Horsehead Postmortem: Updating Beliefs After A 100% Loss

By Jesse Koltes, Founder of TheCharlieton.com

My investment in Horsehead Holding went to zero recently. This marks the second time I’ve lost 100% of my money on an investment, but the first time I’ve done so since stumbling across Ben Graham and becoming an aspiring value investor.

As Charlie Munger has said, it’s wise to embrace your errors, and even to rub your nose in them.

I don’t want to let that happen with Horsehead. Forgetting would only compound what has already been a painful, permanent loss of capital. I want to collect up the broken pieces and build a cairn at this point in the path. I also want to think diligently about the very real possibility that I have been fooling myself.

While I do think the story of Horsehead is quite interesting, the purpose of this article is not to litigate the merits of the investment itself. My focus will be on my reconciling my prior beliefs with my new experiences. As an excellent example of this exercise, I encourage readers to check out Tyler Cowen’s post on how he updated his belief’s after the rise of Trump.

For background on the investment and the events that transpired, I suggest this article by Tom Massedge, as well as this article in the New York Times. I am personally waiting for a tell-all book by Guy Spier and Phil Town to fill in any of the remaining gaps.

Previous Belief #1: Don’t Bowl Without Bumpers

I got this tip from Greg Speicher’s website some years ago. The basic gist is that if you are going to be an active investor, you can probably avoid a lot of stupid mistakes by limiting your investable universe to those investments that have already been prequalified by ending up in some other smart person’s portfolio.

Few ideas have impacted me more than this one. I am a diligent reader of 13Fs, and stumbled across Horsehead while reading Mohnish Pabrai’s SEC filings.

And what an intriguing little finding it was. Not many people held it, it appeared to be an unappreciated, low cost producer with great long term prospects. But most importantly, Mohnish held it, and as far I could tell, he hadn’t “cloned” the idea from anyone else. If the cloner had gone off script, this had to be really good!

Like an idiot, I was attracted to the novelty of my own discovery and quickly fell in love. In retrospect, I loved that I was clever enough to “know” what Mohnish was thinking, and justified the investment decision ex post to comport with that feeling.

While I certainly wouldn’t endorse the opposite of this rule (only bowl without bumpers?), I think it’s problematic for a few reasons. How can we fight the confirmation bias inherent in starting an analysis where a respected person has finished theirs? How can we avoid the crowd following, mean reverting tendencies that arise from looking to others as a source of investment ideas?

The answer, true believers would say, is obvious: exercise good judgement and work hard to understand the investment. I definitely should have done my own work, started with more skepticism, and only made the investment if it fit with my carefully selected rules. But as I’ll address further down, I’m no longer as confident in my abilities to avoid this trap, even after I’ve spelled out how I think the trap works. More on that later.

Previous Belief #2: It’s OK to Ignore Management

I’ve always had trouble with the idea that value investors can adequately assess management talent. How do they do it? No one ever has been able to explain it well to me, and I therefore think most of these judgements are fraught with biases of all sorts, high error rates, and general silliness.

I’ve always been more comfortable in analyzing the business itself. If the returns on capital are consistently high, the business is evidently good, and management has thus far not been able to kill to the golden goose (not that I don’t believe they might be trying).

So prior to investing in Horsehead, I didn’t know a damn thing about the CEO, the CFO, or anyone else for that matter. I knew Mohnish Pabrai and Guy Spier owned nearly 10% of the business between the two of them, and figured that if they liked this business, management was probably not so bad. Even if they were bad, the business was good, and the superinvestor’s minding the store would keep things on track.

I was wrong. After visiting Delaware and listening to the executive leadership of Horsehead take the stand in their bankruptcy hearings, I was nothing short of appalled. Quite simply, these were people I would never go into business with privately. They were slippery, cunning, and didn’t care at all about the shareholders (it wasn’t even clear they knew any shareholders other than themselves). I underestimated how easily bad managers might be identified by showing up and listening to what they have to say.

Belief update: Bad management is like pornography; you know it when you see it.

Previous Belief #3: Diversification is for Suckers

I started off as an efficient markets guy in college. It seemed like a plausible explanation for the silliness I had seen during one summer running papers tickets around an options trading pit in Chicago.  The EMH school taught me that diversification was a free lunch, and therefore a very good idea.

Charlie Munger changed that for me. I think the Kelly formula, the notion of diminishing returns, and basic statistics show that excessive diversification doesn’t help after a certain point. But what, precisely, is that point?

Munger and Buffett often concentrate their holdings in just five ideas. Obviously, they don’t think there is a lot of ignorance to diversify against, and they’re probably right about themselves. The problem is, I don’t have the same level of ignorance as them.  If anything, I think I’ve been too ignorant to know how ignorant I really am at any given moment.

I think this is one of those phenomenon where taking a maximalist view is not wise. You need to scale your level of concentration to your sophistication, while also considering the performance dragging effect of spreading your money too thinly. For me, I think that number is 10 – 20 roughly equally sized holdings for a person at my level of sophistication and experience.

Belief update: it’s possible to “diworsify” but it’s also possible you’re not as clever as you think. Weird stuff happens, and some diversification can help when it does. Having 10-20 equally sized holdings now (in my late twenties) and scaling down as I gain confidence is a better path than starting with an extremely concentrated portfolio now and blowing up while I gain valuable experience.

Previous Belief #4: (My) Discretion Can Beat Rules

Charlie and Warren have said that they don’t believe investing can be boiled down to a formula. They argue that discretion and horse sense will lead to better investing outcomes than rules and algorithms.

I no longer believe this to be absolutely true. First, the academic evidence says simple rules beat judgement in almost every imaginable scenario. We should all get a lot more familiar with the work of Paul Meehl.

Furthermore, even Warren and Charlie endorse rules for the truly ignorant, and that rule is called indexing. In one of my favorite turns of phrase, Warren makes the point: “Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.”

But how do we reconcile the fact that rules nearly always outperform discretion, but Buffett and Charlie defend their approach as discretionary? I think its partially a problem of language.

Perhaps what Buffett and Charlie call discretion is actually more rule like than 99% of other human behavior. Perhaps a great deal of their outperformance stems not from their creative deviations, but from their iron adherence to many (but not all) of Ben Graham’s better than average rules.

I think much of what Charlie and Warren actually do is a sort of self imposed rule following, but they don’t call it that because they don’t like quants. This confuses the rules versus discretion debate and perversely lowers the prestige of the rule following.

Bottom line: I believe that well selected rules are often better than discretion, even in investing. It’s possible that some geniuses can improve on rules after decades of mastering the nuances of an algorithm, but the truly ignorant should stick to the rule.

Previous Belief #5: Reading Big = Big Circle of Competence

I have worked in aerospace, consulting, software, transportation, and the food industry. I have read lots of books about these industries. I have also read lots of books about industries in which I’ve never worked.

Unfortunately, it’s too easy to confuse knowing something about an industry with knowing enough about an industry.

Belief update: My circle of competence for making discretionary investments is smaller than I thought. It’s probably restricted to food companies and absolutely obvious monopolies.

Previous Belief #6: The Most Important Thing is Showing Up

Trying to be consistently not stupid is its own form of genius. My experience with Horsehead confirms and strengthens this previously strong belief.

Had I “showed up” mentally and analyzed the company like I know I am able to, I would have been better served (although I’m not saying I would have been able to avoid – see my point about diversification).

When I did “show up” physically, it was to the Delaware Bankruptcy court and I met some amazing people such as Guy Spier and Phil Town. I also learned an incredible amount about the company that prior to bankruptcy, I had not known. It was silly that I had not taken the time upfront to understand the things that ultimately killed me in the end.

Belief update: show up mentally and physically to the things that matter to you.