A Fairy Tale
Once upon a time, there was a brave knight called Banksia who was revered across the land. One day Banksia was summoned to the King’s castle by the sea (pictured above), where he was given terrible news. The beautiful Princess Seafrest had been abducted by the fire-breathing dragon Insolventor, who was now holding her prisoner in a deep dark cave. The King asked the knight to slay the dragon and rescue the princess, and, in return the knight would receive the princess’s hand in marriage. The knight rode through day and night and then navigated a treacherous subterranean labyrinth until he came to the dragon’s lair. The dragon was the fiercest opponent the knight had ever encountered, but in the end, the dragon was slain and the knight was victorious. The knight and princess were wed the next day. In the following years, they had many children together, the royal family grew in fame and wealth, and they all lived happily ever after.
An Investing Tale
This fine little tale echos one of my investing adventures that started at the turn of this century. While mindful investors focus on index investing, once upon a time, I invested in individual stocks with mixed success. Beyond the vague wisdom that “banks are where the money is“, banks seemed to fit most of the popular stock-picking advice that you’ll still find people spouting today:
- People will always need a safe place to keep their money and someone to borrow from.
- Invest in brands you know and love. While most of us don’t “love” our bank, we may have used the same one for many years.
- Invest in businesses you can understand. At its core banking seems like a pretty straightforward business model.
- Invest in competent management. The success of some growing banks can surely be traced to competent management.
I followed this sort of advice to find a bank in shining armor to protect my portfolio. At the time, my checking account was with SeaFirst Bank, which was rescued from bankruptcy by Bank of America back in the 1980s. Through more acquisitions of this type in the 1990s, Bank of America was growing into one of the largest banks in the country. From a customer’s viewpoint, Bank of America seemed efficiently operated, and the stock price had quadrupled in the previous decade, which all suggested that the management was aggressive yet competent. So, I took the plunge and invested a considerable portion of my savings in Bank of America stock.
The story seemed to be shaping up nicely. So, I assumed the story would continue into a somewhat boring but successful “happily ever after” full of increasing stock prices and dividends. At first, that’s how it went. Bank of America stock doubled again in the early 2000s as it acquired several more regional banks. But then the plot twisted unexpectedly. All the banks started to falter during the first rumblings of what would soon be called the Global Financial Crisis of 2008.
There was no obvious dragon to fear and slay. Instead, all the knights of the realm fell under the same spell of pride and avarice cast by their own financial wizards. Bank of America married with what turned out to be an ugly and pox-ridden stepsister Countrywide Financial, one of the worst offenders in the toxic home mortgage scandal. The knight ended up forking over $350 million in fines to the King for the stepsister’s prior sins. To make matters worse, the King persuaded Bank of America to marry another homely stepsister called Merrill Lynch*, to prevent her impending bankruptcy from pitching the kingdom’s entire financial system into a fiery pit.
I’m sure the King was very grateful. But the dead-weight of Merrill Lynch and Countrywide, as well as subsequent fears about Bank of America’s health, dragged the stock down from a high of almost $55 in 2006 to a low of about $4 in 2009 as shown in this chart.
In 2013, Bank of America was removed from the venerable Dow Jones Industrial Average, and it has never fully recovered. Ten years after the crisis, the once-proud knight is now an addled codger whose stock price and dividend yield remain shriveled at about half of their former heights. My fairy tale turned out to be a horror show that was not so happy after all.
More Than an Anecdote
You’re probably thinking, that’s a nice anecdote, but that doesn’t mean every individual stock purchase will turn out badly. Some would say that Bank of America was simply caught up in the wake of global events that impacted virtually every stock in America.
While that’s all true, almost every individual stock I’ve ever owned experienced at least one price-crushing crisis in the absence of any broader market turmoil. Further, I’ve previously presented some hard statistics that show the clear majority of stocks turn out to be long-term losers. Amazingly, a comparatively few winners account for almost all of the long-term wealth generated by the stock market as shown in this graph from Longboard.
Looking at a much longer period from 1926 to 2015, researcher Hendrik Bessembinder found that just 4% of stocks accounted for all of the net wealth earned by investors in the U.S. stock market. The relative scarcity of wealth-producing stocks isn’t talked about much, but it’s easy to find many anecdotes of stock fairy tales gone wrong. You’re probably familiar with some of the tragic tales of former powerhouse names like GE, General Motors, Nokia, World Com, Sears, Alcoa, Goodyear, and Xerox, to name a few.
I’m not going to tell all these stories. But one additional recent example provides a particularly stark reminder of how even the safest-seeming stock can be remarkably vulnerable.
The Twisted Tale of Kraft Heinz
It’s fair to say that Kraft Heinz is one of the most well-known brands in U.S. history. The company fits all the popular advice about stock picking:
- People will always need staple comfort foods like cheese and ketchup.
- Kraft and Heinz have developed trans-generational customer loyalty in nearly 200 different food brands. Almost every fridge and pantry in America contains more than one Kraft Heinz product.
- The staple food business is easier to understand than almost any other type of modern company.
- The management aggressively and profitably grew by acquiring and merging with other valuable brands to become the fifth-largest food and beverage company in the world.
And the warm and fuzzy kicker is that none other than America’s favorite investing uncle, Warren Buffett, owns more than a quarter of Kraft Heinz through his company Berkshire Hathaway. The merger of Kraft and Heinz was even orchestrated to a large extent by Berkshire Hathaway, because of the huge growth potential Uncle Warren anticipated. Who are you to disagree with Uncle Warren? For many so-called “coattail” investors, who simply mimic Buffett’s portfolio and stock moves, Buffett’s involvement was the only fact they needed to know.
So, what could go wrong with buying some Kraft Heinz stock? In early 2017, after doubling in value in less than 5 years, Kraft Heinz stock was repeatedly hitting all-time new highs. But soon after that, the quarterly reports started to look progressively less dazzling until, early this year, Kraft Heinz finally fessed up and reported extremely poor operating results, admission of some accounting irregularities, and a huge goodwill writedown. They also cut dividends by almost 40% per share. The stock price plummeted more than 25% in one day and now hovers at around $30, a mere shadow of its 2017 high as shown in this graph.
No global (or even sector-specific) market crisis caused the Kraft Heinz problem. The fundamental story about the company hasn’t changed either; everything I said above is still true. Some close readers of quarterly reports claim they anticipated these bumps in the road for Kraft Heinz. But plenty of other companies have reported similarly anemic results and were still able to make adjustments and avoid an outright disaster. Further, it was surprising that a company so closely associated with Warren Buffet would use accounting tricks to appear more valuable. And the biggest surprise for many was the cut of that juicy dividend.
The future of Kraft Heinz doesn’t look any better than the present. Aswath Damodaran estimates that the current stock price is close to fair value and the company’s forward growth is unlikely to keep pace with inflation. Even worse, he assumes that Kraft Heinz won’t suddenly admit to more accounting irregularities or other nasty problems. However, among the individual stock earthquakes I’ve lived through, I’d say that at least half had additional and substantial aftershocks that subsequently drove the company’s value down even further.
People Love Stories
After eating and sex, story-telling has to be the oldest form of entertainment. All primitive cultures have myriad stories that presumably help those cultures interpret the world and make decisions. For example, Native American myths about tricky coyote probably have many purposes including pure entertainment, but one obvious purpose is to help the listener handle tricky people in real life.
For almost any situation we encounter, it’s easy to apply or invent a story that leads to a decision. We love to spin narratives out of random information that fits with our sense of how the world should be. We then assume that because we’re familiar with the beginning of the story, we know how the story will end. But that’s just an assumption based on hearing years of childhood stories that always ended exactly as we expected or hoped they would.
With stocks, it’s easy to concoct a story about a company’s future greatness based on its most obvious assets and a track record of successful growth. But one of the central tenants of mindful investing is that it’s impossible for anyone to consistently predict the future. Assigning one plausible story to a stock won’t guarantee its future. In fact, the statistics on loser versus winner stocks indicate that in most cases the stock will eventually depart from the story and come to a disappointing or even disastrous end.
The Kraft Heinz disaster is particularly telling because so many people expect the preternaturally rational Warren Buffett to avoid mistakes like following hopeful stories. But clearly, no one is completely immune to spinning enchanting stories about the stocks they like, and no one can be sure those stories will play out as expected.
The allure of stories is yet another reason that picking individual stocks is a loser’s game for most investors. You can avoid the game entirely by instead investing in low-cost index funds, which represent large groups of stocks. With index funds, there’s no need to look for stories (good or bad) about individual stocks within the fund. Instead, the story is about the performance of stocks as a group, where only a few unpredictable winners in the group generate most of the returns. This simpler story still doesn’t ensure that your future stock returns will be as good or better than past stock returns, but it ensures you’ll reap the market returns that are readily available to the mindful investor. That’s insurance that the individual stock investor will never enjoy.
* Apparently the King condones polygamy.
