Real investment risk
Any investor who has been in the natural resource markets the last couple of years knows a lot about volatility. I will share about my experience with what I consider real investment risk: the possibility of a permanent loss.
In finance text-books we calculate risk as standard deviation. - How much an investment fluctuates from its own longer term average. When owning stocks this is one of the first lessons you get.
This is a view of what the risks with an investment is, the possibility that you buy when the price of the investment is high and have to sell when the price is low.
The real risk of owning stocks is however the possibility of permanent loss. From Howard Marks memo “Risk Revisited”(2014) you have the following definition:
“A permanent loss - from which there won't be a rebound - can occur for either of two reasons: (a) an otherwise-temporary dip is locked in when the investor sells during a downswing - whether because of a loss of conviction; requirements stemming from his timeframe; financial exigency; or emotional pressures, or (b) the investment itself is unable to recover for fundamental reasons. We can ride out volatility, but we never get a chance to undo a permanent loss.”
I have experience with the second alternative: (b) ”the investment itself is unable to recover for fundamental reasons.”
To paint a picture, this was an investment I had been holding for many years. The investment was in a private company, so opportunities for buying and selling shares were few, as the company was not registered on a stock exchange. I made my first investment in the company in late 2017, and I added to the position a couple of times over the years. In total the amount invested amounted to about two yearly salaries for me at the time. As with other investments, the valuation of the investment did fluctuate up and down over the years. (The valuation did however trend in an upward direction). The exit strategy for the company was for it to grow big enough to list on a stock exchange or get acquired by a bigger player.
At the peak, the company was able to raise cash at valuations at multiples of my initial investment. For me, this did not mean “financial freedom” size of gains, but still big enough for myself to buy a decent house. The one big problem with this private investment was that there was no way of selling, or exiting the position. (The market value of the company was also just decided by what less than a few investors thought the company was worth. There was no market clearing price with several buyers and sellers agreeing on the value of the company on a daily basis).
The investment was in a sector where things could change rapidly, and if the position had been liquid I would definitely have sold half of my position around 2022. At this time the position had grown disproportionately big compared to the rest of my investments. This was however not possible because the company was always raising cash, and trading existing shares was strongly discouraged in favor of printing more shares for growing the company.
The growth ambitions of the company would however show itself to be the downfall of the company. The biggest risk for an investment is not a company that finds itself in financial difficulties. In many instances it is a company that is growing too quickly. The company I was invested in had tripled its workforce based on strong sales growth, in addition to taking on a massive amount of debt, just when the market was turning down and demand started to drop.
With lower sales and a cost base at multiples higher than before, the company quickly came into financial difficulties. Instead of cutting in the workforce the company looked for investors to help carry them over this “temporary” slump. The investors could however demand more from the company in terms of pricing and warrants as growth was not as strong as it had been earlier. Finding agreeable terms became harder and harder.
This “temporary” slump would prove to be persistent, and the financial situation for the company did not improve. Early 2024 all options for the company were exhausted. Only a debt restructuring deal which meant a massive dilution of the existing shareholders could save the company. Shares outstanding in the company would increase by 34X. My investment in the company was for all intents and purposes worthless. The investment has suffered a permanent loss. Even if the company regains all of its former glory in the future, my share of this potential gain is insignificant. It is at a permanent loss.
The biggest gain I can get from this trade is the tax write-offs, in addition to some expensive experience.
What did I learn from this?
Investment risks come in several different forms, but you have to try to stack the odds in your favor. For my part it means that I limit the amount I invest in private companies. The risks are a lot higher, and you are not able to get out of your positions. My positions should therefore be a lot smaller than companies registered on an exchange. If you invest big in a private company you should ensure that you are able to influence the management by having a board seat, or at least have a direct communication line to the board and management. As a small investor this is usually difficult.
Being locked into a position, helpless to get out, and with no influence on the course of the company leaves too much to chance for my taste. The option of getting out when I decide to is worth a lot.