Difficult Investments

NetEnt and Evolution Gaming have been two of our most successful investments to date. Both are Swedish companies operating in the online gaming industry (i.e. casino/betting systems). Since we acquired them through 2018/19, they have returned 120% and 370% respectively. As of March however, the performance of these two stocks couldn’t have been more divergent. Evolution held up well through the first quarter. Even at its lowest point in March it had nearly tripled since our original acquisition. NetEnt on the other hand lost nearly 40% during the first quarter, reaching a new low in March, down more than 50% from where we’d bought it.

Despite the dismal share price performance of NetEnt up to March, our process indicated that the stock was priced for better long-term returns than before. We continued to buy shares through the first quarter (though not quite at the low), making it our second largest holding by the end of March. In the three months between 19 March and 23 June, NetEnt rallied more than 250%. (It became apparent to the market that their US expansion strategy was starting to bear fruit). By May, NetEnt had become the largest position we’ve ever held in our portfolios. As we didn’t deem it expensive we decided to maintain our full exposure.

On 24 June, Evolution Gaming announced an all-stock deal to acquire NetEnt. The deal priced NetEnt at a sizeable premium and sent the shares 30% higher on the day. Because of the large position size, NetEnt has made a significant contribution to our performance during the quarter. NetEnt is a good reminder of how quickly things can change in financial markets. We need to be patient when things don’t immediately go our way, and ready to respond when rapid changes do occur.

Difficult investments require discipline

There are some valuable lessons to be learned from NetEnt about how successful investments can play out over time. On the one hand you can have a company like Evolution. Evolution moved sideways for a little while after we bought it, and then just climbed higher and higher. Evolution has been an ‘easy’ investment in the sense that we’ve only ever experienced success from the get-go.

NetEnt on the other hand has been a difficult investment. After two years of investing more and more into the stock, we found ourselves 50% down. Three months later we’re up 120%. Successful equity investments seldom deliver nice consistent return streams like Evolution. Most successful investments involve long periods of volatility – like NetEnt.

What is interesting about these difficult investments is that we often make more money out of them than the easy ones. We may have ‘only’ made 120% on NetEnt (vs 370% for Evolution), but we actually made more money out of NetEnt than Evolution. How? We kept adding to our position as the price came down and prospective returns increased. To do so required emotional detachment and discipline.

Why is discipline so important? Because without a disciplined investment process, our judgement can easily be clouded by emotion. Emotional investment decisions generally lead investors to buy when stock prices are high, and to sell when stock prices are low.

Ownership leads to emotional bias

An investor’s emotional perception of a stock depends on two things: 1) What the share price has done, and more importantly 2) whether or not he owns it. Take NetEnt as an example. In the two years before we bought it, the share price had dropped by more than 50%. We were excited by the opportunity to buy a good business cheaply. We didn’t feel those losses. But then two years later, we were down 50% on our investment – and we weren’t happy about it. The fundamentals hadn’t really changed, but our emotional perception of them had. Why? Because we owned it. If we’d been driven purely by emotions we might have resisted buying more shares, or worse, thrown in the towel and sold out.

Our natural emotional perception of a stock is highly dependent on whether or not we own it, yet this has no impact on the future of the business. These perceptions shouldn’t enter the equation. Let’s imagine for a moment that we held off buying NetEnt two years ago, and we didn’t own the stock in March. We’d probably have been just as excited, if not more excited about the prospects of this investment than we were two years before. We’d be emotionally detached from the losses suffered by NetEnt investors over the preceding four years. That’s how we needed to think about NetEnt in March, even though we did own it and had suffered through some of those losses.

No investment process can stop us from feeling these emotional biases, but a great investment process needs to override them in our decision making and enforce discipline. We need to make decisions as though we don’t own the stocks. We need to ignore the emotional impact that ownership brings to the table. Every time we look at a stock that we already own, we need to look at it through the same emotionally detached eyes that we had before we bought it. That’s what our process does for us.