It takes courage for a professional money manager to admit to mistakes, especially one that shaved four percentage points off his portfolio’s performance.
But investors can learn some important lessons far less expensively as a result of the price paid and candidly revealed by Francois Sicart, founder and chairman of Tocqueville Asset Management, in a letter to Tocqueville shareholders.
That 4 percentage-point loss occurred with the investment management firm’s purchase in 1996 of Integrated Health Services (IHS).
Seeking to avoid the mediocrity of consensus, Sicart had his portfolio managers debate the investment merits of various companies, though invariably most would be persuaded to buy some of those their colleagues strongly advocated.
Though the health care organization carried a high amount of debt on its balance sheet, the managers took comfort in a government audit that gave the firm a clean bill of health, and the fact that much of its debt was real-estate related and thus “secured”; they also expected a fast-growing subsidiary to provide income needed to reduce some of that debt.
By 1998-99, the firm’s managers realized they had underestimated the impact of Medicaid and Medicare reimbursement procedures on IHS’ margins as well as the willingness of the government to persist in a change that was adversely affecting the entire industry.
Given an already debt-laden balance sheet, the firm’s reduced earnings made debt service more costly and its underlying real estate assets irrelevant. Worse, the company’s debt holders could not come to terms on issues related to an initial public offering of its high-growth subsidiary.
Though the stock collapsed, Sicart gained some valuable lessons that would aid his investing team into the future.
The first lesson was that no investment story, no matter how appealing, can ever be allowed to trump basic principles such as an insistence on a firm’s financial strength.
An added nuance in assessing financial strength is that “liquidity (the ability to face current payments through the ups and downs of the business and financial cycles) is at least as important as solvability (the accounting surplus of assets over liabilities).”
A further lesson Sicart derives from the experience is that consensus thinking can take root despite even the culture of debate he had encouraged.
To safeguard against a recurrence of this “madness of crowds” effect, Sicart established a team of analysts called “The Skeptics,” whose job it was to argue against all new ideas presented at meetings with the hope of making fewer mistakes than other investment teams.
Sicart describes, more briefly, four other investment mistakes and lessons learned.
One involved his purchase, circa 1971, of AVCO Corp. back when conglomerates were fashionable. While analysts touted economies of scale, growth synergies and the like, the accounting liberties available to conglomerates made it difficult to assess which profits would recur.
In 1967, AVCO, originally a military contractor, had purchased the film production company that produced “The Graduate,” the top grossing film of 1968, which helped the firm nearly triple earnings per share in 1967, compared to 1965.
But by the time of the recession of 1969-70, overall earnings collapsed and the stock along with it. Contrarian Sicart purchased shares after the stock collapsed, but without fully understanding how the level of earnings reached in 1967 with the movie company acquisition failed to reflect AVCO’s recurring earning power — a task complicated by the conglomerate’s pooling of various revenue streams.
While the stock failed to bounce back, Sicart learned the importance of ensuring the repeatability of previous profit performances.