Legendary fund manager Peter Lynch said that investors often act as though they are losing money when a stock that they don't own soars. "I can't believe I didn't buy XYZ at $3, it's up 700%". We've all done it.
Lynch says that then investors usually compound a costless error (not buying the stock) with a potentially high-cost error (going all-in on the stock after it's soared) and lose a lot of money. That is true, and is something you want to avoid. However, I also believe it is useful for investors to revisit why they didn't buy the stock – especially on the ones that skyrocket.
Sometimes, but not always, there's some sort of information or indicator that you didn't pay enough attention to, that could have tipped you to a possible winner.
Enter…Me
I made that error with Fortescue Metals Group Limited (ASX: FMG) about 18 months ago, when shares were at around $1.60 and the company issued bonds at double-digit interest rates. I thought the company was going down the toilet. I had this chart in the back of my mind, thinking that China's reduced demand for steel would see iron ore prices headed back to the bad old days:
Iron ore prices fell to US$40 a tonne and I thought the floor was in the mid US$20s as this would make, at a guesstimate, half of the world's mines unprofitable. I figured Fortescue would wither away in mediocrity with minimal profits, paying 11% interest on its bonds, and struggle to pay its debt back by the due date. You know what happened next, and if you'd bought and held Fortescue shares at $1.60, you're now sitting on something like a 20% – yes, twenty percent – annual dividend (based on your purchase price) and a 300% share price rise.
Where I went wrong:
There were 2 primary errors, and the 3rd and 4th error below were really just a product of the first ones.
- I closed my mind to the company. I believe that a low enough share price will make most companies a buy, but despite Fortescue's share price cratering I did not revisit my earlier thinking.
- I did not consider situations in which I could be wrong. The Chinese decision to spend on infrastructure and the subsequent Trump election, which promised spending on infrastructure, were two such occasions. Fortescue's corporate culture was another one; a colleague actually told me this at the time and I did not give much weight to the company's determination to cut costs.
- Because I had closed my mind to the company, I was not open-minded enough to consider that a small recovery in the iron ore price would lead to a big recovery in profits, and I already knew that Fortescue had some breathing space on its debt.
- Because I did not revisit my thinking, I did not value Fortescue to consider what might have happened if ore prices recovered. Had I done that, I might have realised that the company share price could multiply if prices recovered, and that Fortescue could have made for a small but interesting bet for part of my portfolio.
One Australian fund manager did exactly the opposite of what I did with South32 Ltd (ASX: S32) and Whitehaven Coal Ltd (ASX: WHC), and generated very respectable returns for their shareholders.
You can see here how closed-mindedness saw me miss a big winner. Is it just the perfection of hindsight? Possibly. Maybe I would have considered the possible upside and still decided the company was too risky. Mercifully, I didn't lose any money on this one, and I won't compound the error by diving blindly into Fortescue shares before having a good look at them.
