Delta SBD, an underground
coal mining services business I bought shares in almost a year ago, has been by
far my worst investment mistake of commission. Just as my cat learned very
quickly not to pee on the carpet after my dad rubbed his nose in it, I believe
that rubbing my nose in my mistakes is a good practice. Thus, today's rather
unpleasant post.
Less than six months ago I mentioned the
discomfort that this stock had given me in the context of psychological biases,
but justified my decision to hold onto DSB as I thought it was still cheap.
Well, it now seems that Mr Market (an allegory for the general share market)
was right in his pessimistic appraisal of this business, and after the most
recent half yearly results of DSB came out on Friday, I have come to agree with
him. In fact, it took me all of around five minutes of reading the report
before I knew that my valuation was wrong and that I should get out
quick.
I sold out in two parcels,
one at $0.29 and another at $0.28, before the share price dropped further to
close at $0.25 - an almost 22% drop in one day. After accounting for fully
franked dividends and brokerage costs, my personal losses have been 61% and 44%
for the two respective parcels, or a total of $845 in dollar terms. These are
unpleasant numbers, but if it's any consolation to myself, they're not as bad
as Delta SBD's results.
Revenue for the half fell
52% to $35.4 million, while the underlying profit of $5.2 million became an
underlying loss of $1.0 million. All $29.2 million of DSB's goodwill was
written off, and a couple of other minor items meant that the statutory loss
totalled $30.7 million. Poor results were widely anticipated due to the severe
downturn in the Australian coal sector, but evidently they were worse than what
I, and the market had expected. The announcement was enough to send DSB's
closest listed peer, Mastermyne Group (ASX:MYE) down almost 15%, even though
Mastermyne's share price had already been punished from its similarly
disappointing half yearly report three days earlier.
Although the market capitalisation
of DSB is $11.6 million and it has net tangible assets of $28.2 million, the
bulk of its assets are in the form of plant and equipment, which in the current
industry climate would almost certainly be worth less than the $37.6 million
stated on the balance sheet (this amount reflects historical cost minus
depreciation rather than what you could sell it for on market). Indeed, DSB
sold some of its assets to provide cash, and recorded a loss as part of its
statutory results from it. Therefore, it doesn't appear to me that there is
sufficient protection if DSB were to go into administration, and although I am
not predicting this will eventuate, there are some eerie similarities to the
rapid demise of Forge Group that make me uneasy.
For one, cashflow from
operating activities has deteriorated dramatically, going from inflows of $2.9
million, to an outflow of $1.9 million in the current half, and as previously
mentioned, the business has moved from an underlying profit to an underlying
loss. Once you get into the world of negative compounding, it can be very
difficult to dig yourself back out, and it seems to me that DSB won't be able
to withstand the pain for much longer. This business has a worryingly high net
debt to equity ratio of 51%, and a current ratio of just below 1.0, indicating
that it will be having some funding issues over the next few months. To their
credit, management have been working at reducing debt levels as fast as they
can, but with the company now bleeding cash, it seems the only avenue for
further deleveraging will be more asset sales.
Buried in the 'going
concern' section in the notes to the financial statements, there are some more
worrying signs about cashflow and debt. The directors acknowledge the need for
an additional working capital financing facility, which they expect they will
have to start drawing down on in March 2014. DSB has been working to secure an
invoice finance facility of $4.65 million from an external financier, but
should this fail, the group's major shareholders - who I presume are the two
founders of the business that own a collective 47% - have committed to provide
a facility of $3.5 million. However, there are also strings attached to this
shareholder funding, and the report ominously warns that it "will be
conditional on achieving predicted revenues levels and appropriately managing
the volume and profitability of the business. Should this not be achieved and
the Group is unable to restructure existing equipment finance arrangements or
raise additional capital, the Group may not be able to continue as a going
concern." Further paralleling the signs of desperation that Forge Group
displayed before it collapsed, management revealed that "the Group
continues to negotiate with finance providers to extend the repayment terms of
other existing equipment finance arrangements, and is considering a capital
raising via the issue of new shares."
And finally, whilst I
rarely place much emphasis on macroeconomic forecasts (although I probably
should have in the case of DSB), the environment for an underground coal mining
services business seems pretty bleak to me. The big miners - BHP Billiton and
Rio Tinto - have cut capital expenditure in their coal businesses, and in the
face of lower prices, capex spend is set to fall further. I'm no expert, but
with the rapid increases in the efficiency of solar power that I've been told
are trending even faster than Moore's Law in computing power, and the rise of
other renewable energy such as wind power, I can't see a bright long-term
future for thermal coal. In addition, China, which is the world's biggest
consumer of thermal coal, has been making moves to clean up its pollution by
reducing its dependancy on thermal coal. As for metallurgical coal, prices are
to a large extent dependant on China continuing to grow at a fast rate and
build tons of infrastructure, an assumption that appears far from a sure thing
to me.
After all the above, you
may be wondering why on earth I ever held shares in this business and why I
didn't sell out sooner. I am too. But I think I can list a couple of factors
that contributed to this result, many of them psychological. In response to the
first question, I repeat what I said six months ago: "I knew going in that
this was a fairly mediocre business (current normalised return on equity of
14%, net debt to equity of 32%, and a net profit margin of 5.5%), and
anticipated a less than impressive earnings outlook, but the price looked cheap
enough to offer a significant margin of safety - less than 5 times FY2013
earnings. In addition, I liked that the founders of SBD and Delta were still
managing the company, and held a majority stake." I figured that if DSB
could withstand a short term downturn in the coal sector, I would make a fair
bit of money. However, in light of the recent results that's a much bigger 'if'
than it was almost a year ago when I first purchased shares.
Last time I also listed
confirmation bias as one factor that hindered a true objective analysis of the
situation - I remember reading analyst reports that had big 'BUY'
recommendations on them, and although my estimates were more conservative than
theirs, we were both way off the mark. After recently reading Charlie Munger's
brilliant speech, The Psychology of Human Misjudgement, I
realise that I most certainly fell victim to what he calls
Inconsistency-Avoidance Tendency (the brain naturally being resistant to change
in ideas, once you make your thoughts known in public, as I did on this blog,
the tendency becomes even stronger), and Overoptimism Tendency (fairly self
explanatory). Eventually I recognised that the risks of my investment in DSB
had gone up significantly, and deliberated many times on whether to sell out,
but never did something about it, until of course this report came out, when my
fears were confirmed.
Another one would be
Contrast-Misreaction Tendency, which is perhaps best explained through the
boiling frog anecdote. Although the scientific background is shaky, the story
goes that if you place a frog in boiling water, it immediately jumps out, but
if you place it in cold water and slowly turn up the heat, it will boil to
death. Thankfully, the consequences for me were not so serious, but this
cognitive bias applies to the brain and the message is the same. I should have
reacted to the little pieces of information that built up over time indicating
this was a bad decision. Instead, it took a real splash of boiling water in the
form of this half yearly report for me to jump out.
There was simply not enough
of the 'invert, always invert' that Munger espouses. Unfortunately, once I have
sold out, inverting becomes so much easier to do, as the above paragraphs
demonstrate. I should have listened more to the wisdom of Peter Lynch who said,
"Rather than being constantly on the defensive, buying stocks and then
thinking of new excuses for holding on to them if they weren't doing well (a
great deal of energy on Wall Street is still devoted to the art of concocting
excuses), I tried to stay on the offensive, searching for better opportunities
in companies that were more undervalued than the ones I'd chosen." If
someone had asked me a month ago if I would invest in DSB, my answer would definitely
be 'no' because the risks were too high, so why did I hold shares in it?
Because I made kept making excuses.
Perhaps I should have also
followed the advice of Buffett and Munger, in avoiding the 'cigar butt' style
of investing that they had success with but eventually moved on from. But
unlike Mark Twain's cat that sat on a hot stove and never sits on another
stove, hot or cold, I haven't been burned severely enough by this cigar enough
to dismiss cigar butt investing on my first attempt (my apologies for all this
burning animal imagery).
Last time I concluded my
discussion on DSB and investor psychology by saying, "The verdict is still
out on what the future of DSB, the coal sector and China is, but regardless of
the outcome, I hope that I will have at least taken away some valuable lessons
about investor psychology that will improve my decision making going
forward." I just wish it wasn't such an expensive lesson.
P.S. Not all is bad though,
Warren Buffett's annual letter to Berkshire Hathaway shareholders was published over the weekend, and as has come to
be expected, it is always a good read. To any value investor, his annual
letters are required reading.
Chris -- I wouldn't put away the idea of ever buying levered companies, especially levered companies exposed to cyclical commodity prices (like coal, or in turn, coal CapEx). You should just be cognizant of where you think we might be in a commodity pricing cycle (i.e. closer to the trough and heading back up, or closer to the peak and still heading down?) because the operating leverage and financial leverage from the Company magnifies the commodity price move. Effectively, these types of equities are simply super-levered call options on the respective commodity prices, and as you're already aware, long-dated options can sometimes become woefully mispriced.
ReplyDeleteThere's nothing wrong at all with making these types of bets, and in fact these will be some of your biggest winners over an investment lifetime. For example, if you'd bought Mittal Steel (mostly commodity steel) in 2001-02, Dow Chemical (mostly commodity chemicals, whose pricing is highly contingent on global GDP) in 2009, or Pacific Ethanol (ethanol, which has much smaller industry cycles) in 2013-14, you'd be quite happy about your decision. You won't get them all right, but the ones you do will pay you well for taking the risk.
Anyways, great self-reflective post -- I just think the lesson I take away here is that security selection of this type of Company requires having a contrarian (and correct) view on the commodity pricing cycle.
Hi TboneSam, some great thoughts you've outlined there, especially the comparison to call options. I agree that if you can correctly anticipate the direction of the commodity price, you stand to make a lot of money through these kinds of stocks, or alternatively lose a lot of money when you're wrong. However, at least for now, I think that forecasting commodity prices is straying beyond my circle of competence, so I'll probably try to avoid situations where this is a crucial input.
Delete