Sunday, November 25, 2007

Preservation of Capital – A Central Tenet of Value Investing

With Mr. Market currently being so manic-depressive and seeing only bad days ahead, it is important to remember that he is there to serve you, not to instruct you. The pervasiveness of his mood swings has the ability to affect all but those who inherently understand the true value of a business. Market watchers and pundits who are paid to say something about the market everyday will come up with a myriad of reasons why Mr. Market is pessimistic, and a dearth of bad news will continually stream in to reinforce this perception. Thus, the resultant effect is a massive sell off by hedge funds and mutual funds because they too are affected by the fear and panic which is spread by Mr. Market. Oh, what mischief this man can do ! Sometimes, when I glance at the market, I can almost see Mr. Market’s evil face grinning at me as he waves his hands over the market, causing millions to panic and dump their holdings at the lowest possible price (no, I am not schizophrenic, I am just using a metaphor !). This hardens my resolve not to listen to him but to focus on the true worth of the companies I hold.

A falling market is the ultimate test for a value investor. It is mentioned in value investing books that you never know if the companies you pick have the ability to survive Mr. Market’s manic mood swings, and there is no way to know if your portfolio is sound until it is tested by fire. Thus, when I view the current market situation, I see myself facing the “exam” which I have been “studying” for these past 18 months. All the research, reading, analysis and thinking has gone into identifying good companies selling at a fraction of their true worth; but now the time has come to see if the buy-and-hold strategy will ultimately win over the “fast profit” strategy of churning your portfolio.

With this in mind, I would like to reiterate to readers that the goal of sound and intelligent investing is not for quick gains or huge profits. If you want those, please go to the nearest 4-D or Toto booth, put down a few dollars; then hope and pray for yourself to strike the lottery ! In fact, the most important tenet for value investing should be capital preservation. With this, I mean that one should invest with such a wide margin of safety that losses are largely minimized, while gains are almost certainly assured. Too many people throw their money into the market with only the upside in mind; they never think of the potential LOSS they may face, and always end up shocked and stunned when the market turns against them.

It is also prudent to note that one can actually make a lot of money by avoiding losses. What do I mean by this ? It simply means you don’t go out there and take unnecessary risks, like buying into a company you don’t understand, subscribing for IPOs (which subsequently tank) or chasing a company’s share price just because it has just rallied. Please note that avoiding such mistakes can actually make you much richer even if you do NOT know a thing about value investing; as compared to people who keep chasing the next hot tip, or buy at the peak of a bull market, or simply buy indiscriminately. This may sound quite incredible, but one can actually compound their money better in a bank (earning a paltry 0.25% interest per annum for POSB) than letting the market eat up their money through poor judgement and bad decisions.

To conclude, I would say that for one to really practice value investing or go down the path of value investing, one has to change one’s mindset radically. Most investment professionals or fund managers will preach about how their fund has generated the highest returns or how a particular sector is “hot” or “growing at an exponential rate”. Just try asking them about capital preservation and they will become evasive and uncomfortable, and tell you that “in investing, there are always risks, so we must assess if you are high, medium or low risk; so that we can tailor the portfolio to suit your needs”. What I say is: investing is only risky if you do not have capital preservation in mind, and fund managers who invest only thinking of gains are not doing their clients a favour. In order for an investor to do well in the long-run (yes, not short-term !), one has to make capital preservation the central concept in one’s investment philosophy.

10 comments:

Anonymous said...

Hi MW,

Good piece. Though we are on different strategies, our main idea is the same - Preserve your capital and you can come back to play the game. Lose your capital and you lose your train ticket. U can never board the train even if the train arrives ;-)

For me, the way to preserve capital is to pay attention to overall mkt trend and get out when it has gone into correction, like this current one which started about 3 weeks ago and I have notified you too cos' I enjoy your blog ;-)

Current I am sitting on the side line with cash waiting for the market trend to turn. Until it confirms its uptrend, I will not risk my money in the market.

The other tool for me is to cut your losses short.

Happy Investing and I wish you all the success in investing.

Keep blogging. U are doing amatuer investors a big favor by allowing them to learn from you.


Regards,
MM

ThinkNotLeft said...

This is a very interesting and good post that shed light on the market from a less-known angle.

Value investing, given no very bad fortune, would minimize the risk of total losses. And given sufficiently long timeframe, value investing should lower the risks of capital losses.

However, value investing, in practice, may lead to sharp downward volatility at certain times. For example, Warren Buffett suffer a temporary 50% losses in his Washington Post purchase. Looking at other valued investors' results (see WB speech "The Superinvestors of Graham-and-Doddsville", there are large negative returns (-30% to -40%) observed in the period around 1974.

Hence, I feel that the term "capital preservation" in your post may be misleading especially to new investors who may think that value investing has low volatility (or less risky, if volatility equates to risk).

musicwhiz said...

Hi MM,

Thanks for commenting. Yes, preserving capital is important for trading too. Holding cash in down markets is a good way to be prepared for shares of companies to be pushed down to unreasonable levels by Mr. Market, then you can go in and scoop up some bargains.

I admit I do not understand trading or TA too well, but I do know that trends play a part in when to go in. For me, as long as I see value, I will purchase; never mind whether there is a trend or not.

Different strategies, but hopefully same results ! Good luck to you too !

Regards, Musicwhiz

musicwhiz said...

Hi thinknotleft,

Thanks, a good point you brought up ! Value investing does mean that you may have to suffer short-term volatility and have a strong stomach for it. Yes, I have read that article too and a lot of the value investors mentioned therein have suffered short periods of under-performance.

Perhaps I should have added in my post that risk is NOT equal to volatility, unlike what financial newsletters and articles usually preach. Risk is defined by doing something in which you do not understand. For me, higher risk comes with buying without the requisite margin of safety.

Regards, Musicwhiz

Anonymous said...

Right. Risk is not volatility- a point Buffett reminded shareholders at this year's BRK annual meeting (this was in response to a question about how he would adjust "beta" when doing CAPM for valuations).

That we should take advantage of low-risk but high uncertainty situations requires an independent mindset- and knowing the intrinsic value of a business and buying a portion of it at a safety margin (around 25 to 50%) help to mitigate risk.

Derek said...

Hi Musicwhiz,

I have read through your blog and your articles are very well written.

I have set up a new site (http://thefinance.sg) to house the articles of various local bloggers.

Can I have your permission to have your articles in my site? Of course, I will credit you with your work and link it back to your blog.

Cheers
Derek

musicwhiz said...

Hi Anonymous,

Yes, but a lot of research and reading is required before a value investor can identify such good businesses; that's the difficulty involved. Buying at a margin of safety is definitely necessary in order to protect your principle and ensure an adequate return on investment.

Regards, Musicwhiz

musicwhiz said...

Hi Derek,

Thanks, yes you have my permission to post the articles on your website, as long as you credit the articles back to my blog. I have visited your website and it'sa good compilation you have there. Keep up the good work !

Regards, Musicwhiz

Derek said...

Hi Musicwhiz,

Thanks. Can I have a short intro about yourself so that I can post it up in my site (http://thefinance.sg/authors). If you don't mind, I hope to have your email as well.

My email: decarn@gmail.com

Cheers
Derek

musicwhiz said...

Hi Derek,

For intro, I am a 31-year old guy who is educated in accounting and who works in the investment line (but not in a bank, financial institution, brokerage or fund house). I have a full-time job and investing is my side-line as well as passion.

I am a value investor and my technique is derived from the teachings of Warren Buffett, Benjamin Graham and Phil Fisher. I guess you can say I incorporate all aspects of their investing style, and modify my value investing style to the Singapore market.

Sorry about the email though, I would like to keep that private. Thanks.

Regards, Musicwhiz