The Essence of Investing

After the trials and tribulations over the past 4.5 years, I admit I do spend an inordinate amount of time doing self-reflection, and at the same time, reading up on value investing and doing some independent thinking and analysis of my past mistakes; and how I can always improve on my investing techniques and stock selection process. Close to my heart is Benjamin Graham’s definition of investing, which bears repeating: “An investment operation is one which upon thorough analysis, guarantees safety of principle and an adequate return. Operations not meeting these requirements are speculative.” Notice that the man does not define investment in terms of making lots of money, and he also does not specify any time frame with which one should practice the above. This has led me, in recent months, to truly define and ask myself what is my purpose for investing; and what I would eventually like to achieve from it. The answer was quite clear and simple – my purpose for investing is not to “strike it rich”, but to obtain an adequate return on my invested capital which is higher than inflation. With that in mind, I focused on capital preservation and margin of safety, concepts which most readers are familiar with by now but I will discuss these two concepts from a slightly different perspective this time. In particular, the concept of margin of safety is not cast in stone and its definition is subject to interpretation by the practitioner.

Capital preservation is a concept which is not fully appreciated in the stock market. In fact, I dare say it is often downright neglected! This is because of the human being’s propensity to lunge after profits and gains, and to let the greedy side take over (I call it the “Dark Side of the Force”); while the prudent and conservative side of his brain takes a back seat. As veteran investors in the stock market probably know, NOT losing money is already quite an achievement, much less making a pile. Hence, the overarching principle involved in investing should be to protect your principle at all costs; and this can be done by undertaking a rigorous and painstaking research process to protect your downside. Before you even consider purchasing a security, ask yourself if the business can continue to grow or remain stagnant, if competition can erode the competitive advantage which a company has, or if the company has debt levels which you are not comfortable with. In other words, pre-empt yourself for the downside, instead of looking at glittering profits which are non-existent. This is the mindset which an investor should adopt if he wishes to generate a consistent and sustainable gain in the stock market. By protecting your downside, you would be able to sleep well and let your money compound. Please also do note that yield counts as part of capital preservation, as it acts as a return ON investment (not return OF investment). One should aim to preserve capital ex-dividend, meaning the value of the company should remain or even increase the same regardless of dividends being paid out, as a company is supposed to be continually generating cash flows and profits to keep its equity base constant.

The above concept of capital preservation can only be fully appreciated in a bear market, when the market prices of securities tumble like rocks falling off a cliff dragged down by the force of gravity. With corporate fundamentals acting as a cushion, one need not be afraid of declines in market price in the face of the Mr. Market’s desperation. For Graham was right when he said we should not let a certified lunatic with wild mood swings decide the right value of companies in which we own shares of. To quote a simple, yet effective example, imagine a company was worth S$50 million (net worth – assets minus all liabilities), would you accept a price of S$20 million for the company, which is a 60% discount to its true net worth? Stated as such, it would seem obvious to both a casual observer (with average intelligence) and a reasonable man that a huge bargain was at hand and up for grabs. However, in reality, a mish-mash of emotions and cognitive + psychological biases serve to confuse and confound investors into buying high, and selling low. As investors, we have to constantly be aware of these biases and be mindful of their pervasive effect on our investing behaviour, lest we let ourselves suffer from the cardinal sin of losing our precious capital.

The traditional definition for “Margin of safety” would indicate that the investor has some leeway in being wrong in estimating the intrinsic value of a security, and this margin would provide a cushion to ensure that he preserves his capital, or else loses as little of it as possible. But margin of safety can be a notoriously elusive and subjective concept, so much so that two veteran investors may not see eye to eye on the required margin of safety for a particular security; or even whether it has any margin at all! Each of us has a unique ability to read into a company’s financials and business situation cum model, and form our own conclusions as to the attractiveness of the business with which to invest in. Consequently, the margin of safety demanded should also be commensurate with our risk tolerance as individuals, based both on personal circumstances (e.g. age, presence of child, aged parents to support etc.), and asset allocation (some investors may choose to “diversify” into different asset classes, hence he would require less margin of safety as he has parked limited funds in equities). Hence, my point is that the margin of safety is a fluid concept which is not cast in stone, but is subject to interpretation and personal observation and deduction. Furthermore, as a company evolves through time and grows or declines, one should also adjust their view of required margin of safety accordingly; or if there is no longer a margin of safety, the investor may consider divesting his stake to preserve capital for channeling into other more promising securities.

To conclude, the essence of investing is very basic and simple; but somehow human beings have a strange and inexplicable tendency to make simple things complex. The two most basic tenets should be capital preservation and margin of safety; and together these two powerful concepts will guide an investor through all kinds of markets, and allow him to screen through all types of companies for suitable ones. I believe that if one is armed with this knowledge and practices it faithfully, he/she will not get a bad result in his investments.