Ep582: Direk Khanijou – Be Careful of the Dangers of Leverage

Andrew Stotz 00:02

Hello fellow risk takers, and welcome to my worst investment ever stories of loss to keep you winning in our community. We know that to win in investing, you must take risks but to win big, you've got to reduce it. Ladies and gentlemen arm on a mission to help 1 million people reduce risk in their lives and that mission has led me to create the Become a Better Investor Community, in the community, you get access to our global asset allocation strategies and stock portfolios, our investment research, weekly live sessions and risk reduction lessons I've learned from more than 500 guests go to my worst investment ever.com right now to claim your exclusive podcast listeners. Lifetime discount fellow risk takers, this is your words podcast host Andrew Stotz, from a Stotz Academy, and I'm here with featured guests, Direk Khanijou, Joe, Direk, are you ready to join the mission?

Direk Khanijou 00:59

Yes,

Andrew Stotz 01:00

I am. So I want to introduce you to the audience. And it's, the first thing is I want to say that you and I met through a mutual friend of ours, Harry, and we met at a dinner. And it was very, you know, interesting. I mean, you're a younger guy. And I really felt like, Man, this guy is on the right track when it comes to learning about investing and investing. And, you know, I just felt like you were a really sensible guy. And then I asked you to come on the show. So that's why that's how we got here. And so I'm really excited to have you on. And so let me introduce you to the audience. Direct, is a student of business and currently works with his family, in the textile business in Bangkok, he started his investment portfolio at the age 20, and while studying at the University College of London, he looks to differentiate himself through hard work, voracious reading and continuous learning. His objective is to compound capital at decent rates of return without taking undue risk. You can learn more about him and his very, very appealing RB x investments.com. Website, during take a minute and tell us about the unique value that you bring to this world.

Direk Khanijou 02:23

Thank you, Andrew, thank you for the warm introduction. I'm really grateful to be on your show. So thank you for the opportunity. And I noticed that you've had so many amazing people on your show, I noticed that you've had Morgan Housel, and tech Titans on your show. So today, I feel like I am walking among giants, to thank you for making that happen. And, and I think there's a lot of, I think many lifetimes worth of wisdom on your podcast. So I recommend the audience to check out your show. And then, and we appreciate

Andrew Stotz 02:55

that. And yeah, there are some amazing people. But I tell you, it's even more interesting to see someone like yourself coming up. You know, a lot of those guys have got a lot of things figured out. But you're in that process of figuring out discovery, you're sharing stuff that you're doing on your, on your website, you're doing other stuff, maybe just give us a little background on kind of your journey before we get into the story.

Direk Khanijou 03:20

So thank you very much, Andrew, you're too kind. I'm just truly fast. And so just a little bit more about myself. So, as you said, I work with my family in the textile business, and then also have my own investment portfolio, which I started when I was 20. And studying at university. And I'm really fortunate because I get to wear two hats at the same time, the hat of a businessman and the hat of an investor. And you know, Mr. Buffett said that he's a better businessman because he's an investor. And he's a better investor because he's also a businessman. So I think there are a lot of overlaps between the two disciplines. And I get to work with people I like and admire every single day. And you just can't ask more than that.

Andrew Stotz 04:02

You know, it's interesting. I came to Thailand in 1992. In 1983. I started as an analyst, and one of the biggest sectors in Thailand was the textile sector. Okay, and then China entered space. And it was a, you know, it was like a barn fire. I mean, it ripped through the textile industry. And so many textile companies had to find their niche and had to really come up with a just not low cost anymore. But also many families had to decide, Okay, do we continue with this? Or what do we do? So it's kind of interesting about your situation, having had, you know, a family business that's been successful, but then also thinking about, you know, how do you carry on the family legacy and all that stuff? How does that work within your own family and kind of what you're doing relative to what your father or your mother or others in your family have been doing?

Direk Khanijou 04:57

So, my aim is to come to try to improve the business every single day. And, you know, as a poet Rumi said, when you start to walk on the path, the path appears. So you know, just try and just try to make the business a little bit better every single day. And hopefully, if you do it over a period of many days, many months, many years, it compounds.

Andrew Stotz 05:19

And one of the questions I've had, you know, in my own life, and when I was a young analyst, we set up coffee works in our coffee roasting factory. And really, I didn't know anything about being an analyst. And I didn't know anything about being a businessman, because I never knew anything about that kind of stuff. And I had to learn on the fly. But, you know, I felt like, one of the things that I learned a lot about as an analyst was that many business owners are overly optimistic. Because I know my business partner is always focused on the positive growth, the opportunity, and oftentimes, I wouldn't say downplays, but it's just a point that, you know, he's got to focus on the growth. So one of the lessons I learned from that was that, as an analyst, be very skeptical about what people say what CEOs say, and investor relations, people say about what they're going to do, you know, with their business, what, what is, let's say one thing that you've learned from the idea of, you know, kind of trying to wear two hats, investor, and owner operator type of thing, what would you say is something that you've learned from that crossover?

Direk Khanijou 06:29

I've just learned that I really think that business is the ultimate sport. Because it's 24 by seven by 365. And the whole world's trying to kick your butt. And, and that drives me, and I'm a competitive guy. So. So I like it. And you're in high school track, and I did football. So I just like competing. And a lot of fun to be in the arena.

Andrew Stotz 06:53

Yeah, isn't it? I remember my first boss in the industry, when I became an analyst, I came down, the research was on the floor above, and his trading area was down below. And he was kind of a one-man show him that he had all these great relationships around the world, and people around him like, in, he's on the phone, you know, buy this, sell that and all that. And one day, I walked down when I was young, and I was you know, just the new analysts. And he was like, got orders coming in from all around the world. And he's executing and all that. And then he turned and he looked at me, and he said, It's the cutting edge of capitalism

Direk Khanijou 07:31

is an excellent way to put it. And I just love

Andrew Stotz 07:34

that the idea of the allocation of capital is the objective of the investor. But the objective of the business owner is the allocation of resources, which can be money, people, skills, and all kinds of stuff. So I would say sometimes that job of the entrepreneur is, you know, let's say at the cutting edge of capitalism, and yeah, it's just, it's, it's great. And I just had dinner last night with my best friend Dale, and we talked about the business. He's been away for about a month in the US. So he just got back and, you know, being able to run a business now from you know, another country is kind of amazing. But just looking at, you know, what are the challenges ahead? And you know, what are the opportunities, it's such an invigorating thing. Well, now, it's time to share your worst investment ever. And since no one goes into their worst investment, thinking it will be tell us a bit about the circumstances leading up to and then tell us your story.

Direk Khanijou 08:30

Oh, Andrew, how much time do you have?

Andrew Stotz 08:34

The floor is yours.

Direk Khanijou 08:35

I think, Andrew, I think you're gonna love this story. And I mentioned this to you when we met at dinner. So sort of mistakes. Mistakes are great because that's where the real learning happens. And I've been fortunate enough to meet a lot of mistakes. What is one particular mistake that taught me the most, and Stan the most? So my worst investment was in the common stock of a company called Valium, pharmaceuticals. The ticker was V RX. The company is still around today but under a different name. The company's called Bosch Bosch held today, particularly e HC. And I invested in this company in October 2015 at $166 per share, and I sold my investment in March 2017, and about $10 per share. That's a 94% loss on my capital. And so a little bit more about the company. This is a pharmaceutical company based in Laval, Quebec, Canada. The company at that time was run by this fellow called Mike Pearson, who was a former McKinsey consultant and from 2008 to 2000. wasn't 15 The stock had gone up by 45 times. Wall Street and a lot of hedge fund managers were in love with Mike Pearson and the villian business model. And I think my loss in this investment was not due to bad luck. It was a bad analysis. And I'm quoting David Einhorn here. That's the David Einhorn quote. And so then let me tell you more about the Valient business model. So under Mike Pearson, the company relied on gamesmanship, and aggressive accounting to run up its value. And Pearson had this belief that spending money to develop new drugs was inefficient and wasteful. So this is what the company did one, borrow money to acquire pharma companies to slash the r&d three, jack up the prices of life-saving drugs to offset volume declines. And for rinse and repeat. This was not a sustainable strategy. And as Herb Stein said, if something can go on forever, it will eventually em. And if you recall, in late 2015, this was around the time when there was a lot of political backlash around drug pricing. You might also remember Martin Shkreli, and during pharmaceuticals, so they raised the price of one particular drug from $13.50 to $750 per pill. You know, I think that's deeply immoral. And one of we'll figure it out what was wrong with the valium business model. The stock collapsed and Pearson was fired.

Andrew Stotz 11:58

And what let me ask you, what did you see? I mean, obviously, in hindsight, you can describe kind of what they were doing. But how did you what was appealing to you at the time,

Direk Khanijou 12:08

a lot of very smart people in this business. They had some of the most respected hedge funds on the shareholder roster. They had Pershing Square ruin Caniff. And value add was on the board as well. So just an incredible set of investors. And honestly, Andrew owning it made me feel smart. Because it was an incredibly complex business model. So I thought if they got it, who I should also get it. And that's really dangerous in this business. You have to be honest with yourself, and I strayed way outside of my circle of competence. I had no business investing in pharmaceuticals. And I still don't think the industry is really complex.

Andrew Stotz 12:58

And one other question about it is like, this is gonna sound like a dumb question. But like, why didn't you sell when it was going down?

Direk Khanijou 13:07

Andrew, I am part of the slow learning learners club. I will get there. And I had many chances to sell along the way. But I didn't think it was stubbornness. It was ego. It was hubris. And John Maynard Keynes said, when the facts change, you have to change your mind. And my mind in this case is a little too slowly.

Andrew Stotz 13:31

So let's go through the lessons. How would you summarize the lessons that you've learned?

Direk Khanijou 13:35

Painful? So I think there are so many great lessons from this story, because it happened to me. So right when I was just starting my investment, career, investment, career investment journey, and I don't wish a 90% decline on anyone, but having that happen to me. So early on. I think that was a blessing. It taught me about the circle of competence. It taught me about the dangers of leverage. It taught me about anchoring bias. It taught me about overconfidence. It taught me about position sizing. So just so many great lessons. But what I want to say is, I want to talk more about the dangers of leverage, actually, because because of aliens, acquisition of business model, the company had a ton of debt in year end, 2015 $30 billion of net debt, versus $2.2 billion in cash flow from operations that year. So you know, even if the company had no CAPEX, it would have taken them 14 years to eliminate that. And I think they I think a little margin of safety exists in highly levered businesses. And I think if you want to invest in businesses that are run by people with equal measures of talent and integrity, then let Average, I think can be a good guide on the integrity factor. Because if you think about it, if someone wants to steal some money and if they want to maximize the size of the hole, they will have to steal other people's money. So, so and, and you almost, you almost never find frauds at companies that have little to no debt on their balance sheet, or that are 100%, equity finance. So it's just very interesting from that perspective. And there's a great book about the dangers of leverage. The book is called when genius failed by Roger Lowenstein. And I'm sure you've read this book. And it's just a fascinating case study. You know, it's about the hedge fund Long Term Capital Management, which blew up in 1998. And it was because they took on too much debt leverage in their positions in the merger opposition and they just couldn't lay out their hand. And often, when a business has a lot of debt, I think the focus of the management sometimes shifts from managing the business to managing the balance sheet.

Andrew Stotz 16:22

And just out of curiosity, what would you say is a lesson that you learned about how to sell?

Direk Khanijou 16:31

I still haven't learned it, I think? I think they are. There's something known as endowment bias. And there is a good type of endowment bias. And there's the bad kind of endowment bias. The bad kind of endowment bias is when you hold on to your losers for too long. And the good kind of endowment bias is when you let your winners run. So I think it's very important that you strike the right balance.

Andrew Stotz 17:03

Yep. Maybe I'll share a few things. I've been taking some notes as you've been talking, I think the first thing that I take away from it is, you know, following the crowd, sometimes works. And sometimes it doesn't. And following the smart crowd sometimes works, and sometimes it doesn't. That's right. And I think that one of the questions that you have to ask when you're following smart money, is, why do they own this, and what percent of their total investment is this? Sometimes they're just messing around, and they decide, okay, I'm gonna buy a little bit of this, and now their names on that. And then that can be misleading, right? Or someone could be friends with the guy or something like that. So I think one of the lessons is, and I'd say, out of the six common mistakes that I've teased out of what everybody's told me over almost 600 interviews is that the biggest number one most common mistake is failing to do your research. So it's not enough that a smart, successful guy, man or woman has said, you know, is invested in something that is not enough of a reason. So that's Lesson number one. Lesson number two, I would say, you know, you talked about leverage.

And I would just say that, from my experience, as an analyst, leverage is the number one risk that a company faces. Because basically, leverage takes away flexibility. Businesses are going to make mistakes, they're going to face hard times, they're going to face big challenges, and they're gonna have to reinvent themselves. But when leverage is high, your flexibility starts to fall apart. And it can fall apart very, very fast. In the case of the latest crisis, many companies that were under a lot of leverage, basically lost the ability to control their businesses. And so in my own business, and in my experience in investing, I really tried to, you know, prefer companies that have a minimum amount of leverage. Now, that's also an interesting one, because as a teacher of finance for all of my life, wait a minute, the weighted average cost of capital and the capital asset pricing model. And all of these things tell us that there's an optimal point for leverage. But let's explore that for just a minute. That basically tells us that if you're all equity financed, your cost of funding is going to be high, compared to if you could borrow money at a lower rate at a bank. So, therefore, if you were to blend in a little bit of debt with your equity, you're going to reduce the cost of capital, the weighted average cost of capital, but I mean, how much debt could you get, you know, your bank is not going to lend your 5060 70% of your capital as dead. So you're really talking about let's just say 40% is part. But the maximum that you're gonna get from the bank, let's just say that for a moment. And if you borrowed five 5% of your capital as debt, it's not really, it's inconsequential. So let's just say somewhere between 10 and 40%, maybe the optimal level. And then I would say that if someone's looking at that, I would say that probably, it's better to be down at the lower end of that maybe 20%, where you're getting a little bit of a kick from a low-interest rate, but you're not pushing the limits. But the problem is, with cash on your balance sheet, you have different options, you have options of paying in advance for things, and getting a lower price. And when you do that, you're increasing your gross margin. So in the calculation that we normally teach in the world of finance, we teach that by lowering your weighted average cost of capital, you are increasing the value of your firm. But I think that we're kind of missing some of the other things in that, like, the confidence, the flexibility, the ability to move quickly and buy a competitor, when you've got a lot of cash and things that are down the ability to pay in advance, for instance, for goods and services that you're getting from your suppliers. And the end result is that, you know, you have this flexibility, and we're not factoring that flexibility into the capital asset pricing model.

Therefore, I would say that, you know, somewhere between zero and 10%, of capital structure coming from debt, is what I would think is interesting. And I'll tell you a story that I was told by our current health minister in Thailand, couldn't anutin. And he basically told me a case, because he had a lot of cash on his balance sheet. And he told me a case where a customer a supplier of his look, I'm in trouble. And I'm wondering, instead of paying me in 90 days, could you pay me in 30 days, and I Newton said, I could pay you right now, you know, and he said, If you could do that, you'd really save me, you know, save my business and say me, and he paid him then he said, But of course, I want a discount. And the guy said, I'm happy to give you a discount, and he gave him a discount, maybe 10% or something. Well, that built a relationship for life with that supplier number one, because that really saved them. And the second thing is that it increased the gross profit margin. And these are things that maybe not in the capital asset pricing model that we should consider. And that's why I would say that maybe 10 to 20% of the total capital of a company could come from debt. But there's nothing wrong with having zero debt, too. So the last thing I would take away is, you know, you talked about the endowment effect. And I think the best thing that I ever, I remember when I was a young analyst, it was about 1998, maybe we already had a huge crash in the stock market, the stock market had been falling for a long time, and a very brilliant fund manager came to Bangkok and he asked me to take him around to meet the bank. So we were in between the meeting and I can remember that this was in front of central Chidlom.

That's what I remember, I can picture myself on the corner of this, of that corner with that guy. We were in between meetings, and he looked at me says what do you think about a bank? XYZ? Can you remember which one I think it was Bangkok bank? And I started to talk about, you know, well, you know, over the last three months, it's collapsed by x over the last six months, it's collapsed by x over the last three years, it's collapsed by x, but you know, compared to its competitor, and he said, I don't give a crap, what happened, I mark my portfolio to market every day, all I care about is what is going to happen. And it was a real slap in the face and a wake-up call to me to really focus on the future. And that brings me to my way of getting over the endowment effect. Every time that we consider rebalancing our strategies, whether it's stocks, or ETFs, what we do is we imagine that we've sold everything and now we're sitting on a pile of cash. And if I was a, if I was managing an asset management company, I would do that probably every quarter and get all my fund managers into a room and say, good news. I sold your whole portfolio for what you want, and then say, now you're sitting on $100 million in cash, where do you want to allocate it? So always ask the question, if I didn't own it today, would I buy it today? Alright, so those are some of the lessons I took away from what you've talked about anything that you would add to that.

Direk Khanijou 24:34

I would say that there are really two ways to learn from your mistakes. You can make the mistakes and learn it and learn it directly. Or you can learn vicariously from other people's mistakes. And that's just a lot less painful. But I think the lesson sticks better when you make when it's your own mistake. You know, Charlie Munger I support General George Patton, who said, you know, it's an honor to die for your country, just make sure the other guy gets the honor.

Andrew Stotz 25:11

That's a good one. I like Otto von Bismarck's. Only a fool learns from his own mistakes. Why wise man learns from the mistakes

Direk Khanijou 25:21

of others. There you go. And you know, the historian Niall Ferguson has written about this, he said the debt outnumber the living 14 to one. So there are 100, over 100 billion people who have come before us. And Do not ignore the accumulated wisdom and experience of all those who came before us. And the way to access that knowledge is to just read a bunch of books.

Andrew Stotz 25:49

It's all right there. I estimate, I don't know the exact number. But my estimate after now 40 years of reading, I would say I've read close to probably 5000 books. Wow. And I have four books on my bed right now that I've been reading, I just finished the latest one measure what matters. I'm now reading any Dukes book, How to design. And I've got the 48 Laws of Power that I'm working on. And I just constantly reading. So I think that's great. So based upon what you learned from this story, and what you continue to learn what action would you recommend our listeners take to avoid suffering the same fate?

Direk Khanijou 26:27

Subscribe to your podcast.

Andrew Stotz 26:31

It's all there.

Direk Khanijou 26:34

That's right, and many lifetimes worth of wisdom on your podcast, Andrew. And I really mean that. My advice would be to develop your own investment philosophy early on in life, and figure out what kind of an investor you want to be. What's your temperament like. And, you know, Richard Fineman said, the first principle is that you must not fool yourself. And remember, you're the first and when were you the easiest person to Full Sail travel, really figure out what it is that you want to do. And I think something that's really important is to develop good habits early on in life. Because bad habits are very difficult to break, when you're handling, you know, they say into habits are too weak to be felt before they're too strong to be broken. I think that's really, really important. And hang around with people who are better than yourself. Because over time, you will drift in that direction. And you don't, and you don't even have to physically hang out with them. You can mentally hanging out with them in books, talks about making friends among the eminent dead. And I think that's a fantastic way to go Roseville.

Andrew Stotz 27:52

That reminds me of. I gave a presentation to the American Chamber of Commerce here today, a while ago with Dale about our coffee business. And as we started presenting it, I said, I want to introduce you to my eminent board. And I proceeded to put up a picture of you know, Dr. Deming, and Peter Drucker and all of these few other thinking, How the hell did you get all these people on your board? And I said, Well, this is our advisory board. And we've learned from all the books that these guys have written and all of that. So yes, fantastic. Now, what is a resource that you'd recommend for our listeners?

Direk Khanijou 28:27

Sure. So I'm reading this book right now. And I'll bring it up. I'm not sure if you read this, Andrew,

Andrew Stotz 28:34

The Art of Learning? No, tell us.

Direk Khanijou 28:37

So this book is by Josh Waitzkin. Said Josh Waitzkin is this remarkable guy who has figured out how to be world-class at various disciplines. He was a chess champion. Then he mastered Tai Chi, then jujitsu. And I believe now he's learning how to fall surf. And this book is about his learning principles. And learning to learn is a meta-skill in life. So once you figure out how to learn what you want to learn, then you can go in any field you want, I think, great,

Andrew Stotz 29:14

great resource. I'm just looking at it right here on Amazon, The Art of Learning and inner journey of optimal performance, Josh Waitzkin. Excellent. And I would add in Annie Dukes book that I've just started reading how to decide I mean, if you could learn how to learn and how to decide, oh, my gosh, sometimes it's interesting. And one of my questions for her when she comes on is, are we really better as a society at deciding or are we worse? Are we really learning as a society? You know, I know individually, we can point to individuals that are better at learning, but if we go back when I was in high school, and I had to learn French, and you take a young person nowadays in high school, and they got to learn French? Are they able to learn French? If they had the same skill level the same interest in it as me at that time? Would they be able to learn it and half the time? You know, five times faster? Or is it pretty much the same?

Direk Khanijou 30:16

That's right. Sorry, go ahead. Well, one of his mental models is depth over wet. And whenever he's trying to learn anything new, he would try to understand it from the first principles and master the micro positions. In the book, he talks about playing chess, which is three positions on three pieces on the board. Chess and pawn versus sorry, King and pawn versus king. And that's a funny way to play chess, but are you working with us? Starting with the end game, as opposed to the opening? Is that really interesting?

Andrew Stotz 30:59

Well, that's a great recommendation. Last question, what is your number one goal for the next 12 months?

Direk Khanijou 31:06

I don't have a master plan. But what the one I want, you know, have, you know, I'm just inspired by this book. And what I want to do is, I think I want to pick a particular pick one industry, you know, say banking, and then spend the next six to 12 months reading everything I can about that particular industry, and just try to become, just try to develop a really good understanding of that industry. So I think that that will be my goal for the next six to 12 months, and also my sister's wedding is coming up. And yesterday, I had my first dance lesson. So maybe another goal is to get better at dancing.

Andrew Stotz 31:46

That is the best, best recommendation out there. Because if you can learn to dance world is your oyster. I also like the recommendation, I think for the listeners out there, you know what is an area that you want to be a leader in you can be top in your industry, if let's just say that you're a salesperson, and you say I really want to be a leading salesperson. There's, there's 12 great sales books out there. There's more, but let's just say you pick the top 12. And once every month, you read one of those four years you take your notes, and you create cheat sheets and all that's what I do in my, in my business. My book club is I create cheat sheets on all the books that we read. In fact, I'm looking for one right now. But these cheat sheets basically, I've got one that I've just done on 48 Laws of Power. And these cheat sheets are a great way to remind yourself what did you learn and make sure that you're putting it into action, you could read 12 books on sales, by the end of the year, you would be top 10% of your industry as far as knowledge is concerned. So I really, you know, challenge the audience to pick that area and focus in on it. I don't know if it's going to be the banking area but you picked banking was for 10 years. So I did a huge amount of detail work on banks. So it's there is some interesting stuff there. Well, listeners there you have it another story of loss to keep you winning. If you haven't yet joined the Become a Better Investor Community just go to my worst investment ever.com right now to clean your lifetime discount exclusively for podcast listeners. As we conclude directly, I want to thank you again for joining our mission and on behalf of A. Stotz Academy, I hereby award you alumni status for turning your worst investment ever into your best teaching moment. Do you have any parting words for the audience?

Direk Khanijou 33:47

Thank you so much for having me on your show. Andrew, it's a real privilege.

Andrew Stotz 33:51

It's great to have you and you're an inspiration, I think for all the young people out there that are building their knowledge base and finding their investment style, which I think was great advice. And that's a wrap on another great story to help us create, grow and protect our wealth fellow risk takers. Let's celebrate that today. We added one more person to our mission to help 1 million people reduce risk in their lives. This is your words podcast host Andrew Stotz saying I'll see you on the upside.