Our Biggest Mistakes in 2008

One of the most important things we can do to become better investors over time is to closely evaluate and learn from our mistakes. The financial meltdown and economic collapse made 2008 a truly extraordinary year. The year unfolded in a way that was unlike anything the United States had experienced since the 1930s, which is to say, it was a completely novel experience for most of us. Our team of more than 100 equity analysts made our fair share of mistakes in 2008, but we've also learned a tremendous amount along the way that will improve our research going forward.

Below, we highlight some of the biggest lessons we learned this year and some of the botched stock calls that helped to teach us. Although it is essential to learn from one's own experience, it is even better to learn from the experience of others, which is why we are glad to share these lessons with you.

Watch Out for Correlated Risks
Equity valuation is a highly imprecise undertaking--more of an art than a science. Many important variables are almost completely unpredictable, such as short-term commodity price, currency, or interest rate fluctuations. We couldn't have foreseen the stock market crash of October and November, nor could we have known that credit markets would almost completely shut down.

However, we did know that all of these things were possible, but in a few cases, we misjudged the degree of uncertainty these possibilities contributed to our fair value estimates. This is especially true of companies with multiple correlated risks. A good example is health insurer  Cigna (CI), which is sensitive to the direction of financial markets through several different components of its business: an underfunded pension liability, a highly leveraged investment portfolio, and reinsurance liabilities related to discontinued product lines.

Although we always were cognizant of these risk factors, it wasn't until mid-September--when real chaos started to ensue in the financial markets--that we recognized the degree of uncertainty that these noncore components of Cigna's business contributed to our fair value estimate. We raised our fair value uncertainty rating to very high from medium, and in early November we ended up cutting our fair value estimate in half.

Conditions Can Change Rapidly, Radically
We also underestimated our uncertainty rating for gathering-and-processing master limited partnership  Crosstex Energy . Crosstex was at the top of its game in late 2007, with easy access to credit and a plethora of growth opportunities in Texas' Barnett Shale. Wide spreads between the price of natural gas and natural gas liquids (NGLs) added to the value of Crosstex's processing capacity. We entered 2008 with a $48 fair value estimate and a below average business risk rating on the company.

In the second half of 2008, however, Crosstex's business fundamentals underwent a series of shocks. The same fundamentals that had made Crosstex so appealing during the boom times now became its biggest liabilities. Credit markets began seizing up, leaving the company unable to fund its many growth opportunities. The credit markets, coupled with falling natural gas prices, also caused Crosstex's customers--Barnett Shale drillers--to cut into their own aggressive growth strategies. At the same time, processing spreads collapsed as natural gas prices held up relatively well, helped by expectations of a cold winter, while NGL prices plummeted, along with oil, because of the weak economic outlook. To top it all off, Crosstex suffered significant damage in the unusually strong hurricane season.

The main lesson we learned from Crosstex is that conditions can change quickly and dramatically--in this case, they upended the fundamentals that supported a case for sizeable distributable cash-flow growth. A company that looked to have many high-growth, high-return projects in a favorable credit and commodity-price environment ended up suffering significant distribution cuts, a collapsing unit price, and possible liquidity problems when critical fundamentals changed. Over the course of 2008, we lowered our fair value estimate to $14. We also changed our risk rating methodology in April 2008, focusing on "fair value uncertainty" rather than "business risk." We think the fair value uncertainty metric provides more meaningful information to investors, and Crosstex ended up with a very high uncertainty rating.

Liquidity Concerns Can Be a Self-Fulfilling Prophecy
One of the biggest lessons of the year has to be that, in the words of junk-bond pioneer Michael Milken, "Liquidity is an illusion. It's always there when you don't need it, and rarely there when you do." 2008 provided plenty of examples of companies, both inside and outside of the financial sector, that experienced a "run on the bank"--a situation where suppliers (of capital or goods) become concerned about a firm's ability to pay them back and become hesitant to extend the firm credit, often leading to the exact kind of liquidity issues the suppliers were concerned about.

In the case of investment bank Lehman Brothers , we underestimated the collapse in the firm's earnings power as it experienced massive deleveraging. We also overestimated the soothing effect on the markets of the company's access to short-term financing from the Federal Reserve. As it turned out, creditors and counterparties weren't reassured, and they ended up driving the company to bankruptcy.

Bookseller  Borders Group  experienced a similar crisis of confidence. The company has been hit hard by lower consumer spending, a secular decline in CD sales, and deleveraging of its fixed costs. Although we thought the firm had enough liquidity to muddle through the economic downturn, the threat of skittish suppliers not shipping new products forced Borders to raise additional capital on unfavorable terms, diluting existing shareholders' stakes. We began the year with a $26 fair value estimate and above average business risk rating on Borders. By the end of the year, our fair value estimate had fallen to $14, and our uncertainty rating had increased to extreme. Borders is currently under review.

Beware of Companies That Double-Down in Boom Times
Another repeated theme this year was that investors should be very cautious of companies that double-down in the midst of a cyclical boom. Such a move could be an indication of imprudent management, and these companies are often the most vulnerable in a downturn.

Mexico-based cement company  CEMEX (CX) acquired Rinker in 2007, taking on significant new debt in the process and increasing the company's exposure to the U.S. construction industry. Much of the debt was shorter term and denominated in dollars, as management counted on being able to quickly pay down the debt with robust operating income from the new subsidiary. CEMEX's timing couldn't have been much worse, as demand for building materials plummeted, especially in the formerly hot real estate markets of Florida and Arizona, where Rinker's assets were concentrated. This left CEMEX in a precarious position, faced with declining operating cash flows, closed-off credit markets, significant refinancing needs, and a currency mismatch (79% of debt but only 16% of year-to-date earnings before interest, taxes, depreciation, and amortization were denominated in dollars). The issues have been compounded by millions of dollars in losses from poorly executed currency derivatives. We cut our fair value estimate for the company to $18 from $41 in 2008.

REIT  Maguire Properties  made a similar misstep, adding $3 billion worth of office properties in Southern California to its portfolio in 2007, mostly funded with $2.5 billion in new debt. California's property market has been one of the hardest-hit in the downturn, causing falling rents and occupancy rates for Maguire, which will only be compounded as new office supply that was planned years ago hits the market. To make matters worse, Maguire counted now-bankrupt subprime lender New Century Financial as one of its biggest tenants. We think Maguire will struggle to refinance its enormous debt load, and where it is able to refinance, it will likely be at higher interest rates. We lowered our fair value estimate all the way to $0 from $35 in 2008.

Never Lose Sight of Competitors
Not every lesson we learned in 2008 was directly connected to the financial crisis. Slot-machine manufacturer  International Game Technology  reminded us that wide-moat companies are still under constant assault from competition. Although the company has been heavily investing in next-generation server-based technology, it was slow to bring new products and game titles to market, allowing competitors  WMS Industries  and  Bally Technologies  to steal market share. At the same time, declining Las Vegas tourism has both lowered the firm's take of gaming revenue and hurt product sales as casino operators cut back on planned upgrades and new construction. During 2008, our fair value estimate fell to $15 from $50, while our average business risk rating turned into a very high uncertainty rating.

The World Is Interconnected
Like other market observers, we were slow to recognize that the "decoupling" theory--the idea that emerging markets, such as China, could continue their robust economic growth even as the developed world experienced a significant recession--was bunk. It is a lesson we won't soon forget: We rise together, and we fall together, and the world's economies are as interconnected as ever. A good example is construction- and mining-equipment maker  Terex (TEX). Although the company had been battling a declining residential construction market in the U.S. since 2007, we thought that its overall results would be relatively insulated by the 65% of sales it derived from abroad. As it became increasingly clear that we were in for a global decline in construction activity, we cut our fair value estimate for Terex by 57%.

It's the Economy, Stupid
And that leads us to one final lesson: Macroeconomic events matter. Our approach at Morningstar is to focus on bottom-up analysis; the economy is just too big and complicated to try to second-guess its next move. In most cases, knowing the precise direction of interest rates, inflation, or unemployment next quarter will have very little bearing on the long-run value of a company. The biggest problem arises when macroeconomic events in the short run can prevent companies from ever reaching the long run. During the course of the last year, we have been directing more of our attention to the macroeconomy because for many companies the events of the next few quarters may be the difference between a prosperous future and an early end.

Although there are plenty of examples in the U.S., the importance of the macroeconomic environment is even more pronounced in emerging markets such as Russia. Russian telecom firm  Mobile TeleSystems  has a massive footprint in the oligopolistic Eastern European market and has enjoyed significant growth from rising usage and higher average revenue per user. However, the Russian economy is heavily dependent on the price of oil and gas, and political instability, a war in Georgia, and currency devaluation have all added significant risk to this otherwise solid business. We were late in raising our uncertainty rating to extreme in recognition of the economic and political uncertainty, though we still think Mobile TeleSystems is worth more than twice its current trading price.

Share some of the lessons you learned last year on our discussion board, here.