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Martian Chronicles
Thoughts on a Failure

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By greenmartian2
August 6, 2003

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I finished an evaluation of a retailer I own that has decreased more than 40% from my original purchase price, though assorted buys at lower prices currently have that loss around 20%. I'll keep the company under wraps but figured a small observation post-modem might help, either me, or maybe some poor scum sucker out there. Some of these are very obvious, but some aren't. Here goes:

*Always write down your transaction justification � for every transaction. This is fairly simplistic but yields very tangible benefits. I was able to go back and read my evaluations, complete with valuation data and my thoughts at the time, and rapidly get a clear picture of what went wrong in the evaluation

*Beware of same store sales that are driven primarily by pricing and transactions. Some companies can keep up profits even when this happens � ANF comes to mind right way � but if comps are up and transactions down, begin to wonder if the core customer can continue to support that business quarter after quarter. The core customer might shop somewhere else one day, especially if there are pricing differences between this concept and competitors, and if she does what are you going to do?

*Be cautious of buying when transactions are down and comps are down AND the valuation is high. I can't even believe I'm writing this, because going through my notes my first purchase occurred when comps were down 2% and transactions were down 10%. I put this in my primarily evaluation ("the only negative is that this was driven by higher margins and multi-unit sales, not transaction counts") but allowed other factors to overwhelm this concern.

*In tandem with the above, consider that a strong balance sheet and high cash flow are nice but in a commodity company � at prices that reach 20x earnings and above � earnings drive the stock price. All the balance sheet does is provide a floor of sorts, and you should never underestimate how low the floor can go.

*Look at the price history of a stock. This particular issue had already suffered wide swings in fortune. While this doesn't mean that volatility will return, you can be certain that history WILL repeat - especially in a commodity company. That's why they call them "commodities".

*Beware of analyst estimates. I know, you don't need to hear this, but I put an outside estimate in my notes, with specific eps figures and growth rates. Nothing wrong with that, nothing wrong with looking at the justification that led to such a conclusion, but if you must use future earnings estimates be sure those estimates are believable � and develop a scenario for what might go wrong. Again, this one is redundant for the folks on this board, and I didn't buy it based on this brokerage firm, but frankly it does bother me that I thought enough to include it.

*Be careful buying companies with modest top line growth rates (12% or less) or sqft expansion rates and high margins and relatively high pe ratios. Maybe this is more my personal opinion than anything else (review the CTR thread before), but I've seen case after case where companies like this falter and there is nothing left to excite investors. You can't get blood from a turnip, and high margins are very susceptible to poor sales. Poor sales, poor margins, poor stock price.

*Never be too impressed with a conference call or the clarity of management's presentation. I was, both with how the company explained their business and presented future growth plans. And they've been consistently lucid in call after call. Yet, this same company said that a secondary concept was doing well in one call and then a month or so later said that the concept was going to be shuttered for something else. Remember that these are businesses, and while management does its best, bad stuff does happen from time to time. Again, maybe this is just my personal experience but there is something intangible that you get from listening to management OVER TIME that you don't get from just reading the financials, no matter how many things you read. This was a new company for me, followed less than a year.

*When management says something to the effect of a 'fundamental shift in their business occurring', listen closely. Again, this is an obvious one, but I focused far more closely on the potential for a turnaround instead of a possible impairment of the business model. Heck, I'm not even sure that management isn't using poor sales and execution to lowball estimates, but clearly you want to investigate this very closely.

*When a company does a secondary offering, watch out! I've seen this again and again in retail and restaurants, and it doesn't always lead to a problem then next year, but clearly companies do secondaries when business is good � otherwise nobody would give up the money! It'll make the balance sheet prettier but it doesn't mean that performance will continue.

*A repeat, but the balance sheet can give a company time to solve its problems. This company has solved nothing yet but finances aren't an issue. They've got time to right the ship, but considering that 'fundamental problems' might exist, don't expect anything to happen overnight. If you can't be patient, sell out � now!

Frankly, in dollar terms this wasn't a huge deal (the stock was never more than a 2% position), and I don't want to overestimate this mistake. This is NOT the same as Wet Seal last year, but I allowed what turned out to be superficial things blind me to the fact that the risk/reward level on this stock was very unfavorable.


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