Monday, January 23, 2012

Principles of investing


We need to have a set of principles to be able to make decisions that lead to good long-term returns and avoid the trap of making decisions based on what seems best for the immediate moment. I believe that an investor will almost always fail in the long-term if he compromises on the basic principles of investing (I say almost always as the investor could get really luck and still make good stock picks even if the way he arrived at his decisions is unprincipled and irrational; however, this happening in the long-term is highly unlikely).

In this article, I will talk about the investing principles that I hold as absolutes to achieving good returns.  

Principle 1: Preservation of capital

The preservation of capital is one of if not the most important thing Benjamin Graham looked for in an investment. Like the foundation of a skyscraper, your investment capital or your portfolio’s “foundation” needs to be strong and solid for you to build on and hopefully turn it into a huge fortune one day.

To ensure that the capital we put up is safe, we need to consider things like the amount of discount to intrinsic value that we’re getting, the company’s competitive advantage, balance sheet strength, management and etc.   Even then, there’s no guarantee that you won’t lose money, but that’s the risk investors take to earn a better return.

Principle 2: Superior returns are achieved by investing either in companies with superior business performance or companies with average performance but trading at steep discounts. I believe that the best way to achieve attractive long-term returns is to invest in companies with excellent underlying businesses and holding on to those investments for the long-term. This is the case as it is a fundamental rule that long-term investment returns will reflect the long-term business performance of the company (the best measure of business performance is the return earned on shareholders’ money, also known as the return on equity). These long-term investments in companies with strong fundamentals should be the core of a stock investor’s portfolio.

However, there are times when you find huge opportunities in the form of average companies trading at very steep discounts. But you really need to know what you’re doing before trying to take advantage of those opportunities. These investments can be quite risky so the investor needs to make sure that the returns he expects to get justifies the risk. These are also not long-term investments and should be sold once the share prices of those companies recover.

Most investors will be better off avoiding cheap average companies and just invest in good companies at reasonable prices. Even for those investors who want to take advantage of buying average companies at steep discounts, the core of their portfolios should still consist of companies with strong underlying businesses, as investments like that are by far the best and most reliable way to achieve good long-term investment returns. 

Some of you might rightly be asking if I’m violating the principle of capital preservation by investing in average companies. The answer is no. No, I’m not violating that principle as the shares in the average companies are purchased at a steep discount to intrinsic value. This discount will offset the lack of safety in the profitability of the average companies. Your principles cannot contradict one another, it has to be integrated or you will find yourself making a lot of inconsistent decisions.

Principle 3: Know your opportunity cost

Before committing our money to a certain investment, we need to know our opportunity cost or what is the best alternative to the investment that we plan to make. And if you expect the returns from the alternative to be better on a risk-adjusted basis, then maybe you should consider putting your money to work in the alternative investment opportunity instead. Only by knowing our opportunity cost and holding the very best long-term investments in our portfolios do we position ourselves to earn the very best risk-adjusted returns available to us.

Principle 4: Invest based on facts, do not evade reality

A lot of wealth was destroyed because people chose to evade reality. To be successful investors, we need to observe reality and act accordingly with the facts. It doesn’t matter how many times some guy on the television tells you that a certain stock is a great buy, if the facts say that the stock is terribly overvalued, then an investment in that stock will only lead to disaster. If the facts tell you that the fundamentals of a company you invested in are impaired, then you should sell the stock or risk further permanent losses to your capital. Reality is independent of what we wish it to be, or what some talking head tells us it is.

The investing process requires you to analyze reality, envision the future based on the facts, and then judge the investment based on your analysis of the company and the vision you have for its future. By replacing the investing process with your gut feeling, irrational investing techniques, or the herd mentality, you would have become a gambler and your long-term results will be that of a gambler: losses.      

Principle 5: Know what you’re doing

To do something well, we first need to understand the thing we’re doing. Just like how you can’t bake a good loaf of bread without the knowledge of baking, you can’t obtain satisfactory long-term results from your stock investments if you don’t know how to properly analyze and value companies. Even analyzing companies from different sectors requires different types of knowledge. Example: Same-store-sales is an important performance indicator for retailers while net interest margin is important when analyzing the results of a bank.

If you don’t know what you’re doing when it comes to investing, you wouldn’t know whether a stock is overvalued or trading at a steep discount, you wouldn’t know whether the earnings are sustainable or a result of a one-time gain, you wouldn’t know whether the company has a fortress balance sheet or is flirting with bankruptcy, you wouldn’t know if the fundamentals of the company got impaired. If you were to simply start buying shares without knowing what you’re doing and what exactly you were buying, then all you would be able to do is to stare at the meaningless day to day movements of stock prices without knowing what drives long-term profitability and investment returns.

Conclusion

These are my principles of investing that I believe are crucial to me obtaining high risk-adjusted returns over the long-term. While following these principles won’t guarantee you success or a risk-free investing experience, adhering to these principles in your stock investing activities will only improve the odds.

If you have any questions, or have anything that you would like to add, please feel free to comment or send me a private message. Thank you for reading, and may you always sustain good returns on your portfolio.