Our biggest investment mistake
Image by Sarah Kilian via Unsplash
Our mistakes define us. They can and should make us better.
From the day we are born we are bombarded with advice from those more battle-hardened than us in the amphitheatre of life. The problem with advice is that it is exogenous. We only really find true answers when we experience a situation ourselves and internalise its lessons. Everyone makes mistakes in life, it’s part of the learning curve – provided we don't repeatedly succumb to the same errors. Fool me once shame on you, fool me twice shame on me, right?
So why then are our primitive brains so dominant when it comes to admitting mistakes? Most people shudder at the prospect of admitting they were wrong. This is due to our ego, which is dominant but inherently fragile. It takes determination for our rational (and far younger) brain to confront our primitive mind and admit the unpleasant reality that yes, we made a mistake.
This reluctance to publicly admit to mistakes is endemic in the fund management community. It's completely understandable. Given the competitive nature of the industry and the plethora of talent competing for business, it is natural for participants to want to tell of their successes, not their failures. Everywhere we look we hear stories of victory, opportunities spotted early and costly mistakes avoided. This makes sense, as each manager looks to rise above their peer group and attract more plaudits, talent and of course, capital.
What we don’t hear about nearly enough are the mistakes. We don’t hear about the investment that went sour, the one that wasn't cut in time. Our aim is to be fully open and maybe even a bit vulnerable, so that we can have meaningful relationships to build trust with our partners and investors.
Our most spectacular failure.
We believe our path in life from the very beginning is what defines us as human beings and certainly as investors. This week on the blog we are doing something that investment managers are told we shouldn’t do. We’re going to tell you about our most spectacular investment failure.
This was incredibly difficult to write. Just using the word “failure” in a personal context makes us deeply uncomfortable inside. Wise men speak of the cathartic actions, of confronting your demons. Screw that, this was seriously grim. But only by laying out the mistakes of the past can we move forward and evolve as people and investors. So here is the story of a stock pick gone wrong. And here are the lessons we have learned – some obvious, and some rather more nuanced and philosophical.
In our previous iteration as fund managers we had much success with stocks in the Philippines. From 2010–2016, during a period of growth and optimism under the leadership of Benigno Aquino III, the country was awash with optimism (and liquidity) both locally and from increasingly exuberant foreign investors. We had invested early on in many names such as D&L Industries and Double Dragon Properties which contributed to our golden run particularly in 2014 and 2015. As such, we were always on the lookout for new ideas, especially in the tech space as we searched for potential tech platform businesses in Southeast Asia.
In late 2014, while trawling through local feeds on twitter we came across a small upcoming IPO for a tech company called Xurpas. After a spectacular IPO, we waited and watched for a few weeks before arranging a call with Xurpas’s founder Nix Nolledo. The call was electrifying. Even across the airwaves, Nix was a superb storyteller and a passionate entrepreneur. The vision was compelling. We went through both his history and the history of the company (which since its launch in 2001 had never raised external capital). The company was profitable, debt free and even paid a reasonable dividend. It had a solid cash generative core legacy business and a few small growth businesses alongside it. Xurpas’s founders were convinced that there was a bigger opportunity and we agreed. The Philippines was underpenetrated in terms of mobile data and smartphone use. They saw a chance to build a platform in ecommerce and digital payments using their existing relationships with the major telcos as a springboard. The IPO was a means to raise funding to accelerate the growth of the platform.
We completed our bottom up work and began with a small test position at around P8 per share and as some acquisitions came through and the vision was communicated to more investors, Xurpas began to gain traction as the first listed internet play in the Philippines (and even Southeast Asia at the time). We increased our position in 2015 and the stock closed 2015 pretty much at its all-time-high. By then we had met Nix a number of times both in London and Manila and we really liked him and backed his vision.
In early 2016, Xurpas informed us of a plan to raise additional equity to fund more acquisitions and investments. We raised some small concerns on the logistics of the raise but we understood why the raise was needed and it was not unexpected. After all, part of the reason for being public was to tap the markets for growth capital. The sale went ahead at P16 (vs P3.97 at IPO), and Xurpas’s share price peaked at P19.62 before starting to fall.
From mid 2016, the company began to disappoint. First the few institutional investors on board (many from the recent placement) began to offload and soon local retail investors started to sell. 4Q16 saw the stock fall rapidly from 14.50 at the beginning of the quarter to 7.94 at year end. We were in constant close communication with the company and determined that similar to many of our previous investments throughout the emerging world, there were a few hiccups along the way but that being long term investors supporting a multi-year vision, we would see it through. We were rewarded with a brief rally back to P10 earlier in the year, but then the selling resumed and at the end of 2017 the price was nearly down to P5.
To cut a long story short, despite numerous further false dawns, including an ingenious idea for a tokenized emerging markets data connectivity platform, which was way too early for its time, the stock continued to fall and liquidity continued to dwindle as Xurpas failed to show progress in delivering its vision. In early 2018 we were stuck with the nightmare that every fund manager dreads – an illiquid small cap with no bids on the table.
Someone we respect once told us years earlier:
“Do you know what an owl market is?”
Laughing nervously, we replied that we didn’t.
“It’s when you arrive to sell your stock, only to hear the response, ‘To Hoo?’.”
While this is amusing in theory, in practice it’s not funny at all. Our options were either approaching a broker to place our block at a significant discount (20% was our estimate) or cause an even larger one-off hit to the price by dumping it into the market. Either of these would have meant a further significant certain loss or alternatively, we could hold and hope for a recovery in a beaten down stock. We had succumbed to the famous example from Prospect Theory.
The moral of the story.
Let us be very clear. We did an inordinate amount of work along the way - probably more so than any other company we had ever invested in. At one point we embedded ourselves inside the company for a week in Manila trying to understand even more about the day to day operations. What became clear was that the company didn't suffer from a lack of talented people or ideas. We don't think the company would mind us saying that the problem was very simple – execution. Ultimately, we succeeded in liquidating the position in 2018 thanks to a favour from our local brokers in the Philippines. Only a few weeks ago, Xurpas received an offer to be delisted at nearly 25% lower than when we sold it off (P1.45).
The moral of the story is that the blame here does not sit at the door of the Xurpas team. They had some good ideas. There was no nefarious activity, no hidden agendas and no underhanded practices. Just poor organisation, execution and some bad luck. We always had full access to management and Nix was generous with his time and insight into how he saw the business evolving. We were simply unable to cut our position both physically due to poor liquidity and mentally due to being embedded in our view that this visionary team was simply not being properly rewarded by the market.
The lessons are plentiful.
Of course liquidity was the problem on the surface – it was there, and then one day, it wasn’t. Many warned us during this period of the risks but we were simply already in too deep. This is certainly a mistake we won’t make again and something we are focusing firmly upon in the mandate for the Three Body Fund.
The more subtle lessons are numerous – not only from the case of Xurpas, but from other mistakes we have made over our careers. In our previous incarnation as managers, we very much focused on seeing our sacrosanct base case come to fruition. So much so, that it became almost an embarrassment to sell a formerly “high-conviction” stock – only the weak changed their minds.
This was a perpetuated culture which proved hard to reverse - mainly because for a very long time it worked. Our thinking has evolved since then. We believe that in markets, managers spend far too much trying to predict what will happen and far too little time preparing how to react to conditions as they unfold.
A multi-path approach.
The solution for our investment process is to focus on a multi-path approach – inspired by the many worlds interpretation of quantum mechanics. Just like the theory that there are many parallel worlds in the Multiverse with infinite outcomes, so there are many paths an investment outcome can take and none of these are necessarily related to each other. Of course there is a base case for each opportunity which we research to the maximum, but instead of prescribing the base case and waiting for the market to adjust to our view while buying each dip (thus exhibiting confirmation bias), we acknowledge from the outset that there are many paths that can be taken, and we set out simply to search for truth. We use the charts in this pattern-driven market we have evolved into, to help us see when we are on the wrong track.
Moreover, in the past our focus was always on how much we can make out of a position with far too little attention paid to how much we could lose. Our investment process at Three Body Capital begins with how much we can lose and using that ethos we size exposures accordingly and give ourselves the chance to capture the upside optionality we seek. This is so relevant to us that even our mandate and our returns profile have been adjusted accordingly to account for this lower risk level.
Finally and arguably most importantly, the culture we have built at Three Body Capital is one where we focus relentlessly on the process. The inputs are team-based and the output of the process is risk adjusted returns. All traded instruments are treated equally and are simply one of many instruments. Good ideas are easy for us to find. If one proves to be less appealing than we initially believe and hits our predetermined loss limits, it will be gone from the portfolio without a second thought. And if it reticks all our boxes then we will buy it again in the future.
Truthfully, this is not one of our more fluid blog posts but we needed to write it - more for ourselves than anyone else. We wanted to get across just how seriously we take our process, to try and whittle down the mistakes as close to zero as we possibly can, by publicly exposing what we consider to be our lowest professional moment. We have never struggled for winners, whether markets go up or down. The losers drag down returns and our belief is that once we limit the downside risk, the upside will always take care of itself through the investment process of identifying potential winners.
Our core belief is that in managing money, our biggest enemy is the part of ourselves that is anxious, insecure, greedy and fearful – our primitive brain. Sure, we are good at ideas and at analysing companies, but the biggest mistakes come when we are unable to deal with our inner demons which are particularly adept at exploiting pressurised situations to manipulate us into believing we are acting correctly. It is to this endeavour that we dedicate our resources, energy and intellect in order to try and successfully compound the return profile we aim to deliver to our investors. Every day we need to make dozens of decisions. If we make 90% of them correctly we can still mess it up through the other 10% being more costly. Process is everything and we believe we have built ours to last. Time will tell.
We are happy to chat in more detail with our readers and investors and aim to open ourselves up for discussions at any time. We want our readers and our investors to understand everything about us. After all, who are we if not the sum of our experiences – good and bad, personal and professional?