This post was originally published here.

I invested in a company operating in a dominant position of its segment within China’s processed–food chain. I liked the investment idea based on the theme that processed food consumption typically rises alongside a country’s rise in income and urbanization. We see this play out when branded products on the shelves of the modern food retail networks replace wet markets, butchers and greengrocers (produce markets). 

Business model in one country may not work in another

This investment theme had worked very well in Europe around 20 years earlier. Back then it was more about industry consolidation and increased raw-material-pricing power. China appeared to have a massive, organic market for the taking.  

Long list of good reasons for investing can make investors blind to the bad

The main points on which I was basing my investment were: 

• The company was already operating in its home market with scale advantages and market share in the early stages of the industry’s development. 
• Its position relative to customers was on the comfortable side of one-to-many. There were even benefits of customers consolidating their own industry in a massive conversion of traditional localized players to a modern branded and national platform. This rapid modernization accelerated the drive to reach every urban wallet in tier one and tier two Chinese cities.  
• The company was hitching a ride to a more expansive distribution channel. Its move could hardly be better. It could let the consumer brand owners deal with growth, brand goodwill, and marketing expenses. All it seemed to need to do was budget for expansion to match its customers’ volumes and keep the product quality good enough not to be rejected. 
• Its position relative to suppliers was also favorable. It was the main buyer from several producers of what was largely a by-product or discarded waste product. 
• There were no competitors using its technology in the domestic market, certainly none at the same scale, so the company had major market advantages. 
• Already operating in China, it was running at the lowest point of the international cost curve. Foreign competitors entering the market would have to be prepared to subsidize their China ventures for years to gain serious market share.  What did it matter?   
• This company was trading in the stock market at a very low price-to-earnings ratio (PE) multiple. If the international players drew attention to their activities in China, this company would only be undervalued. 
• The company clearly had growth, but its margins were super impressive: EBITDA was more than 40%, especially when compared to the low-capital-intensive production and the low volatility of demand from consumer growth. Consumption per capita was tiny compared to every other country at higher levels of per capita income. 

The positives outweighed the doubts

This stock was one to buy and lock away, for sure! Well, that’s not how it turned out. With so much in the future looking so favorable, it was easy to overlook the high proportion of variable costs, especially fuel.  Sales were up, margins were high, so why be concerned with operating leverage?  

After about two years on from listing, management appeared to be delivering consistently. Enough in fact to overlook murmurs of the controlling shareholder and chairman dabbling in property ventures and the loans to directors that were rising over time. Other investors by this time had been reacting favorably to the story. There was a nice re–rating of the PE multiple. Earnings and price had favorable momentum and the brokers who covered this mid-market company loved the stock. 

But then, the momentum broke. 

Penny drops as management’s dark deeds and subsidiary failures hit main company

The main shareholder had been more than dabbling in other business activities and more than just borrowing funds from the company. Furthermore, other company ventures were rapidly becoming liabilities and infecting the core business.  Worse still, material parts of the company’s business simply did not exist. The auditors, it turned out, had been complicit and, for whatever reason, chose not to speak truth to power, or in this case, patron, and went along with the deception. 

Amid tainted-food scandals, clean firms flourish but buyers walk from this one

Meanwhile, the branded food processors were derailed by Chinese food-tainting scandals. The trends in consumer income, urbanization and modern distribution networks all continued to grow in quantum leaps, but this company’s products and share price were no longer rising in line with those complementary conditions. The trend could continue happily without this company or its suppliers. Consumers always have the ability to change their tastes and preferences. 

The stock went from a home run to only one cent on the dollar. It can happen so easily when you’re busy doing other things. 

Emotional about stock, investor ignored ‘lover’s’ flaws

When we fall in love, we are willfully blind to the defects in the object of our affection. Picking stocks or owning companies can never be a love affair. There can be passion but only if it is a metaphor for our determination to be thorough in our research and mindful of the shortcomings of our own assumptions. But even then, a single company is rougher territory than the maps we draw in our minds of macro trends. 

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Andrew’s takeaways – Avoid these mistakes to become a better investor

Corporate governance damage can come out of nowhere

Corporate governance events, where managers or owners act against the interest of minority shareholders, can happen with any company. There are two main types of corporate governance situations. The first is where the market is already aware that the company has poor corporate governance. This knowledge would come from observing the actions of the owners and management. The second case is when corporate governance events surprise and come from out of nowhere. 

Much less is lost when bad corporate governance is already ‘in the price’

If a company is already known for its poor corporate governance, then we can say that this is “in the price”, meaning, bad corporate governance in the past has depressed the price of the stock. Many investors would avoid this stock, but some would be willing to trade on the belief that the price cannot go any lower. They believe that investors have overly punished the company’s stock price and there is a chance to make money with the stock going up. 

The corporate governance event that matters is the one you won’t know

But the corporate governance event that will hurt the most is the one that happens at a company where nobody expected it. This pain is because it will have the most damaging impact on share price when that event hits the market. This type of situation is almost impossible to detect before it happens. And you cannot always rely on financial professionals to warn you. There are various reasons why they may not raise a red flag, even if they start to get suspicious. 

A stop loss is one option to protect against corporate governance events

Though most long-only fund managers are not interested in stop loss as a risk management tool, it does have some value in the case of corporate governance. One idea is to set a stop loss that’s deep enough that it would only be triggered by a serious bad corporate governance event. In my case, since I view stocks more quantitatively these days, I am okay with putting on a stop loss on each stock when I buy it. When the stock price hits the stop-loss price I sell; it doesn’t matter to me whether it is a corporate governance event or some other negative factor. 

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Mistakes in this story

2. Failed to properly assess and manage risk

• Failed to consider cultural issues (in Asia, saving face, fear of giving bad news)  
• Lacked influence over management 

3. Driven by emotion or flawed thinking

• Let emotions drive their investment decisions 
• Got too emotionally attached to an investment 

4. Misplaced trust

• Failed to review a person’s history and references 

5. Failed to monitor their investment

• Failed to review investment strategy regularly 

6. Invested in a start-up company

• Expected idea from other country or region to work

 

Learn about the six ways you will lose your money and how to avoid them here.

 

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DISCLAIMER: This content is for information purposes only. It is not intended to be investment advice. Readers should not consider statements made by the author(s) as formal recommendations and should consult their financial advisor before making any investment decisions. While the information provided is believed to be accurate, it may include errors or inaccuracies. The author(s) cannot be held liable for any actions taken as a result of reading this article.