The Stock That Burned Me: Scottish Re

Worldwide Invest Better Day 9/25/2012
Worldwide Invest Better Day 9/25/2012

We all love to talk about the stock home runs we've hit. But when it comes to learning and becoming better investors -- which is what The Motley Fool's Worldwide Invest Better Day is all about -- revisiting our worst investments can often be much more instructional.

Which brings me to the painful story of my investment in Scottish Re.

Singing the sirens' song
While we're all familiar with insurance in some form or fashion, Scottish Re is a reinsurer, which is essentially an insurer for insurers. Insurers turn to reinsurers to protect themselves in case they're hit with greater losses than expected.

If run properly, this can be a really good business. Fans of Berkshire Hathaway (NYS: BRK.A) (NYS: BRK.B) likely know that the company's General Re and Berkshire Hathaway Reinsurance subsidiaries constitute a considerable portion of the conglomerate's $32 billion insurance business. In 2011, General Re had $5.8 billion in earned premiums, while Berkshire Hathaway Reinsurance had $9.1 billion.

The structure of the risks that reinsurers take on might be slightly different than standard insurers, but the recipe for success is very similar: Collect premiums up front, invest them wisely to earn returns, and assess the risks well enough that you don't pay out claims far above what you collected in premiums.

While that may sound like a simple recipe for success, complex tax planning came back around and bit Scottish Re in the butt. In 2006, the company realized that it wasn't going to be able to use a deferred tax asset, and that reversal led to a huge loss that year and the resignation of the company's CEO.

Not surprisingly, the stock got hammered. And that's where I got suckered in.

What I saw was a solid insurer that had made some boneheaded tax moves and was now trading at a small fraction of its book value. If it could weather the storm and get back on its feet, I figured that the stock had the opportunity to double, if not triple.

But wait, it gets worse
Going into the investment in Scottish Re I had no misconception that this was a healthy company. I knew it was a company in trouble. In fact, I often invest in companies that are going through tough times and whose stocks can be purchased at very low valuations. The trick is that I invest in many of these situations, keep each individual investment small, and then allow the ones that work out in my favor to outweigh the ones that end up blowing up. Unfortunately, I didn't stick to that strategy with Scottish Re.

Not long after I invested, Cerberus Capital and MassMutual Financial jumped on the opportunity as well, throwing the company a $600 million lifeline and buying convertible preferred stock that represented around 70% of the company's ownership. That diluted my investment, but it was a huge shot of confirmation bias -- if these savvy investors see opportunity, surely I couldn't have been wrong! I doubled down, and then tripled down on my bet.

Well, it turns out that tax planning wasn't the only thing that Scottish Re had gotten aggressive about. The company had also loaded up its investment portfolio with high-yield, risky mortgage-backed securities, many of them of the subprime and Alt-A variety. Long story short, Scottish Re had investment losses of nearly $1 billion in 2007 and nearly $2 billion in 2008. Because an adequate capital cushion is a must-have for an insurer, that was really all she wrote. Scottish Re still exists today as barely a ghost of its former self, but my investment was almost totally lost.

The lesson portion of the program
One potential lesson here is to just not mess around with sickly companies. As Scottish Re proves, sometimes companies that stumble don't get back up. Another potential lesson is to be very wary of confirmation bias. Just because supposedly smart investors have invested in the same thing you did doesn't mean it's right. Even the very best investors get it wrong sometimes.

But the critical lesson I took away from this experience is the importance of having a clear investment strategy and sticking to it. The majority of my investment portfolio is dedicated to investing in great companies that I want to own for a long time. On the side, I have a portion of my portfolio where I go fishing for bottom-feeding stocks that could have big upside potential. But as I pointed out above, I have a very clear strategy for the latter -- make lots of small bets on the knowledge that some are going to go very, very wrong.

With Scottish Re, I threw my strategy out the window simply because I got greedy and stupid. Greedy because I thought the stock was going to have huge upside, and stupid because I allowed behavioral biases to drive my investment decisions.

How can you avoid making the same mistake? Make sure to start with a big picture. Know what kind of investments you're looking for. Know how you want to allocate your capital, and stay diversified. Perhaps even set dollar or percentage limits for any one given investment or type of investment. Then, most importantly, follow those guidelines when making investments!

Moving on and investing better
Some lessons come hard-leaned and expensive -- like Scottish Re for me. But there are a great many pitfalls that you can avoid simply by learning as much as you can. And that's our goal with the upcoming Motley Fool Worldwide Invest Better Day. To find out more, just click the bar below.

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