The Big Picture for the Week of April 3, 2011

The other day a reader left a comment about my investing foray into Iceland a few years ago which triggered some other comments including one where the reader asked how I knew to get out before the banks literally went to zero.

My starting point for Iceland was this post six years ago. The story was simple, I thought, in that the country had transformed itself into a relevant financial hub, relevant to Europe to a great extent less so globally. This started in the fishing industry as capital was taken and invested in a multitude of ways. The Icelandic people are very well educated and inserted themselves into world commerce, they created a very sophisticated banking system that created enormous wealth and all the while there remained the promise of geothermal to create even more wealth and prosperity for the country.

Iceland was not really available as an investment destination via US brokerages but there were no restrictions for US residents opening accounts in Iceland to buy stocks, the one ETF or fixed income. The largest bank, Kaupthing, had a dual listing in Stockholm that could be accessed on the US pink sheets. I owned Kaupthing personally and for a client or two off and on. There was one great trade in there along with a loss but I exited a long way before zero so while not the ideal outcome, the net result isn't even memorable which is a good thing given that it ultimately went to zero. There was also a stock called Decode Genetics that traded on the Nasdaq. I never really checked it out, it appears to no longer trade on Nasdaq and I am not sure what happened to it.

Then in late 2005 I started the process (it really was a process) to open an account at Kaupthing with the intention of having a 50/50 split between the ICEQ 15 ETF and bonds or cash in the Icelandic currency--interest rates were very high. At this point things in Iceland were still going very well. I got the account opened, funded and implemented in February 2006. A couple of weeks later there was a negative outlook announced for the debt, I wrote about my ongoing faith but also disclosed a previous sale of some Kaupthing shares after a nice lift.

Then a couple of days later I posted a very negative analysis of Iceland passed along by a reader after which I pointed out a couple of inaccuracies along with concerns that were valid. And although I am not sure if I blogged about this or not, Danske Bank had some very negative comments about Iceland along the way as well. A month later I blogged that I felt the long term was still in tact but anyone worried about the next year should probably stay away.

Joellyn and I went to Iceland in the summer of 2006. We saw the huge Alcan plant running on geothermal, the abundance of cranes and a lot of very young looking professionals driving BMWs and Range Rovers. The story on the ground was one of prosperity without any signs of trouble. No signs of trouble doesn't mean there wasn't trouble, just it was not evident. Here is an update I posted in October 2006 where after being at the center of a risk-aversion trade the ICEX had taken back a lot, not all, of the decline. I expressed my ongoing faith in the long term and noted that it had become more globally relevant.

This post from April 2007 notes a sale of Kaupthing as things were still going ok but I do acknowledge some doubt. Here I acknowledge more concerns but still have my exposure in the country in January 2008. This post from April 2008 I disclose having sold my equity exposure and recap the math which was not bad, I lost 15% on the ICEQ ETF. I was not able to find the post where I disclosed closing my account and having my money wired back but the loss was minimal. This post from September 2008 I note that I had been out for a while, I mention the problems will take a while to fix but that I do not think the country is permanently broken. Indeed they did the difficult thing and appear to be much further down the road to health than many other countries crushed in the crisis. I don't know when, if ever, the country will be an investment destination but it is on the road to functioning.

As an amusing side note, while I thought I had closed my account it is still open at the successor bank and has ISK219 which is a buck or two.

I felt a decent recap was in order given how much I wrote about Iceland (I also had a couple of articles at theStreet.com) and how long this played out. I believe the entire story has examples of things done well and things done poorly which makes it constructive on multiple levels.

I think I was clear all along that I thought Iceland was a very compelling destination with a lot of promise for prosperity and increased global relevance but that it was a risky or speculative investment. I also hope I was clear that the sizing was very small so that in the face of a total blowup I would not be forced to re-write my financial plan. This is true with how I manage client accounts as well as my own--a blowup in a narrow exposure weighted at 2-4% will simply be a drag on a portfolio not a calamity.

Part of the blowup was the extent to which the banks, like Kaupthing were over leveraged. This is what took down the entire financial system all over the world. The leverage versus GDP of the country was massive in Iceland but this was not really how the question was framed until after the blow up. The fact is that Kaupthing was diversified which was a positive but in the face of a genuine unraveling diversification did not matter. Maybe the Icelandic banking system would have collapsed without the global meltdown but there is no way to know.

So to the reader's question about why I got out when I did. The easiest answer is that buying individual countries from the top down requires ongoing monitoring of each country. This does not mean it is crucial to know every data point as it hits or have total recall of the last ten years but it does require paying attention. As all of this was happening there was news everyday about Iceland and it was easy to find. Long time readers may recall I used to own Ireland and sold that in March of 2008 and that we had Barclays Bank which we sold in December 2007. The other important action in this context was selling Bank of America in the immediate aftermath of buying Merrill Lynch.

The first point here is that these pockets of the market had become sources of obvious risk and volatility. WRT to selling Ireland and Barclays; I've joked how many times are you going to read that things are deteriorating rapidly before you sell? Barclays was a great proxy for the UK financial system. To me this was not a bottom up issue, from the top down the story in the UK was unraveling. This was also the case with Ireland where we owned Allied Irish Bank. Things seemed (to me anyway) to start to unravel in Ireland a little later but did so with greater velocity.

With Iceland it was obvious that this was a more speculative situation. I would say I probably expected it to become less speculative as the rest of the world caught on to the story and the theme matured a little bit. It became a very important global destination in terms of influencing how other markets behaved shorter term which turned out to be part of the flaming out process. By virtue of paying attention it was obvious that things here were deteriorating, things were coming to light about leverage, gross compensation, wildly aggressive decision making and so on. Looking at the timeline of blog posts this happened over a period of months that gave a reasonable period of time to assess the situation and get out.

I've described my investment process as combining what I know about market history with what I think is going on now to make a forward looking analysis. Embedded in this is active decision making. Active decision making can include simple, subjective judgment which was a big part of these decisions. If you can really focus on forward looking analysis then there is less likelihood of anchoring to some past price. No one is perfect in this of course but if the fundamentals or perception of the fundamentals change for the worse then some sort of sale (either exiting the position or reducing the size) becomes the right thing to do and this was the case with all of the above.

Iceland worked until it didn't (quasi-humor attempt). I can't defend that I should have drawn different conclusions before going in so this is where I turned out to be wrong. I recognized a problem long before this turned tragic which is a positive. I am not sure if I really failed to recognize the problem in 2005 when I got serious about investing in Iceland or if the story changed and the problem surfaced as I was on the way to getting out. The truth is probably in the middle.

The other point here is not letting ego get in the way of taking action. Generally I would rather tell a client I was wrong in explaining a 25% decline then sticking to my guns all the way to zero with some sort of rationalization about the market not understanding. Realizing it turns out you were wrong or didn't understand something the way you thought you did are great reasons to sell even if the stock is down 20%.

The pictures are all from our trip to Iceland in 2006. The first picture is from the Blue Lagoon geothermal spa, the second one is looking at Reykjavik from the top of the church tower a couple of blocks from the heart of downtown and the last one is out in the countryside on the way to Hellnar.