A Cautionary Tale from Paul Scott

City AM published an educational story last week which is worth repeating. It covered the investment record of Paul Scott who is very well known in the small cap investment world. He writes very perceptive, and quick, analyses of announcements by smaller companies for Stockopedia with a strong emphasis on the financial accounts. He trained as an accountant and worked for a retailing company as finance director for some years. He then became a professional investor – one might say living off his wits – and reportedly turned £50,000 into more than £5m in a few years. Then the financial crisis hit in 2008/9.

This is what he said in the City AM interview: ““I lost the lot and had to start all over again in the financial crisis. It was horrendous, it ruined my life at the time. I had to sell my house, I lost all my savings, I ended up £2m in debt. It was a catastrophe.”

The article suggests Scott made two mistakes: “One was investing in stocks with low liquidity. The other was gearing up on them through spread-betting. When the crisis hit, he couldn’t get out.”

Now with speculative small-cap stocks again riding high, with valuations not based on current fundamentals such as profits and cash flow, but on their future prospects and for their ability to dominate their markets, it is surely again a time to be wary.

Markets are driven by emotions and once a panic sets in then small cap stocks in particular could become very illiquid. Having a major proportion of your portfolio in such stocks may have done wonders for your investment performance in the last couple of years but it is high risk. That is particularly so if you also gear up, and have an undiversified group of holdings – a portfolio of less than a dozen holdings of such companies is positively dangerous.

So the moral is surely never to hold a company on the premise that you can get out if the market turns sour for shares in that company, or in general. Unless you are sure you want to hold a company for the long term, and can afford to do so (i.e. you have not borrowed money to buy it), you should not buy it in the first place.

In addition never let a few holdings dominate your portfolio. And in particular be very wary of companies where there is little trading (i.e. low liquidity). If your own holding is a multiple of the daily trading volume, you’ll never be able to get out at a fair price if there is a crash.

This is what Paul had to say recently in an interview for Stockopedia: “I’ve learnt all my investing decisions the hard way. 2008 taught me that you need to keep an eye on the exit and you need to consider what will happen to liquidity if there is some sort of awful event. Not necessarily a minor event, but if the financial system starts to cave in again – which it might well do. So for that reason, this time my risk management is much better. I’m keeping the gearing lower than it was and I have a general rule that I want to be able to exit every position I hold within a maximum of two days in a bear market. So I position size accordingly. If something is very small and illiquid, I wouldn’t have more than £30,000 – 40,000 worth of it. If it’s nice and liquid then I’ll have £500,000 of it. I think liquidity is so important.”

I would only comment that when everyone wants to exit, shifting even a relatively small amount of stock in small caps can be damn difficult. Having solely small cap stocks in your portfolio can be a risky strategy when mid to large cap stocks will be much more liquid and less volatile. For example, private investors could easily sell their holdings in HBOS, RBS, Northern Rock and Bradford & Bingley even when they were in dire difficulties.

Diversity in individual holdings, and in company size, are both prudent.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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