Sunday, July 18, 2010

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.

14 comments:

Createwealth8888 said...

Stock market is a dangerous place to do capital preservation and just to fight inflation.

Risk/Reward is just too low.

Musicwhiz said...

Hi,

I don't necessarily agree. One has to focus on what's important (companies, the business and dividends), and the rest will take care of itself.

Don't need to make the process more complicated than it already is. :P

For me, risk/reward is acceptable to give me a decent return and I also enjoy the intellectual challenge which investing has to offer! :)

Regards,
Musicwhiz

la papillion said...

Hi mw,

It's a good post - very well thought out :)

But I do think that bro8888 has a point. If you need to beat inflation - say 5% - a bond might do better. Capital protection upon maturity, coupled with buying at a good margin of safety below the par value of the bond, you should get maybe 6-8% pa off a good corporate bond. I'm sure with your skills in reading financial statements and your patience, choosing a good corporate bond/pref shares shouldn't be that much of a problem.

That makes me think that you are either understating your goals for investments because you're humble, or you are simply treating it as a hobby :)

ThinkNotLeft said...

A famous poker player has probably provided a more succinct idea of sound investing.

Ain't only three things to gamblin'," Pearson said, "knowing the 60/40 end of a proposition, money management, and knowing yourself."

Createwealth8888 said...

Stock or company analysis is just the starting point to investing.

A classic investor is very much concerned on how much is the net return over a period? What is ROI and payback period?

Investing as hobby can be equally fun as it can help one to pass their time easily by reading tons of reports which are FOC too.

Musicwhiz said...

Hi LP,

Haha thanks for the compliment. Well I think it's rather hard for retail investors to access blue-chip corporate bonds in Singapore. The most accessible bonds are SGS which pay a yield <3% currently. So I'd say equities still gives a substantially higher yield + potential capital appreciation to boot if the business does well.

And yes you are right I am treating it as a hobby as well! An intellectual exercise if you will. Haha.

Regards,
Musicwhiz

Musicwhiz said...

Hi Thinknotleft,

Wise words indeed, thanks for sharing!

Cheers,
Musicwhiz

Musicwhiz said...

Hi Createwealth8888,

Yes, ROI is of course important but we should let the power of compounding grow our money over the long-term. Short-term ROI may be high for some investments but then again we must be careful not to fall into the trap of neglecting margin of safety in pursuit of higher-than-normal returns.

Reading AR can be tedious at times, but it's always rewarding!

Musicwhiz

la papillion said...

Hi mw,

Nah, the corporate bonds are denominated in USD usually, haha :) There'll be forex risks of course, but it's good to think about it :)

Createwealth8888 said...

Next year, SGX may introduce bonds for retail investors. Time to educate yourself on Fixed Income Investing strategy and do asset allocation between bonds and stocks over market cycles.

Musicwhiz said...

Hi LP,

Ok thanks for the info. Will definitely consider those as I grow older and my risk profile changes. Haha.

Regards,
Musicwhiz

Musicwhiz said...

Hi Createwealth8888,

Is that so? That's good news then, at least it offers investors more variety and choices to do portfolio allocation. Bonds are an important part of a good portfolio too. I agree on this.

Cheers,
Musicwhiz

Lemizeraq said...

Hi Musicwhiz,

Warren Buffett quotation on this is:

Rule Number 1: Never lose money

Rule Number 2: Never forget rule number 1

Your investment yield is pretty impressive so like what LP is saying, you are being humble.

Regards,
Lemiz

Musicwhiz said...

Hi Lemizeraq,

Thanks for visiting and leaving comments! Haha I think you really give me a lot of credit; my returns are decent and I am still in the learning phase so please do share more knowledge and info with me too!

Regards,
Musicwhiz