An investment strategy that is long-term and focused on quality faces inexorable challenges, such as resisting temptations to respond to short-term dynamics and standing by qualitative judgments. Such challenges can include corresponding mistakes.

These challenges are analyzed in this article, which is taken from the book “Quality Investing” that I co-wrote with Torkell T. Eide and Patrick Hargreaves, portfolio managers at London-based AKO Capital. The focus here is on two common categories of mistakes: those made when buying and those made when deciding to continue to hold, instead of sell, a stock.

Mistakes When Buying

If smart people learn from their own mistakes while wise people learn from the mistakes of others, the goal is to be both smart and wise. The best thing to do after making or observing a mistake is to acknowledge it and absorb the relevant lessons to avoid repeating it. In the case of quality investing, to paraphrase Mark Twain, while scenarios do not repeat exactly, they do rhyme.

This affinity enabled my co-authors and me to classify mistakes we have made or seen into a few categories that, if kept in mind, significantly reduce the probability of future mistakes. Several mistakes plague the initial purchase decision.

Top-Down Intrusion

Quality investing is best conceived as a “bottom-up” exercise in the sense of focusing primarily on a company and its industry—the firm-specific or microeconomic factors. While many investors share this approach, a good portion also engage in “top-down” analytics by looking at the broader environment, considering the state of international trade, the rate of inflation or the relative strengths of currencies.

In a quality-investing context, mistakes can arise from elevating top-down perspectives above bottom-up analysis. This kind of error often occurs when large macroeconomic themes start wreaking havoc with stock prices, leading to questions about an investor’s exposure to factors such as trade, inflation or currency values. These macroeconomic trends do warrant close attention as they bear on given companies and industries. However, when top-down factors trump bottom-up analysis, it often leads to choosing companies and industries for the wrong reasons.

A secondary source of mistake risk from top-down investments is weak conviction. Quality investors, inclined to hold for the long term, require the conviction upon purchase to ride out volatility. When an investment idea is predicated on elusive and exogenous forces of macroeconomics, it is far more difficult to have a conviction about a company or even an industry. When adversity or surprise strikes—for example when commodity prices fall or currencies reverse—it can be harder to stand by the thesis. The result is often not only a mistake on buying, but a mistake on selling prematurely—even the dreaded syndrome of buying high and selling low.

Next-Monday Optimism

Optimism is a common source of investing error, plaguing quality investors as much as any other. In the criminal justice system, recidivists often plea for leniency by arguing that they are remorseful and pledging to do better—kick an addiction, get a job and straighten up. Prosecutors and judges alike would like to believe them, but are often disappointed. In the corporate world, many managerial laggards sing the same tune, stressing that good times are around the corner, assuring investors that problems are behind them and swearing on a new product launch or acquisition. It is tempting to believe in such hopes—which we call next-Monday optimism—but they frequently yield mistakes.

Troubled firms and problem-riddled industries are far more likely to stay that way than to recover and scale new heights. Managers and their advisers who strive for a turnaround and present compelling strategies, however, are often convincing enough to induce investor optimism. Good examples recur every decade or so in the case of the airline industry, and occurred in the steel industry for a few years at the start of the 21st century.

Most next-Monday industries and companies continue to disappoint because their infirmities are due to external factors that no management can permanently overcome. While turnaround or restructuring programs may create windows of opportunity for incremental improvement, broader industry conditions ultimately prevail. Even for investors able to pinpoint the time when a structurally challenged industry is due for its moment in the sun, they still must time the sunset. That means timing both the decision to buy and the decision to sell, which makes mistakes twice as likely.

Overconfidence

Overconfidence is the root cause of many mistakes. Some individuals may command the relevant background knowledge to credibly evaluate most leading companies in at least a few industries. But even this does not eliminate risks of overconfidence. People are inclined to overestimate their knowledge and abilities, whether in driving or romance. In investing, overconfidence manifests in many ways, not least in the reliance placed on specific earnings forecasts despite their inherent limitations.

Straying beyond the boundaries of one’s knowledge and experience increases the risk of error. For instance, any investment in a stock that depends on the outcome of external factors beyond a company’s control is on shaky ground. Examples of such buys are a pharmaceutical company on the assumption of forthcoming approval of a drug, a gaming company on the belief that authorizing legislation will be enacted or a mining company because iron ore prices are likely to rise. Given the arbitrary nature of many political decisions, even the most expert analysts struggle to predict how a government’s actions might impact a particular stock. The same is true of companies with exposure to commodity prices. As a result, where these variables are present, the chance of making erroneous forecasts increases.

Many investing mistakes arise from an illusion of predictability, which is especially acute in any rapidly changing industry, such as technology. An investor may command considerable knowledge of a given tech-driven industry—whether artificial intelligence or robotics—that facilitates reliable evaluation of the short-term performance and prospects of the companies operating within that sector. Beyond that, factors of dynamism and fluidity degrade forecasting reliability.

The illusion of predictability also seems to recur in companies that are organizationally complex, such as industrial conglomerates or diversified financial institutions. Such companies may well be accessible to the student of industry or finance and even manifest features associated with quality companies, but their sheer scale and inherent opacity can lead even experts to perceive predictability that is partial at best. For example, Siemens operates through 19 divisions, ranging from smart grid to medical diagnostics and industry automation. While it is tempting to evaluate whether Siemens is a quality company, its enormity and intricacy present considerable risks of mistake.

Insisting on a firm basis of knowledge about a company and its industry, and being alert to the risks of straying into unfamiliar territory, is important. When this sound foundation exists, interpreting and responding to surprise events or disruptions is more likely to be done rationally. Being aware of the risks of overconfidence is an equally important step: In a well-known sector, the danger of overestimating one’s ability to forecast is most acute.

Debt

Many investing mistakes can be traced to overlooking the downside risks of debt or its sources. Debt can be seductive, because even investors wary of excessive leverage can be deceived into stressing its upside more than its downside. After all, leverage can readily be rationalized, with managers and advisers alike explaining how unconventionally high debt levels are either under unusually tight control or insulated from the usual risks of calamity amid business adversity.

Debt brings varying interest rates, restrictive loan covenants, and scheduled due dates that put considerable control over value creation in the hands of lenders rather than managers, to the detriment of owners. Risks are particularly great for companies exposed to cyclical end markets. Since cycles invariably defy expectations, borrowers and lenders alike often miscalculate the line between reasonable and excessive leverage.

Drastic mistakes regarding debt levels congregate in two related situations. The first are companies that combine substantial financial debt with high operating leverage. Amid periods of economic expansion, the operating leverage enables growing revenue at lower cost, enabling cash flows that comfortably cover repayment of borrowed money. But in economic downturns, high operating leverage readily translates into rapidly deteriorating cash flows and difficulty meeting debt obligations. Overlooking this feature of debt is a trap for the unwary and one that even experienced investors are prone to fall into.

A second place where debt poses elevated risk of mistakes concerns companies heavily reliant on leases, such as retailers. When retailers grow rapidly during economic expansions, growth often includes adding stores using leased spaces. During such periods, it is easy to overlook that such leases are a source of leverage. When economic conditions contract, the lease rates remain the same while revenue and cash flows decline.

More generally, debt-oriented mistakes are most likely during periods of economic expansion. Amid prosperity, even mediocre companies appear to perform exceptionally well. During such frothy periods, market valuations tend to be high and it can be tempting to compromise on issues such as leverage. Such an environment breeds mistakes, few more dangerous than overlooking the downside and sources of debt.

Mistakes of Retention

Since quality investing entails owning the best companies for the long term, mistakes can occur due to complacency and failure to appreciate when a once-great company is falling from grace. My colleagues and I refer to this as the problem of boiling frogs, referencing the experiments that purported to demonstrate that frogs dropped in boiling water promptly jump out, but those placed in cool water whose temperature is gradually raised to boiling remain in the scalding caldron. (Ironically, this premise was subsequently proven to be false.)

No company is invincible and we devote considerable effort to monitoring and noticing signs of deterioration to enable us to jump out of the pot before being boiled. In addition to the problem of the boiling frog are mistakes of myopia, rationalization and developing emotional attachment to investments.

Boiling Frogs

Companies rarely deteriorate from great to good in a single quarter or year, but rather decline gradually over a few years or more. There is seldom a single defining moment when it becomes obvious that a business has gone from high quality to low. In the rare cases when decline is rapid and clear, it is easy to sell as quickly as a frog might jump from boiling water. In most cases, it is necessary to develop a means to discern the gradual decay and, especially, to resist complacency and denial in the face of gathering adversity.

For instance, a profit warning is potentially a symptom of deep-seated problems. Research among European companies by AKO Capital indicated that one-third of those issuing large profit warnings (measured as causing a stock price drop exceeding 10%) issued another, usually larger, profit warning within one year.

A material profit warning, even from a company in a relatively stable industry, can indicate that serious internal problems are brewing and suggest the need to fully re-evaluate the investment thesis. The fact that one profit warning increases the chances of another one also raises questions of how much of a company’s stock to own, even when we are confident that no structural changes have occurred to the investment thesis.

For many fallen angels, overall deterioration generally begins with small things not going according to plan: growth not materializing, unexplained pressure on margins, more discussion of competitive pressures or gradual increases in capital expenditure. Each disappointment is small in isolation; management provides a good explanation for each and dismisses them as non-recurring. But a string of setbacks often signals a larger set of problems, which emerge or crystallize after it is too late for the business to make corrections or for the investor to mitigate losses. Thus, even small setbacks warrant rigorous evaluation.

Ignoring Changes to the Marketplace

Since quality investing chooses great companies for long-term ownership, complacency amid adversity is fertile ground for mistakes of omission—in other words, failing to sell ahead of decline. It is tempting to interpret adversity as transient—to see sagging growth as a blip rather than a structural issue, or a new competitor as unthreatening to a company’s core business. This attitude promotes a long-term view, but can also create blind spots. While each change warrants individual scrutiny, a few categories of change seem to account for a large portion of mistakes.

Firstly, technological changes driving market alterations are often more serious than they initially seem, especially in consumer or retail channels. The Yellow Pages companies from America to Europe went from virtual monopolies to business dinosaurs within a few years. This teaches us to scrutinize and question a company’s ability to make the changes necessary to protect its business model.

Secondly, business downturns from changing economic environments tend to be more protracted than anticipated. Any company forecasting improvements several quarters into the future despite a choppy near term is conveying hope, not facts. Few industries go from boom to bust and back in less than 12 months.

Finally, if a company’s customers are getting poorer, the company will soon follow, as struggling customers reduce budgets. A German manufacturer of bank ATM machines, Wincor Nixdorf, assured investors of continued prosperity as the 2008 financial crisis dawned, since credit market turmoil did not bear on cash dispensing. But as faltering banks cut costs, they bought far fewer ATMs.

Thesis Creep and “Yes, But” Mistakes

Mistakes often originate in how investors defend a decision to retain ownership of a stock. In regular portfolio reviews at AKO Capital, for example, one colleague plays devil’s advocate to challenge another on the merits of an existing holding. As the proponent engages with the critique, everyone listens for a “yes, but”—an acknowledgement of difficulty followed by a negating qualification.

When the argument for holding a position starts with a “yes, but,” it often means both that a mistake has been identified and that someone is unwilling to admit that. Often, a “yes, but” response shifts the investment thesis for retention from bottom-up quality investing to top-down variables—the mistake of top-down intrusion noted earlier.

Two common variations of top-down intrusion are “yes, but” arguments: “the market is on top of the issue now” or “the stock is cheap now.” But both statements indicate thesis creep and are also usually truisms: If a company has highlighted a problem, the market knows about it and the stock’s price-earnings (P/E) multiple will have accordingly contracted. Many investment mistakes of retention follow such special pleading: If a position is maintained as a result of “yes, buts,” it is probably a mistake.

Accounting Red Flags

As accounting is the language of business, every investor must be conversant in it. Beyond assessing fundamentals of asset turnover and margins to evaluate business quality, financial reports often contain innumerable subtle clues about the sustainability and predictability of earnings growth, cash flows and returns on capital. They also occasionally reveal chicanery, eliminating a company from contention as a quality investment.

A perennial challenge that investors face is earnings management, which a 2012 academic study found is pervasive: one-in-five public companies misrepresent earnings by an average of 10%. Accounting shenanigans can manifest in many ways, including premature revenue recognition, inflated gross margins, improperly capitalized expenses, depleting reserves and manipulating cash flows. Many of these areas include some degree of judgment. However, when these judgments start to move beyond the realms of reasonableness, it is usually a mistake to ignore them: Such accounting red flags can be powerful indicators that the underlying business is also deteriorating.

The Endowment Effect

The quality-investing method of conducting rigorous fundamental analysis and holding for the long term creates one final pool of mistakes arising from what behavioral economists call the endowment effect—an overappreciation of things already owned compared to other opportunities.

Quality investing is particularly susceptible because the considerable upfront research and extensive winnowing increases the endowment effect: The investor’s sense of ownership encompasses not just the stock, but also their analysis and judgment. The emotional connection amplifies with time, increasing susceptibility the longer a stock is owned. The endowment effect may manifest itself when an investor continues to own a stock despite a drumbeat of negative events revealing a deterioration of the company’s fundamental economic characteristics. One strategy to combat this is to ask whether, with a fresh start, you would still buy the same company today.

As with other sources of challenges and mistakes catalogued in this article, the endowment effect also plays a positive role in quality investing. It strengthens resolve amid relentless but erroneous pressures to sell. The competing factors therefore call for alertness above all.

Conclusion

A long-term strategy must be finely balanced against the recognition that things can, and will, change. All companies evolve to some extent, and closely monitoring such evolution is an essential part of the investment process.

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