What I Learned From My Biggest Losers Of 2022

Fred Brooks once said:

You can learn more from failure than success. In failure you’re forced to find out what part did not work. But in success you can believe everything you did was great, when in fact some parts may not have worked at all. Failure forces you to face reality.

I believe this quote is perhaps never more accurately applied than to the art of investing. In life – and especially in the stock market – we are too often “fooled by randomness” (to borrow from the book by Nassim Nicholas Taleb). If a stock we buy happens to go up 50%+ over the next six months, we often just assume that we were brilliant in picking that stock when we did, perhaps lock in the profits, and then move on to the next pick. Meanwhile, within a year or two, the company may stumble into hard times and the stock will crater to all-time lows as our original investment thesis is laid bare as actually being seriously deficient. Perhaps the most clear example of this is in the high growth technology sector that was championed by ARK Invest’s Cathie Wood for several years. Her funds (ARKK)(ARKG)(ARKQ)(ARKX) shot up like rockets initially and everyone hailed her as a genius. However, all it took was the Federal Reserve raising interest rates a little bit to send her stocks tumbling back down to earth, generating massive losses for those who bought into the hype on the way up:

Meanwhile, the legendary Warren Buffett’s Berkshire Hathaway (BRK.A)(BRK.B) has proven once again that the tortoise often beats the hair over the long-term:

In fact, it was Warren Buffett who summarized this very phenomena with the graphic illustration:

Only when the tide goes out do you discover who has been swimming naked.

So – with this important truth in mind – while my portfolio was blessed to significantly outperform the market in 2022, I think it is valuable to take a closer look at my worst picks this year. In the rest of this article, I will share my worst performing stocks of 2022 and shares some of the lessons learned from these picks.

Loser #1: Hanesbrands (HBI)

HBI has been a colossal loser this year, down over 60% year-to-date as of this writing:

At first look, it is easy to make excuses for its poor performance as being purely the product of factors that are simply out of its control:

• a very costly cyber attack on the company earlier this year
• a whiplash supply chain dynamic that saw the company rapidly swing from paying for expensive air freight in order to get its products to consumers on time to suddenly having a massive buildup of inventory and having to swallow significant de-stocking costs and a rapid slowdown in demand.
• Furthermore, inflation is hurting the company as it had to pay elevated prices for its inputs but now – due to evaporating demand and an inventory surplus – has little to no pricing power to pass those increased costs on to consumers.
• Finally, the strong U.S. Dollar is hurting the company as its overseas sales are being diluted significantly once translated into U.S. Dollar based earnings for shareholders.

In fact, despite the cyber attack, HBI shares have actually slightly outperformed apparel industry blue chip and Dividend King V.F. Corporation (VFC):

On top of that, there remain reasons to be very bullish on the company’s long-term prospects (and in fact, we do remain long with a small-sized position):

• It is keeping market share pretty well in its core brands, is making continued progress on its Full Potential Plan which is unlocking substantial cost efficiencies across its business and also resulting in improved brand focus and competitive strength.
• Insiders – including the CEO himself – have been buying shares aggressively this year at prices well above the current share price.
• The company currently trades at just four times the free cash flow it generated in 2021 and its current investments should lead to further free cash flow growth on top of that 2021 basis over the long-term once macro conditions become more favorable.
• The company has strong relationships with its banks and just had their bank covenants modified to put the balance sheet on stronger footing through the next year.

Another positive has been that we have managed the position somewhat well at High Yield Investor in order to minimize some of the losses – selling it in May 2021 at around $22 per share for a 55.3% total return (131.07% annualized) and then buying back in as it tumbled through the teens and in the single digits over the past year and a half, so our overall total losses are not as bad as they could be at this point.

With all of that said, however, a major lesson learned for me through this loss-generating position is that – if I am going to invest in a cyclical stock like this during such a tumultuous and headwind-filled macro environment – I need to insist on a stronger balance sheet. Yes, VFC – which has been hit just as hard as HBI this year – has a BBB+ credit rating. However, it also did not have nearly the valuation margin of safety heading into this year that HBI had and it never really crossed my radar for potential investment for that reason. As a result, what this year showed is that – especially in the short-term – a company that appears to be trading at a bargain price can still get dramatically cheaper if its balance sheet is weak.

HBI has a junk credit rating (BB with a negative outlook from S&P) and just felt the need to go to its banks for a debt covenant modification. Yes, HBI has a sky-high dividend yield and an even more lofty normalized free cash flow yield. Yes, it looks incredibly cheap according to virtually every metric out there and the CEO has been buying shares hand-over-fist this year. However, at the end of the day, if macro forces are slamming you straight in the face and the balance sheet is on shaky footing, the stock is going to have an exceptionally difficult time maintaining any sort of positive momentum and further short-term downside is very possible.

Yes, if HBI can navigate the current choppy waters fine it will likely deliver exceptional long-term performance and it is true that we do not know when the market will price in that upside. However, as a dividend investor, it is seldom prudent to pick these stocks at the beginning of their tumble, especially when a dividend cut could be in the cards down the road. You can read our latest update on HBI and exclusive recent interview with the company here.

Loser #2: Algonquin Power & Utilities (AQN)

AQN has been another massive loser this year, though fortunately we have purchased most of our shares after the big drop in Q4:

The big reasons for the rapid drop are the disappointing Q3 results and the weak full year guidance. While this is partially due to some timing issues which will be compensated for in 2023 results, the biggest hit came from the rapid rise in interest rates this year. This hit the company particularly hard given that they were trying to finance their upcoming (now indefinitely nixed by the FERC) acquisition of Kentucky Power.

Moving forward, we remain bullish on AQN as well given that we think the underlying assets are high quality and defensive in nature, they still have an investment grade credit rating, and the value in the shares is very attractive right now. After speaking with the company, we believe they are likely to emphasize cutting growth spending in favor of saving their investment grade balance sheet and maintaining most – if not all of – their current dividend payout.

However, once again, the big lesson learned here is that balance sheet strength in a rising interest rate environment – even in a relatively defensive business like this one – is of utmost importance. Furthermore, AQN left itself exposed to rising interest rates by forcing itself to depend heavily on equity and debt markets in order to finance a major transaction (as well as their other ambitious growth projects) that they had already agreed to. Given that they are dependent on regulators to recoup much of that increased cost (not to mention the significant regulatory lag involved), this is hardly a low risk investment in the current environment. I should have been more mindful of this risk when making my initial investment in the stock.

You can read our full investment thesis here and our recent exclusive interview with AQN here.

Loser #3: Lumen Technologies (LUMN)

Last, but not least, LUMN has had an abysmal year as well:

While we were initially bullish on this stock due to its high free cash flow yield and the clear fact that the sum of its parts was worth significantly more than what the market was valuing it at, we ultimately decided to sell for the following reasons:

• Management’s repeated promises of “growth” were ringing increasingly hollow in the face of continued deteriorating results.
• The rapidly declining free cash flow and heavily leveraged balance sheet did not bode well for the dividend, especially in the current stagflationary environment.
• Management continues to prioritize investing aggressively in “growth” projects despite little evidence in the results that these investments are a good use of capital. Given management’s track record of destroying shareholder value over a period of many years, we had little to base any confidence on moving forward.

Fortunately, we sold a sizable portion of our position back in May at a meaningful profit and then sold the rest at a loss in early October before management ultimately decided to cut its dividend.

While our overall results were not terrible in LUMN given how we managed the position, we still initially had a bullish investment thesis in a stock that failed miserably this year. Once again, the big lesson here was that even if a stock appears to be dirt cheap, if the balance sheet is weak in a rising interest rate environment and the business model is capital intensive, the dividend is very likely going to be threatened. In LUMN’s case this was compounded even further given that its top and bottom lines are deteriorating so rapidly. To make matters worse here, it appears that management is more concerned about throwing as much capital as possible into unproven growth projects rather than simply focusing on selling off the company and paying down debt/buying back stock as a surer path to create shareholder value.

Investor Takeaway

Investing is not easy and even years – like 2022 was for us – where you generate a positive return and beat the S&P 500 (SPY) overall, you still often have some miserable losers. The big lesson I learned from each of these losers was that you cannot overemphasize balance sheet strength enough during a stagflationary/rising interest rate environment. As we detailed in our recent macro outlook, moving forward into 2023 we are increasingly emphasizing balance sheet strength in our portfolio and are focusing our investments on undervalued high yield, recession-resistant businesses with strong balance sheets.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.