Humans are predictable creatures; we tend to learn only from our own mistakes. It's a shame, because it would save a lot of hassle if we were better at gleaning what we need to know from those who have gone before.
Whenever I make a poor investment decision I
frequently discuss it with my wife. Her response is always: "Why do you still make mistakes - I thought you'd learned your lessons by now!"
Alas, no, but I am learning to pay attention to cautionary tales from history. If you are walking in the dark, better someone warn you that there are rocks about - you will still trip, but hopefully the fall won't be so bad.
Beware the Sun Ray Lamp
During World War II, German General Erwin Rommel, highly regarded by both sides, referred to Hitler as the Sun Ray Lamp. Rommel, a military genius, was very outspoken, a dangerous characteristic for any Wehrmacht General under Hitler's command.
Rommel's problem was that he often opposed Hitler's plans, believing that if he reasoned with Hitler and presented his case, the Fuhrer would see sense (for instance, Rommel wrote to Hitler after D-day telling him Germany should surrender in the West, because once the Allies had a foothold on the Continent, their overwhelming material superiority would crush the German Army).
However, whenever Rommel met with Hitler, he was sucked in by the Fuhrer's powers of persuasion and oration - this he referred to as the Sun Ray Lamp. Hitler's ability to convince was such that despite all the glaringly dark facts, people would leave a meeting with him feeling everything was bright and achievable.
I find this can happen regularly with CEOs. One gets caught by the Sun Ray Lamp. I have yet to meet or talk with a CEO who is not optimistic about their company's future regardless of the situation they are in.
This can be very deceiving, because if the company is potentially in bad shape and you have a number of serious questions, the CEO will always, like a politician, avoid the question and tell you what you want to hear (that everything is okay and next year is going to be a fantastic year). Bear in mind the effect of the Sun Ray Lamp: if you think there is trouble brewing, you are probably right.
Show me the money!
Many oft-used phrases have fascinating origins, such as 'in the hot seat', which refers to the mediaeval inquisitional torture chair, which was covered in metal spikes and would be heated from underneath. The 'hot seat' would force helpless victims to confess to heresy.
The root of the phrase 'cash is king' remains unknown, but it's nonetheless important to monitor a company's cash position and their ability to generate cash.
I was once involved with a firm that was booking revenues from large offshore contracts, but six months after they had been booked, the payment still hadn't been received. Once the market got wind that the dinero wasn't forthcoming, the stock was crucified.
Debt is a dirty word
Easy: too much debt is very bad. A simple rule of thumb is if a company has more than 2x EBITDA in debt, avoid.
Roll in, roll out
In the halcyon days of easy credit when every banker was your mate, many companies came to the market as part of a roll-up, or listed and then started rolling up.
A roll-up is a firm that goes around acquiring other similar firms using debt and, in some cases, shareholder cash. What usually happens (these are the stories that end in tears) is that the CEOs of these roll-ups get greedy and start making more and more 'earnings accretive' acquisitions.
The problem is, once you start acquiring a new business every month, any potential synergies get washed down the toilet and integration becomes a nightmare. The left hand can't keep track of what the right hand is doing.
While these debt-gorged beasts can keep rolling during the good times, the slightest chink in the armour brings the whole rotten structure tumbling down.
I invested in a roll-up media company that acquired 25 companies in a few years, and 15 in the final nine months.
Just two months before they collapsed, the CEO said, "These acquisitions further cement our leadership position globally as we continue to grow from strength to strength in all leading markets around the world."
And from the chairman: "Fifteen companies have been acquired since listing....More will follow....we have a long way to go - the journey has barely begun."
In fact the journey never really had a chance.
Margin Loans
We probably won't have to worry about margin lending for a few more years because I doubt those bankers, if they still have their jobs, will again be lending on margin to CEOs in the near future.
But here is a snippet of what happened to a few small and large companies in 2008. The directors of these companies had been buying stock on margin, with the banks taking the stock as security.
When the recession hit in 2008, their share prices declined, but when the hedge funds found out the CEOs were leveraged in, all hell broke loose. Prices collapsed and the directors were forced by the lenders to liquidate the positions.
In the case of ABC Learning Centres, CEO Eddy Groves owned 20 per cent. The collapse of a business so stable that the Singapore government had a stake illustrates what can happen in a worst-case scenario.
Mike Taylor is co-founder and MD of Pie Funds, a boutique investment manager.
