Dear reader,

I came home with wet socks today.

The shoes I bought last year let the rain in. They were cheap, which was about all the comfort they offered while I was peeling them off.

Next time I’ll have a reason to buy something else.

That small disappointment sent me back to Dexter Shoe, the company Warren Buffett bought in 1993. Dexter had spent decades making shoes people wanted, it supplied the big retailers, and for a long time it had been up against cheaper imports.

Buffett liked the people who ran it. He thought the business would keep doing well.

He paid $433 million for it.

Years later he admitted he was wrong. And because he paid with Berkshire Hathaway shares, the mistake ended up costing a hell of a lot more than that price suggests.

I wanted to know how that could happen, so I went back through his letters. Not just the later ones, where he explains what went wrong, but the ones he wrote when he still thought Dexter was a great buy. I wanted to see why he was so sure, and what the rest of us can take from what came afterwards.

One question kept coming back as I read.

Was it just a bad year for the company, or was something happening that it would never recover from?

Hold that thought. First, let me tell you about the people who built Dexter.

Before the mistake had a name

Harold Alfond was working in a shoe factory at 20, earning 25 cents an hour. In 1956 he started his own company, Dexter, with $10,000, and two years later his nephew Peter Lunder joined him.

By the time Berkshire took it over, Dexter was making more than 7.5 million pairs of shoes a year, mostly in Maine and it ran 77 stores of its own. Big retailers like Nordstrom and J.C. Penney had given it awards for being a good supplier.

Buffett also had a reason to feel at home in shoes. He had bought H.H. Brown in 1991 and Lowell Shoe at the end of 1992, and both had done better than he expected.

In his 1993 letter he praised Dexter’s managers and said the company could compete with cheaper shoes from other countries, even though it cost more to make shoes in America.

Now put yourself in his shoes (sorry). A company built up over many years, people who know the job, customers who want the product, and two other shoe companies that had worked out well. You’d feel good too.

But the story contains one big guess.

Dexter had beaten cheaper shoes before. Buffett assumed it would keep doing it.

Every time you buy a share in a company with a good track record, you’re making the same kind of call. You can look at what it earned last year, or ten years ago. The money you’re hoping to get, though, comes from years that haven’t happened yet, and somewhere between the two you have to make a judgment.

The danger was already in the room

It would be a much simpler story if cheap foreign shoes had turned up the day after Buffett signed.

They didn’t.

In his 2001 letter he explained that Dexter had done well against tough, low-cost competition from other countries, both before Berkshire bought it and for a couple of years afterwards. His mistake was believing it could carry on like that.

Think about what that means. Nobody sneaked up on him. The danger was in the room the whole time, and he could see it.

Most company reports have a section listing the risks: competition, rising costs, changing customer habits, a weaker economy. They’re all standard. But a list like that only tells you what could happen. It doesn’t say how likely it is, how much damage it would do, or whether the company can cope.

Here’s the simple version. Somebody else could make the same shoe for less.

That doesn’t kill a company overnight. People may love its shoes, the stores may like its service, and new ways of making shoes may close some of the gap. But those good things have to be strong enough to matter when a rival says, “Ours is cheaper.”

Past success tells you the company dealt with yesterday’s problem. It says nothing about tomorrow’s.

While reading I found something else, a sentence Buffett wrote in March 1995 about a different mistake in a different business. I’ll show you in a moment.

First, 1995.

That was the year the shoe businesses made much less money. Berkshire gave a reason, and it sounded reasonable, even a little reassuring.

I’ll show you the numbers and the reason. Then you tell me whether you’d have believed it.

Subscribe free to keep reading. Next: the numbers from 1995 and the reason management gave, the sentence Buffett wrote about another mistake, and why paying with shares made the mistake so costly.

Read more

Imagine your neighbour at the barbecue saying he’d bought a stock at $10 and it’s now at $100. By that stage the explanation is obviously correct. The company had a good product. There was scope for growth. Management were absolutely on top of things.

All true I suppose. There are loads of companies out there with a decent product, a sound plan to grow and a confident manager and their shareholders are still holding on.

So what should we have been looking for prior to the end being obvious?

That’s the real question behind the search for a multibagger (a stock that becomes worth several times what you paid). A tenbagger is a stock that turns $1000 into $10,000 (before taxes and all the other costs). The term describes the outcome. It doesn’t tell you how to find one.

To find a candidate you need a story of how the business could get there. You need a company that can survive a blow, that can put its money to work and generate a return on equity. Then you ask whether the price is a sensible one to enter at.

There’s a trap and it’s worth you understanding it before you open a screener. Here’s the best way I know to illustrate it.

Imagine two companies. Both make $10m a year. Both have 10m shares. Both trade at $10 a share. Over the next 10 years each one grows its annual profit to $50m. Same profit. Same time. Same starting price.

One of them could be a ten bagger. The other might well leave you with a much smaller gain.

Which one? And what’s the difference?

Subscribe free to keep reading. Next: which company wins and by how much (those two questions which effectively vanish behind every growth story) and the five checks we use before we even spend time on a stock.

Read more

Imagine a livestream with 96 people watching. That’s fewer people than a fairly decent wedding. According to Keith Gill’s own testimony to Congress it was the largest audience his final livestream of 2020 ever attracted.

Weeks later the whole world knew his name and the name of the company he was talking about. This story isn’t about the frenzy though. It’s about the quiet bit before that, the bit where a man is explaining a company he didn’t like to a small room.

Here’s the question I keep returning to. You’ve walked past the shop at the mall with the ‘closing down’ signs in the window. Most of those shops go under. A few of them come back. Before anyone’s even got to the end of the story, how do you know which one you’re looking at?

Gill’s original case is the place to start and there are plenty of problems apparent in the company’s own reports. Taken together they tell a much more interesting and less comfortable story than the standard ‘one man against Wall Street’ tale.

This piece reconstructs parts of that argument from his public statements and from the documents that were available as the events unfolded. It is not a complete account of his private thought process and it is in no way a recommendation to buy GameStop at this point.

There are three questions that apply to pretty much any company that people have written off. I’ll give you all three. But the bad news is that that’s where his case starts.

The shop nobody wanted to own

Gill bought the GameStop call options on June 7th 2019, having concluded that the stock was undervalued. In his testimony he gave two broad reasons for that view. The risk of bankruptcy was being exaggerated and the late 2020 console cycle could generate real cash. There was also scope for a bigger transformation of the business. Those were his views at that stage, not outcomes.

Before you go and think about the share price that came subsequently, think about the logic.

If you’re buying a shop with the ambition that it’s going to become the best retailer in the country then a hell of a lot has to go right. If you’re buying it at a low enough price because you think it can at least stay in business and make some money then far less has to go right.

Neither purchase is automatically the right one. The difference is what you need the business to achieve.

With a troubled company the first job is survival. A recovery three years down the track is of no use if a loan payment forces a crisis next month.

That’s why “everyone hates it” is not an investment case. That just tells you where the argument might be. The company’s accounts tell you whether the argument has any substance.

First, the bad news

GameStop’s Q4 2019 results were a real cause for concern for investors. Q3 sales were down 25.7% and the company reported an $83.4m net loss. That was still a loss from continuing operations even after their own adjustments.

These are not the figures of a healthy business just being ignored for no reason.

That’s important when you’re looking at a famous winning bet. It’s easy to retell the story as if the sceptics had absolutely nothing to go on. A better approach is to lay their best evidence out first.

Falling sales can be a sign of a weak season. They can also be a sign that customers are simply walking away and never coming back. A closed store can remove a losing location or it can be a sign that the business has lost its place altogether. The same headline can lead to very different conclusions depending on why it’s happened.

So get down the question that really matters: which of these problems is going to get better and which is going to get worse? Then go and look for the evidence on each. Knowing the product enables you to ask the right questions. It doesn’t answer them.

And the ultimate question was this one: could GameStop survive long enough for anything to get better?

The answer wasn’t what you’d get from a quick glance at the bank balance.

Subscribe free to keep reading. Next: the cash that looked like a rescue, where it really came from, the three tests you can use on any hated company, and what the SEC later said about the squeeze.

Read more