The Surprising Ways In Which Losing Money Can Help You Build Wealth
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I had just made an investment mistake. And not just one mistake – I somehow managed to combine three different mistakes on a single investment recommendation. I was a senior investment analyst on a team managing billions, and it was time to decide what to do next.
When I had started researching Sprint, there were few clouds on the horizon. The company had just announced its acquisition of Nextel, another wireless career. There were plenty of cost cutting opportunities, or “synergies,” from combining two wireless networks into one. So plenty of value to be had for the buyer… right?
Gary Foresee was a very confident CEO. Most are. He was quite articulate about how combining the #3 and #4 wireless service providers in the U.S. was going to create massive value for shareholders. After all, what could go wrong when you increase industry concentration and cut costs from eliminating duplicate infrastructure at the same time?
Sprint was the #3 wireless carrier, behind the much better-positioned Verizon Wireless and AT&T Wireless. The company had a permanent disadvantage in the spectrum that it had, which caused the quality of its network to be inferior to that of the top two players. To offset this inferior service quality, the company offered a lower price, and thus attracted a class of customer that was satisfied with that trade-off.
Nextel was a niche player. Its key differentiation was a Push-To-Talk (PTT) product. That allowed groups of people, such as construction workers at a worksite, to simply press a button and be immediately connected to others who were part of their group. The crucial feature was low latency – pushing the button resulted in instant communication. This created economies of networks – nobody who was part of the group could easily switch unilaterally to another carrier, since they would no longer be part of the PTT group.
I, of course, knew that Sprint had a permanently inferior network. I also knew the statistics that large acquisitions tend to create value for the seller, but rarely for the buyer. However, it was going to be different this time. Or so Gary Foresee said. And I chose to believe.
I supported my belief with reams of data and analysis. Market share changed very slowly in this industry. So even if there were some initial turbulence, it would be muted. The synergies were large enough to offset any market share loss anyway. Besides, the stock was really cheap on post-synergy earnings.
I studiously built a giant Excel spreadsheet model. Complete with hundreds of lines and a fancy Discounted Cash Flow valuation analysis. The model “told me” that Sprint was worth $25. It was trading at $15. It was time for us to put on our Benjamin Graham value investor hats and buy the stock. At least that’s what I told our team. Unfortunately, they listened and we bought the stock.
Why unfortunately? Well, it turns out that I had made three mistakes:
For starters, my Excel model was so complicated that I managed to make an actual error in it. Not a conceptual error, but simply linking one cell to the wrong cell. Well, that was embarrassing. The model spit out $25 as the value – but it should have been $20.
Integrating Nextel and switching users to the Sprint network broke the economies of networks. If people were going to be migrating to another network, they might as well go and explore alternatives, such as Verizon Wireless, which was working on its own Push-To-Talk product. This eventually led to far greater churn and share loss than management (and I) had expected.
I focused very much on the numbers, and what the post-synergy profits should be. I spent insufficient time on thinking about business quality. Investing in a #3 player with a structural disadvantage in a slow-growing, capital-intensive business with marginal industry economics is rarely going to lead to massive returns.
As soon as I discovered my Excel error, I was faced with a decision. My first thought was “gee, can I find some offset somewhere else in the model to get the value back to $25?” I immediately discarded that idea. That would be intellectually dishonest, would likely cause us to make more bad decisions and would set a terrible example for the younger members of the team for how to behave.
I came clean to the team. At our next meeting, I told everyone exactly what happened and that I made a mistake. My hope was that maybe at least that would lead other analysts to be forthcoming about their mistakes and hopefully save us from some bad decisions in the future.
We lost money on our Sprint investment. A lot. It was painful for everyone involved, clearly including me. So how does this kind of loss help build wealth?
Through learning. There were three lessons that I took away from my Sprint debacle, and over the course of my career they have saved me far more money than the Sprint mistake had cost:
Don’t use overly complicated models. Yes, we should approximately quantify the intrinsic value of our investments. However, as Warren Buffett said, if you need much more than a four-function calculator to figure out that a security is really undervalued, you are probably doing something wrong.
Don’t ignore the qualitative attributes of the business in favor of the quantitative attributes of the security. As Will Danoff, the star manager of the Contra Fund with whom I had the privilege to work as a junior colleague during my days at Fidelity Investments was fond of saying “price is forgotten but quality remains.” Buying cheap stocks of pretty bad businesses is a tough way to make money. This doesn’t mean that valuation is irrelevant – it’s very relevant – but it shouldn’t be the only consideration.
Don’t ignore base rate probabilities. There is something known as the inside view bias – we know that in similar circumstances XYZ usually happens, but we think that we are very special and those odds don’t apply to us because of our mad skills. Yes, you are very special, but that doesn’t make you immune from the fate that many others before you had suffered. If you insist on choosing to select from a negatively biased universe of investments – chances are you are not special enough to overcome the odds.
In investing, you need to accept that you are going to make many mistakes. That’s just the nature of the beast. The key is to learn and improve along the way. Don’t take losing money as a loss – it’s only a loss if you don’t learn enough from your mistake to save multiples of the lost amount in the future.
Clearly this story isn’t one of the shining moments of my 20+ year investment career. So why am I sharing it with you? Because smart people try to learn as much as possible from others’ mistakes. My hope is that by sharing this with you, you can save some of your hard earned money, which will help you build your wealth.
Speaking of sharing – if you could please share this article with your network and on social media, you could help others build wealth by letting them learn these lessons on the cheap as well.
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