You can spend a lot of time researching a company, decide it has what it takes to be a great investment, buy some shares, and then watch the stock collapse. When that happens, the temptation is often great to double down and buy even more shares. "After all," the thought process goes, "if the stock was worth owning at $30, it should be even more worth owning at $10, right?"
Unfortunately, that line of thinking only works if the underlying business is still healthy. Quite often, however, a collapse like that is driven by a very good fundamental reason -- and the company simply isn't worth what either you or the market had previously thought.
When a collapse is justified, buying more isn't a smart idea -- indeed, it's simply throwing good money after bad. That's an investment sin I've committed more often that I care to admit, but it's one I vow to not repeat in 2012.
Here's the story of my largest such transgression. In early 2010, I first bought shares of Life Partners Holdings (Nasdaq: LPHI ) , a company that specializes in selling life settlements on no-longer-needed life insurance policies. At the time, the company looked like it had the phenomenal combination of a pristine balance sheet, a solid (and rising) dividend, and still tremendous growth ahead of it.
By late 2010, the story started quickly unraveling, when The Wall Street Journal ran an article calling into question the core of the company's operations. At issue were the life expectancies the company attached to the policies it sold, which were central to justifying the prices it was charging for those policies. Shortly thereafter, the company acknowledged that the SEC was investigating its operations.
And, as committed as I was at the time to throwing good money after bad, I read that news and thought, "Oh, this too, shall pass," so I bought more shares.
Not to excuse my idiocy, but I had previously seen a formal SEC investigation into climate control company Lennox International (NYSE: LII ) look more like a tremendous buying opportunity than a reason to sell. Yet Lennox's accounting problems (related to its Canadian subsidiary) were obviously minor compared to what was going on at Life Partners Holdings, but I nevertheless drew the wrong conclusion.
So this time, with the SEC's announcement on Jan. 4, 2012 that it was suing Life Partners Holdings for fraud, I decided to finally wise up and not throw even more good money after bad.
Buying low is still a good idea
Of course, buying a solid company during a scandal can be a very good way to make strong profits. Indeed, one of Warren Buffett's most famous investments was when he heavily bought into travel and entertainment card processor American Express amid the Salad Oil Scandal. Yet, what American Express had that Life Partners doesn't have is a very strong business that generates cash and that wasn't directly touched by the scandal.
Similarly, some of the biggest winners from the Enron debacle were the owners of the pipelines and oil and gas exploration businesses Enron sold off to instead pursue its sham energy trading business. Kinder Morgan Energy Partners (NYSE: KMP ) took the pipelines and EOG Resources (NYSE: EOG ) took the exploration business, and both companies have performed phenomenally well.
Once again, the difference between these Enron cast-offs and Life Partners Holdings is the difference between night and day. The Enron cast-offs were fundamentally strong, cash-generating businesses that were largely tarnished only by association with their former parent company. Life Partners Holdings, on the other hand, is being smacked around because of its own alleged actions. That's a distinction worth remembering the next time I (or any other investors) go sniffing around a scandal looking for opportunity.
Here's to a more successful 2012
In a nutshell, bargain-hunting is smart investing, but throwing good money after bad is anything but smart. It doesn't take a rocket scientist to tell the difference, but it does take a willingness to investigate whether a company's troubles are permanently crippling or merely a tangential distraction. That distinction makes all the difference in the world between a legitimate bargain worth buying more of and a permanent loss of capital made worse by flushing more money down the tubes.
If you're looking for some bargain stocks to get you started, check out "The Stocks Only the Smartest Investors Are Buying," which details several solid companies with beaten-down shares.