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Financial Advice

My Investment Howler

As portfolio blunders go, this one is difficult to beat.

Win Some I wrote about this topic three years ago, but that discussion was in passing. Today, the full treatment.

In 1998, I owned three assets: 1) my 401(k) plan, to which I contributed the permitted maximum, 2) a fresh award of Morningstar stock options, with a strike price of $2.67, and 3) human capital. It was a good retirement plan. At worst, I would build a seven-figure 401(k) account, while working for another 25 years in a well-paid industry. At best, I would win the lottery.

Not that the latter was more than an occasional thought. Morningstar was privately held, so my options could neither be exchanged for shares nor sold for cash. The only way to realize their theoretical worth was to leave the company, at which time Morningstar would pay the difference between the option’s strike and exercise prices. I wasn’t going anywhere; thus, until further notice, the options were like the 401(k) plan--assets for later, not for the here and now.

Morningstar persisted, and it went public in 2005. The IPO’s price was difficult to predict. In the mid-'90s, a consultant valued Morningstar at twice its annual revenues. By that measure, the stock was worth $9 per share. On the other hand, SoftBank SFTBF had paid 8 times revenues when buying a 20% Morningstar stake in 1999. Perhaps the truth lay somewhere between the consultant’s conservative estimate--used for paying departing employees--and SoftBank’s aggressive bid.

Indeed, it did. The Morningstar MORN stock went public at $18 per share. SoftBank cashed out, having profited from its $10 investment. (Gaining 80% in six years isn’t typically regarded as a high return on venture capital, but doing so after buying at the New Era’s peak, and then selling after its crash, was quite the achievement.) My lottery ticket had scored.

Lose Some The options had become real. They expired in summer 2008, having been issued with 10-year life spans. I had three years to use them wisely.

Wisdom was not achieved. I overestimated what I knew about options. My academic background was strong. Not only had I studied derivatives in the Chartered Financial Analyst curriculum (which I had completed), but I also had taken two MBA classes on the subject. Few investment writers, or financial advisors, for that matter, had such formal training.

The strongest lesson that I had learned from my options education was not to exercise them early. Morningstar had issued so-called "American options," meaning that the securities could be exercised at any time, up to and including their expiration date. In such cases, I "knew" that exercising options before their expiration date for stock that doesn't pay a dividend is never optimal. Hold them until the last possible moment.

That was my scheme, and it was deeply flawed. Academic recommendations about options assume a single time period that ends on the option’s expiration date. Nothing that occurs after that day is relevant. The recommendations also ignore taxes. However, I planned to buy and hold Morningstar shares when exercising those options, and taxes were very much a consideration. What applied to my blue-book exams did not address my real-life situation.

Death and Taxes The problem lay with my tax exposure.

(It also would have been prudent to diversify more rapidly from MORN into other securities. However, as Morningstar was debt-free, generated large amounts of free cash flow, and received most of its revenue from long-term customers, the company was highly unlikely to go bust. At worst, the stock might disappoint. But it would remain a significant asset in my portfolio.)

If taxes did not exist, as in most academic models, then the timing of my trades would have been relatively unimportant. Yes, it would have been better to wait until the expiration date to exercise my options, because the money spent on paying their strike prices could otherwise be invested elsewhere. (That is the logic behind the advice to forestall exercising American options.) However, that was a minor effect.

The real danger was that I would buy high and sell low. Exchanging options for shares creates a tax liability on the trade’s profit. The greater the profit, the greater that liability. It doesn’t take much analysis to realize that if the investor exercises the options when the stock is rich, with the intent of paying the eventual tax bill by selling shares, that the math will fall apart if the stock collapses. It’s fine if the stock treads water or even loses modestly. But it’s a disaster if it plummets.

Which is precisely what occurred. Reluctantly, I had cashed out 25% of my options in late 2006, for the unwise reason of making a down payment on a house (bad timing) and the sound reason of creating a rainy-day fund. That was helpful. However, the remaining 75% suffered an unhappier fate. I exchanged those options for Morningstar equity in May 2008, when the stock sold at $80. We will skip over the Alternative Minimum Tax, which to this day I still do not understand: My profit was $77, which incurred a tax liability of $27 per share.

By October, that was MORN’s market price: $27 per share. It wasn’t worth a penny more than its tax liability. Had I held the stock through the end of the year, my April tax bill would have required me to sell every MORN share. The lottery proceeds would be gone. Fortunately, I could book a large loss by selling my newly exercised shares at $27, and then use that loss to offset most of my previously recorded gain, for 2008 tax purposes. The wound stung, but it was not fatal.

Hard Knocks That experience gave me investment religion. Unlike many investors, I wasn't shaken by 2008's equity market collapse. Morningstar continued to plug along, registering sales and serving its customers. Eventually, I figured, the stock would follow suit. What shocked me to the core, and still does to this day, is how I vastly I overrated my knowledge. I never asked myself: "How could I be wrong?"

I do now. And I consult with others when facing such critical decisions--both co-workers and investment professionals. Sometimes, there’s no sense in going it alone.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

The opinions expressed here are the author’s. Morningstar values diversity of thought and publishes a broad range of viewpoints.

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