Saturday, 11 February 2012

Safety of Capital: Most Understated Yet Most Rewarding Element of Investing

Warren Buffet has attributed his success to two golden rules. 

Rule 1: Never Lose Money 

Rule 2: Never forget Rule 1. 

This is the most simplistic and yet most fundamental idea behind value investing. According to Ben Graham,  "An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative." This is one of the most succinct and effective definition of investment. Hence the most important task while following value investing approach is to assess the safety of principal. 

How does one go about ensuring safety of capital while making investment decision in stocks? the answer lies in the framework provided by Ben Graham called Margin of Safety. According to Warren Buffet, "Margin of Safety" are the three most important words ever written about investing. The idea behind margin of safety stems from the belief that it is almost impossible to predict future of an enterprise, its profitability and cash flow over long horizon. Hence after all the rigorous analysis of business, financials and management quality, intrinsic value of business is still, an approximation, at best. Moreover even this approximation of inherent value of an enterprise may not materialize due to number of negative unforeseen events and intrinsic value of an enterprise may be lower than the estimated. 

Mr. Graham suggested that to account for "unforeseen negative future events"     one must apply discount to the approximation of intrinsic value derived based on conservative assumptions. Even though he has left the decision for quantum of discount to investors, most successful value investors suggest it to be at least 25%. Hence if one decides that based on very conservative assumptions of growth rates, profit margins and capital investment needs, the intrinsic value of business is 100, one shall buy interest in such enterprise if the market values such enterprise below 75 (25%  discount to conservatively estimated intrinsic value).

Now one may start thinking that since this frame work is based on low risk approach, returns shall commensurately be lower.
However, the way it works is exactly the opposite! Since, we have built in margin of safety of 25% even after making most conservative assumptions, if the "catastrophic scenario" does not turn up as built in the price, and actually company does at least as well as one's conservative assumptions, one is entitled to returns equivalent to margin of safety (25%). Now on the optimistic side, if company does better than the conservative assumptions, you have windfall gain. On the downside, if catastrophic events occur, we do not make gain, but we still preserve our capital in most of the cases. Hence on the downside investor does not lose, while on the upside he makes disproportionate gain. In my opinion, this is the most risk averse way of attaining high returns. 

Now if this framework is so simple, why is it not so popular? 

First, it is not easy to find such mispriced/conservatively priced opportunities that frequently and hence one has to work hard to find such opportunities. 

Secondly, one has to be disciplined to stay in cash to invest substantial amount of his portfolio when he finds one. This implies, one has to imbibe the philosophy of "No action is the best action" most of times while acting decisively when the odds are in investor's favor. 

Finally, one has to be patient enough to allow market to bridge this gap between price and intrinsic value without worrying about market volatility. Keeping patience is the most difficult part of the process and one requires conviction in one's analysis and judgement that stems from thorough understanding of business and meticulous analysis of its financials. 

In the end in Charlie Munger's words 

"It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”

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