It’s impossible to know in advance how any investment will turn out. Only in hindsight will you know for sure. So it’s likely that you’ll always put too much or too little money into any one investment.
This is why position sizing — the amount held in one investment in relation to the total portfolio — is so difficult yet important. Especially when it comes to losing money. Having too much money in a single investment that turns out badly can cost you dearly.
Bill Miller relayed this lesson when he talked about one of his biggest losses. It involved Enron.
Enron was a Wall Street darling, throughout the 1990s, that had a magical ability to grow earnings at will. Its stock hit a peak of $90 per share in the summer of 2000. But the price dropped over the next year or so.
Throughout the decline, the CEO, Kenneth Lay, assured shareholders and employees that the company would rally, urging them to buy more Enron stock, while quietly selling his shares.
The magic turned out to be accounting fraud.
Enron’s stock hit rock bottom on November 30, 2001, at 26 cents per share. The company filed for bankruptcy two days later. It was the largest bankruptcy at the time and dragged the accounting firm, Arthur Andersen, down with it. Many shareholders, including employees, were wiped out in the bankruptcy.
Luckily, Miller and his shareholders were not:
We bought Enron just before it went bankrupt. We had avoided it all the way up and all the way down, even though we were interested in the company. I had met with Jeff Skilling a few times. Enron was one of Forbes magazine’s most admired companies, and Andy Fastow was regarded as the best CFO. But we always regarded it as being richly priced because no matter how quickly its earnings were growing, it actually didn’t earn its cost of capital.
That was a red flag to us because that was the theme of the old W.T. Grant case back when I took the CFA exam about 25 years ago. It was one of the classic cases. So, it was clear that Enron couldn’t keep doing that. But when it slowed its growth and it looked like it might earn its cost of capital or more, then we got interested.
When the stock got down to the mid-teens, we started to do some serious work on it, and we parsed off every hard asset (the pipelines, etc.) against the debt. We looked at all of the off-balance-sheet stuff. It was sort of opaque, but we knew what had gone into it. And we assumed that the equity in the off-balance-sheet partnerships was zero. But we also assumed that it could pay its debt.
We had all of the assets parsed off except for the trading operation, and we valued the trading operation in the twenties — assuming access to capital and assuming an investment-grade rating. So, to make a long story very short, we concluded that if it could maintain access to capital, it was a buy.
So, we bought it starting in the low teens — all the way down to about $3 — and we put $300 million in it. And the reason I’m going on about it is that I think it’s instructive about our process. This was in the fall of 2001 — I guess it was post-September 11.
As we looked at it, we thought there was about a 10 percent chance that it was a zero. We didn’t know of any fraud there, but we knew that, because of all the controversy, if Enron lost access to capital, it would be a zero. And our view was, “OK, if it’s a zero, can we still invest in it? How much can we invest in it if it goes to zero and with our overall portfolio, still beat the market?” And that’s how we calibrated our position size in it. As it turned out, our average cost was probably $7, and we sold it at 80 cents.
Miller lost $300 million on Enron. It was roughly an 89% loss and the most money he had ever lost in a single position (at that point in his career). It also turned out to be the quickest. It only took 60 days.
One of the biggest mistakes investors make is they fail to consider the downside. They get caught up in how much they can make and size the position accordingly. But if things go south, that oversized position severely handicaps their portfolio. The lesson from the Enron scandal is the risk of having too much money in a single stock.
The important question to ask is: how much can I lose and how might that loss impact my overall portfolio?
For Miller, the loss might have been the biggest but the damage was small. He still beat the market that year because he sized the position based on how a total loss would impact his portfolio.
Conversation with a Money Master