What do you do when you make a bad investment in your HF job?
Currently at a L/S equity fund, and one of my investments blew up, as in the investment thesis didn't play out since an unforeseen event happened. So I lost my fund money. Literally just hid under my desk all day while my PM was busy with other stuff. Literally worst feeling ever. How do you cope with this? The only positive thing I have going for me is that all of my other investments have been fine and this investment was neither big or small relative to the portfolio size.
Don't work at a hedge fund; take this with a grain of salt.
I think you go back and reanalyze your thesis with what you could have known at the time - not what you know now. Was your thesis flawed because you didn't research thoroughly enough and you should have been able to identify a risk? Or is there no way you could have reasonably predicted this event, so you feel bad about the outcome but good about your approach?
It's like poker. You don't kick yourself for folding 2-7 when the flop comes 2-2-7. You might be disappointed, but it doesn't mean you made the wrong call.
We underestimated the competitive rivalry. The company we invested in had a market leading technology and market share. However, the competitors have chipped away significantly, and we didn't see that coming because we believed in the "switching cost effect" that this company had (i.e. once the customers got used to the product, there was very little reason to switch away because switching costs were high)
Turns out switching costs were not that high if competitors can do it better :/
The company had gone from doing 25%+ EBITDA margins and having a 20% ROIC business for the last decade to now burning cash today.
Welcome to the small cap world folks,
This is an error where you're at fault. In other words, the failure wasn't the result of an unforeseen shock to an exogenous variable (such as unexpected inflation in a carry trade, or a sharper than expected rise in interest rates, etc.). The failure of your hypothesis is the result of your unfamiliarity in company/industry specific attributes.
I would say that this is a very big issue for you, depending on how much you lost. It means that you don't understand your industry. Your due diligence also sounds incredibly shotty. "Customers raved about the technology" is hardly sufficient cause to assume significant (sounds like near impenetrable?) barriers to entry.
I don't work in AM but, if my forecasts leading up to a deal was this wrong and if we lost a lot of money, I would be prepping my resume.
They say that the absolute best traders/investors are only right about 60% of the time. That means they get a lot of trades wrong. No one can get every single thesis right. The name of the game is developing both sides of a trade and then assigning probability weights to the various scenarios. Always know what the person on the other side of the trade is thinking and how they will be right and you will be wrong.
So like I said, you're going to be wrong a lot if you stay in this business, shake this one off and get the next one right. You said that your track record has been good so far and this position was immaterial so you're good. If your PM is seasoned, he's not expecting you to get them all right. Be prepared to discuss exactly what went wrong and how your thesis was flawed, that's probably what he's looking for from you, that you learned from this one. I've found that in both business and sport that you always learn more from a loss than a win.
Surely you are not "wrong" if its an event that was basically unforeseeable for example 911?
Just curious on your thoughts on these sort of events.
In a portfolio of investments (trades), given a large enough sample size, some % of those investments will be wrong, and you will lose money on them. The key is to make more money on the wins in aggregate than you lose on the losses.
Agree with many of the posts above.
From what I've learned in investing, you just need to be right more than you're wrong. If your initial investment thesis is intact and and "an unforeseen event" happened, if you back out that "unforeseen event", does your initial thesis still hold true?
We're all humans and we can't account for every single thing that could possibly happen. The key is to do everything you can (and focus on what you know) to mitigate downside risk.
If you talk to everyone in the investment world, everyone had one particular investment that sucks. For me, it was when I first started investing, and was absolutely convinced that a Biotech company was going to get FDA approval. Charts were running up, everything seemed to be in place given that the management company was in consistent dialogue with the FDA, and analyst consensus was also positive in supporting my thesis. Lo and behold, the company didn't approval. Our fund lost money, the PM was a bit pissed, and I learned a lesson.
Try to gather what you can about the investments that don't work, retain that knowledge, and apply in the future. Doubt doesn't help, nor does getting hung up on a bad investment. Move on.
Never invest in dishonest management teams, I have learned. See response below
Shows me how much luck matters in this business. As in Batman, Two-Face used a coin to decide his fate and destiny. It's a game of roulette...at the end of the day. Win or lose. Win or go home.
It's a cruel world.
Losing money is part of the game and you'll get used to it eventually. I've lost 50%+ of my networth probably about 4 or 5 times now. The first time sucked but now it's not really a big deal, kind of the nature of the business I suppose.
It's worse when you lose money that isn't yours though for sure. Just hang in there and you'll learn to ride the emotional rollercoaster...especially when you deliver returns. :)
Why are you saying the event was 'unforeseen'? You bought into a company you thought had a competitive advantage through its best-in-class technology and a sticky customer base due to what you assumed were high switching costs. And you backed that analysis predominantly through customer interviews. It turns out, you were wrong on both accounts and your diligence was weak. Don't chalk this up to unforeseeable circumstances. Even 'acts of God' can at least partially be accounted for using insurance contracts of some sort, and these errors certainly don't qualify as divine intervention.
Just because you can't see something doesn't make it unforeseeable. You shouldn't beat yourself up too much. It happens. As long as you learn from it, you'll get better. Investing is about weighing the odds. You conduct due diligence so you can calibrate your bullshit detector and see the odds more clearly. I think you've learned that in conducting customer interviews, the credibility of the customer's knowledge of their alternatives to the product or service they use matters a great deal. Even if they use a product or service from your company, do the people buying that product or service know what else is out there? Maybe they do, but more often they don't, especially if the product in question isn't core to their business. And 100 interviews saying something is great by people who don't know any better aren't worth the single conversation explaining to you why it isn't.
I spend less time these days worrying about financial models and more time trying to think through the scenarios that might lead me to a capital loss. Putting numbers on the probabilities I associate with those various scenarios is a fool's errand. And the potential outcomes are also somewhat unknowable, so attempting to determine my return is also something of a waste of time outside of basic sensitivity analysis. Still, I think you could see the possibility of a new entrant or an existing competitor simply producing a better piece of tech. That's always a risk in technology investments regardless of the switching costs. The higher the switching costs, the lower the probability of losing customers rapidly. But no matter how high the switching costs, that probability will never be zero.
At any rate, when you speak with your PM and he asks what happened, own the fact that you misjudged the switching costs, or that your customer interviews didn't reveal a piece of upcoming technology, or that your crystal ball was a bit cloudy. It's much better to own the mistake and explain why you think it happened as opposed to saying you think it was unforeseeable. That suggests you don't know why it happened, and that's neither true nor productive.
Thx for the response. We do a lot of upfront research, and it wasn't until we went to the indsustry-wide event when we realized what was happening, and by that time, it was too late. Even management didn't know what happening. Instead, they blamed the overall market being weak. The biggest mistake I made was when I spoke to their biggest competitor (who was private, by the way) and learning their sales were sharply up, which had meant they were taking share and growing with the market. When I went over this with my PM, we still believed our company would be able to hold their share, because of the switching cost effect.
Dishonest, aloof management was my biggest mistake. The most successful investments are those with honest management teams, ESPECIALLY in the small cap world.
I feel you, and it has definitely been my experience in buying smaller companies. I've done deals ranging from $3M-$4B, and the investments in smaller businesses are much riskier in terms of potential capital loss. The management teams of small caps tend to be less professional than the management at F500 companies. They often don't know their competitive positioning as well as they think they do.
While large companies can be blind to the challenges to their business models posed by smaller, more innovative firms, smaller firms have a greater tendency to misunderstand their market. It's not necessarily dishonest of management to misrepresent their business and its prospects if they don't really understand the changing dynamics of the market in which they operate.
That's why I don't like making those sorts of investments. They're too heavily reliant on my ability to fully understand a market that I may only have just started researching a few weeks ago. This happens in VC and corporate development roles at tech companies all the time. There are so many sub-sectors of 'tech' that it's hard to be any sort of expert in everything. Making investments in cybersecurity companies is not the same as making investments in, say, data analytics or tech-enabled services businesses. The level of understanding needed to fully diligence a small cap cyber business is the same level needed to diligence Palo Alto Networks or Palantir, but in those larger deals, you have shitloads of lawyers, accountants and consultants on your side. On smaller deals, you're on your own trying to determine the quality of a firm's tech without being able to conduct the technical due diligence yourself. It's dangerous. Relying on customer interviews and management to determine competitive positioning in such a highly fractured space can burn you.
It sounds like this was something of a one-off situation, but that's not to say something like it won't happen again. As long as you've learned a bit from it, it's really not that big of a deal.
Few questions here, which your PM might ask too:
At some point, you need to reassess the trade entirely. It seems to me like the margins did not magically go from one quarter to the next from great to negative, so what happened during that time? Why were you not managing your investment or listening to earnings calls or whatever to understand the changing business landscape?
Your event was not unforeseen, rather, it sounds like it played out right before your eyes and you didn't do anything about it. It sucks to be wrong, but the only thing you can do now is look forward.
You have a loss, but does that mean you sell? You need to figure out what the best trade is now, regardless of what happened in the past. We all lose money, but the worst thing you can do is panic and ignore the fundamentals because holding on doesn't feel good. Dig in, do some work and know what to do next. If its not a glaring sell, then don't sell. If you do the work and as a trade its a good short, then sell and get out, otherwise its a hold. Figure out what your bid/ask is on the trade...where you buy and where you sell. You should have done that in the first place and constantly moved it around (and I am not talking about a 5 cent spread). Maybe you do work and still believe in it now, but at a lower base...add to the position maybe.
I don't want to beat you up too much, but on point number two, the customers of a lot of small caps are themselves small caps. If they don't have sophisticated or competitive procurement processes in place, the fact that they use the products/services your company provides isn't sufficient for determining the competitiveness of your products/services. It could just mean the customers don't know any better, especially when the product/service your company provides isn't core to their business. I mean to say that you have to diligence the knowledge level of your customers. If they're experts in the space in which you're operating and they think your product is great, then you're probably okay. But if they're not particularly well-versed in the sector, then maybe they just use whatever product or service they have been using for a few years because they don't know something else exists that better suits their needs. Or maybe they don't care that much? In any case, you need to assess whether the customers you're interviewing actually know anything about the business. Maybe they did in this case, but it should be a standard diligence item.
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