LMIJ #2: First Marblehead (FMD): Blinded by Macro

Posted on 18. Sep, 2011 by TheFreeInvestor in General, Investing Philosophy

This is my second post in the Lessons from My Investing Journey (LMIJ) series. Here is the link to the first post in the series. As promised in my first post, this is a story of one of my investment failures.

Interesting Stock in a Unique Industry

I started investing in First Marblehead (FMD) from early 2006 and kept building my position all the way upto October 2007. By that time, FMD was one of the top five positions in my portfolio. First Marblehead was in the business of processing and securitizing student loans for large banks, e.g., JP Morgan Chase (JPM) and Bank of America (BAC) — these two banks accounted for more than half of FMD’s revenues. The private student loan market was growing at a breakneck speed and the future looked bright for FMD. In addition to upfront cash, FMD was expected to receive residual income many years later after the securities hit parity. The Education Resource Institute (TERI) was the gurantor.

It sounded like a pretty good story — rapidly growing company in a fast growing industry. Well, when the financial meltdown of 2008 hit, the entire student loan ABS market froze up. The Education Resource Institute (TERI) filed for Chapter 11. With in few months the entire business of FMD dried up. Gone.

I lost approximately 90% of the original investment by the time I sold the stocks in the second quarter of 2008.

Importance of Diversification and Asset Allocation

The significant loss of my investment in FMD and couple of other such stocks reinforced the value of being diversified. Though I lost significant amount of money, it didn’t permanently impair my portfolio as I had more than 20 stocks in my portfolio. However convincing the investment theory appears, it is always possible that some external shock will obliterate the investment.

Second lesson from the FMD episode was about asset allocation — be very careful about going overweight in any stock. You never know what unexpected external factors will hit the company. As long as you have a diversified and holding disciplined and pre-determined weighting in the stocks you own, if something unexpected happens, you are less likely to lose sleep. Since that time, I make sure that I invest pre-determined level of capital in any stock and not go too overweight. The only overweight positions that I allow in my portfolio are the stocks that have run up significantly since I bought the stock.

Final Thoughts

Loss on FMD was one of the biggest losses I ever had in my portfolio. Though I was blinded by macro factors (i.e., credit crisis of 2008), I could have minimized the loss by controlling my position size.

So, the bottom line is — diversify, diversify, diversify ……

Related post:
LMIJ #1: Netflix (NFLX): Survival and Success of an One Trick Pony

Tags: BAC, FMD, JPM, LMIJ