While it can feel a bit depressing to focus on adverse outcomes in these markets, I believe these are where the real investing lessons can be found. If we can learn from mistakes and challenging market conditions, we become better investors, and our future expected returns are much higher. So, continuing this theme, in this week’s article, I will relive a painful loss, examine a recent failure, and introduce the concept of a premortem, thinking about what might cause a company to die before it happens.
A Total Loss
One of the keys to successful long-term investing is to avoid severe adverse outcomes. It takes finding a 10-bagger to recover from a 90% loss but just a double to recover from a 50% loss. However, no such outcome is as severe as a total loss. This represents a permanent loss of capital. The reality is that there is a set of circumstances that will cause even the most apparently robust company to be a zero, and it often can happen overnight with no warning and no ability to exit a position. This is one of the reasons that investors should err on the side of greater diversification (a tendency to be overconfident is the other main one). However, the out-of-the-blue losses are infrequent. Often, there were signs that a business was close to failure. I have covered some of these topics in my recent articles (here and here) and in more detail in my book.
This focus on avoiding fads, frauds and failures means that I have had very few total losses in over 20 years of investing in UK small cap stocks. But I have had one: Redhall
Redhall was a specialist engineering business whose history can be traced back to 1932. In June 2019, they appointed administrators. They had recently had a profits warning and become loss-making. However, the balance sheet didn’t look terrible. Indeed, I invested after these warnings and initially did well from my investment as the market bounced back from an initial sell-off. We can’t see the historical StockReports for delisted companies, so I will have to turn directly to the last set of accounts to 30 September 2018. Although the company didn’t hold any cash at this date, the current ratio was 1.34. The current debt was a mere £209k. There was £5.24m of bank debt on top of this, but…
