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There have been lots of emotional comments and questions regarding Home Capital Group, which I own as well.

I continue to hold at the cost of having to sell them for nothing, as I evaluate them further. I plan to hold them until fundamentals deteriorate (cash flow dries up and/or dividends are cut), which we’ll know very soon on their next earnings call. Sentiment caused this, not a weak balance sheet. But sentiment can potentially impair them permanently, as they need deposits to make money. Since sentiment is temporary, I’m waiting.

HCG has been worst stock performance since I started in 1998, but HCG represents only 3.5% of my investing port, and my investing port is 60% of my total port, so even if I sell it by zero, it’s a very small loss to lock. Having built my port allocating equal weight to sectors really helped (but that means that I carry extra risks on other sectors, like the ones with just a few stocks per sector). Regarding the recent events with HCG, it will not change my strategy to buy. Other mistakes will be made along the way, but since there are more sucesses than mistakes, it works out well in the long term. However, I will incorporate a new rule to sell. When to sell is the most challenging decision. I’ve never sold on fraud allegations, since I’ve always been successful deciding on numbers instead of news. However, fraud is serious and allegations don’t happen often. Reputation is paramount to partner with management, and if OSC (or equivalent in US) is challenging them with such, then that should be the selling signal. So it will be for me moving forward. This was the best example of underestimating what reputation damage can do to a business.

For now, I want to see how they will react and adapt. Maybe they won’t survive. But since I didn’t exit on the first allegations, I will stay until the end. Not much point selling now anyway. Their balance sheet is good, but cash flow is in jeorpady. I expect dividends to be eliminated on the next earnings call. That will confirm that they no longer meet my goals and I’ll exit when that happens.

They always had a stellar record with earnings and dividend growth (which is why I decided to partner with them). But dividends comes from cash (not earnings). In 2008, and in the latest real estate crash in the 90s in Canada, earnings were affected, but never cash flow. Therefore, dividends kept coming. Same with IBM (declining revenue and earnings for years), yet they keep increasing dividends because cash flow allows so. Or Corus, which pays a healthy 8.5% dividend (11% not too long ago), because cash flow supports it. But for HCG, with less deposits, it impacts their cash flow. Therefore, it impacts their ability to pay dividends. That has nothing to do with their healthy balance sheet and earnings affected by this loan. They could even increase earnings – cash flow is the ultimate financial health check, and what makes a difference for the company to survive during crisis or be permanently impaired. Therefore, I fully expect dividends to be cut or be totally eliminated. The market might respond well (company is reacting to grow again), but it might respond harshly, adding further fuel that they are fighting for survival. Although management reputation is tarnished, that’s the best I can go with for my decisions – not somebody’s opinion. My base for partnership has always been based on trusting management, so I’ll stick with that until they prove that I shouldn’t do any longer. Therefore, I’ll wait and see what happens on the next earnings call. And moving forward, further fraud investigation allegation by regulators will be added to my rules to exit, as I should have done it before.

It’s a shame that a company with such stellar record on earnings, cash flow and dividends all these years ends up this way. But reputation is one of the biggest company’s asset, and little care was shown with this precious asset.

I firmly believe that companies will become more aware of reputation and its impact. A few years ago, Maple Leaf had a huge recall due to Listeriosis outbreak in their plants, and being transparent with consumers and quickly responding to not tarnish reputation is what made a difference in Maple Leaf to recover, as opposed to other companies that took allegations lightly and didn`t recover (like Peanut Corporation of America, when there was a huge recall and fatalities when salmonella broke out on PCA plants and ended up filing for bankrupcy shortly after). The recent fiasco reputation with United cost them $12MM setlled before courts. A similar incident took place with American Airlines a week after, but they were much quicker to respond and backlash from public were more contained. Or Wells Fargo attitude of firing the little guys that were told to falsify information, which cost the CEO his job once that surfaced the news. Reputation can bring a business down, and Buffett words can’t be stressed enough: “Reputation takes years to build and seconds to destroy”. Like any major event, new regulations and safer controls will come from that. But humans are humans, and the bad ones will always find ways to circunvent the system a take actions that will reflect poorly on their business and themselves. Criativity has no limits. There’s a reason to why most of CEOs can psycologically classified as psycopaths. A successul CEO has to be a good manipulator. That’s also why Buffett always suggests to never fall in love with a stock. It’s hard to take rational decisions when emotionally attached to a stock, company or decision to why that was bought. Investing is a business, losses are part of it. There will be others. Accepting the fact that mistakes will be made help with that. And for these reasons, to me, is why a diversified portfolio, made of investing and trading strategies is so important. And a good temperament test is to look that you’re down on a stock by 60%, shrug and move on. Keep the strategy that is working so far (there will be other losses, it doesn’t mean the strategy is weak) and don’t let that distract from the things that matter.

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