Acknowledgement: This is mostly a compilation of material from various books and blog post. I have tried to quote source wherever I could recollect.
I have a firm belief that any investor can easily outperform market over 5-10 years by a wide margin only if he follows two rules 1) Focus on the size of the win. In other words refuse to invest in any situation if the upside is less than 5-10x in next 5-10 years 2) Avoid big mistakes [Where you loose more than 50-80% ]. My entire focus of studying failure patterns is to eliminate BIG MISTAKES.
I have received varied feedback from senior investors about utility of studying FAILURE PATTERNS in eliminating big mistakes.
- Some say act of studying failure patterns is nothing less than INTELLECTUAL MASTURBATION, an act just to satisfy our ego with no utility. Just study annual reports and that should be sufficient.
- Some say they do not think in terms of patterns at all. What counts to them is what is priced in the stock price and how the current financial numbers look like.
- Third group of investors feel that studying failure patterns might help, but this is an act of laziness. One should study the business model in-depth, do lot of scuttlebutt and then try to identify all the key risks and keep a close eye on the key risks.
- Fourth set of investors says, number of variables which can go wrong in the business model are far higher than we can think of. In investing we cannot do control experiments, so one has to study patterns of what has worked in the past and what has not worked in the past. Studying success and failure patterns are very important and one should not get too fussy about survival-ship and hindsight bias. [I fall in the fourth category]
I am in no way suggesting that my view of studying failure patterns is the only way or the correct way. I will continue to look for ways and means to reduce BIG MISTAKES and if I come across another better way, I will switch to that.
In my earlier post on “What Causes Long Term Destruction of Capital – High Valuation or Lack of Sustainable Profits” I have highlighted that
Almost all cases of Permanent Loss of Capital has happened in Bad Business.
In the same post I have tried to group cases of PERMANENT LOSS into FOUR category.
In this blog post I have tried to study various failure patterns which I have come across. In my definition, a non-financial company will get classified as FAILURE if it fails to generate SELF FUNDED Sales, PAT and EPS CAGR of > 15% over next 5-10 years [15% is in Indian context based on last 10-15Y nominal GDP growth rate. Infact the rate 15% is not that important. What’s important is that over long term PAT should grow at higher than or equal to nominal GDP growth rate of the country]. At the current stage I do not have lots of Indian examples. I plan to do this over next year. If you have any failure examples or patterns please do share.
You can download detailed write up from here.
ContrarianValue Edge 
Hi Anil,
Thanks for writing this up!
How would you identify management risk, say in terms of embezzlement? Meaning, is RTP in the AR enough or do you have other hacks?
Regards,
Prashanth
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If its material.. numbers will speak when we compare with peers.. or we will know economics is not making any sense….we will miss in case a business is making 50% ROE and management is stealing 10%….
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Thanks!
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Thanks for making this exhaustive treatise public. According to Jim Collins follow-on book titled “How the Mighty Fall” , The really great companies are the ones who have failed and come out of failure to be great again. As he says that the management has leaned the art of navigating tough business cycles and cumulative learnings help them to withstand future shocks. This would be the ones which would qualify for the “long term investing”. So in todays times, would companies like Jain Irrigation which you have studied in depth or Similar ones qualify for rising out of the ashes, subject to balance sheet health? How do we get a sense of it?
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For me, nothing sounds a better example than my worst ever investment of helios and Matheson. This eroded almost 90% investment and I was totally helpless. I am still holding it just as a reminder of my worst mistake ( It’s banned from trade). Fortunately, it happened at very initial stages of my journey when the amount was very small. Even then I held highest by % in that stock. That mistake has made a lot of impact on me.It seems to me that everything happens for good.
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Can you elaborate more on your mistake…in Hindsight why it happened, what u misjudged
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One big mistake I did was not to verify to what extent the business of the company is genuine. Secondly, I was drawn by extraordinary results they were posting every quarter. But failed to verify it with minute details like compensation etc. Later on, I got a warning from one of my friend about the stock who too had invested in it. He exited with a handful of gains. The flag there was, a serious allegation of fraud on top management and subsequent stepping down of some people from jobs. Stocks price started crumbling down.But was still above my Avg buy price.Later police raided their office and arrested top guys. But I still don’t know why I continued to hold that stock. I had a conviction which I am not able to explain now. Later I almost wrote that off from my books.!!
Other things I did not verify was their client base, future plans etc. It was the time when i had just started investing. I had bought alembic at 70, maruti at 1k, krbl at 20, vakrangee at 50, escorts at 80, voltas at 90, mrpl at 41, avt at 38.appollo tyres at 82. Lnt finance at 78. But I sold it all bcz of that mistake. It was so terrible. But now when I look back, things look different. A lot of lessons learned. I have started again with investing. Presently I am looking at stocks like ujaas energy, thyrocare, berger paints, aksh optifibre (!), Edelweiss. Holding in all stocks for more than 6 months. I wonder if I am committing any mistakes in above choice. If you have come across any.
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