out. My experience, and it is certainly the case for cannabis stocks, is that it is often subject to exaggeration and hyperbole.
I recall seeing charts of extraordinarily low 3-5 year EBITDA and sales multiples based on the projections of the analytical community. Some are still delivering them with regularity! Those estimates (based on TAM) were not worth the cost of the ink needed to produce them.
Total addressable market can help you understand the size of the market opportunity. However, you need to view it through the lens of “how much can my company realistically win?”
If hundreds of companies are vying for the market share, then the likelihood of any one company gaining a meaningful toehold is small. Instead, it can be better to wait for leaders to establish themselves rather than bet that one of many will be the winner. Frankly, far too much can derail a small company on its path to meaningful market share.
11. “When Looking for a "Bottom," Selling Call Premium Against Unloved Stocks Can Insulate Investors From Some Losses: This is exactly what I have done throughout the painful drop in cannabis stocks. I have consistently been short (high implied volatility) (MSOS) calls throughout my losing investment in the sector.”
If your thesis is intact but the stock isn’t performing well, writing covered calls can provide income that can lessen losses. However, if your thesis is wrong, the best course of action is often to sell because holding exposes you to opportunity cost (i.e. the chance to buy something else that will perform better).
12. “A Low/Conservative Weighting (Particularly Of Out of Favor Sectors That Are Trending Lower in Price) Can Also Insulate Investors From Losses: I have never had more than 5% of my portfolio in cannabis stocks, sometimes far less. “
Investors often spend too little time on position sizing, exposing them to outsized risks. For example, everyone talks about why concentration can elevate returns during a bull market. However, that concentration risk can be disastrous in a bear market, especially if holdings are highly correlated.
Instead of betting heavily in one position, embrace strategies that increase diversification.
For example, studies suggest a portfolio of 20 or more stocks minimizes single stock risk. Benjamin Graham recommended owning 10 to 30 stocks, and Berkshire Hathaway's top 20 holdings comprise 96% of its portfolio, suggesting Warren Buffett, a Graham disciple, agrees.
The Smart Play
You might want to start if you’re not journaling investments like Kass. Tracking buys, sells, wins, and losses makes evaluating your performance honestly and objectively easier, resulting in better rules and decision-making. Of course, it’s not easy reliving losers, but the insight it provides makes learning from your mistakes an investing superpower.