Posted by: sanjayshetty | December 5, 2007

Rule #1 Don’t lose money

Rule #2: Don’t forget Rule #1. However, how does one go about ensuring that one doesn’t lose money.

Ok! First the reality, even the greatest investors who proclaim the above tenet have lost money, even Buffet! However, it is important to understand the underlying essence of the statement.

“Making sure that the chances of a loss is minimal“. As Benjamin Graham said “investment is most intelligent when it is most businesslike”

So how does one do that?

Ok if you’re getting over eager to get to the meat of the article, move on. As one of the first things which you need is a LOT OF PATIENCE. It’s like slow and steady wins the race; remember the childhood story about the Tortoise and the Hare…

The key to Rule #1 is making sure of a lot of things; like making sure the company has good numbers, it has to have a sustainable moat, great management etc. I’ll examine a few of these things.

A tenet which is oft repeated to ensure Rule #1 is; make sure the company you’re investing has a sustainable moat. Well, to figure out if a company has a sustainable moat is an exercise which is going to take you some time. As you have to not only assess the company’s strengths and future prospects correctly, but also analyze how it stands up with regards to it’s competitors. So time and patience, plays a big role. Now let’s say you’ve found a company which has a great set of past numbers, good management and seems to have a reasonable moat, you might think you’ve found a winner right? Wrong! Past data is not very good at predicting future results. (Read up Tweedy, Browne Study entitled “Great 10-year Record = Great future, Right? How well did companies with great 10-year records as of December 31,1990 perform in the next 7 years? A study of the predictability of long-term earnings and intrinsic value growth.”).

Very few companies with great past data do well in the future. Here are a couple of reasons which could change the scenario for your potential candidate.

1. The managers who you love and are running the company, change!

Take the case of APOLLO GROUP (APOL)… for no clear reason the CEO has moved on… There is an interesting discussion, at Phil Town’s blog about the same (http://www.philtown.typepad.com/phil_towns_blog/2006/03/your_homework_a.html)

2. New technology, new way of doing business leaves your golden goose far behind.

Newspapers a safe bet of the past are struggling with the Internet publishing phenomena. The viability of Garmin a leader in the GPS space faces a question mark, it must adjust to changes in access to content and to an attempt to take GPS out of the car and put it into mobile phone users’ pockets. (http://www.smartmoney.com/onedaywonder/index.cfm?story=20071001)

3. Mr. Market has a mood swing…

The list is endless….

Now, when you think about all of this you might realize that Rule #1 is a hard proposition; however, the underlying principle is very simple and clear. You need to be extremely careful with your money. You need to really understand the company where you’re putting your money, and you need to have a great level of confidence in the fact that the company is going to continue to do well.

So how does one do that?

I’m including below a longish quote from Buffet’s 1996 Letter to Shareholders, read carefully there are some amazing jewels within this quote.

“Let me add a few thoughts about your own investments. Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.

Should you choose, however, to construct your own portfolio, there are a few thoughts worth remembering. Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.

To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing of these. That, of course, is not the prevailing view at most business schools, whose finance curriculum tends to be dominated by such subjects. In our view, though, investment students need only two well-taught courses – How to Value a Business, and How to Think About Market Prices.

Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards – so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren’t willing to own a
stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.”

Warren Buffet is talking about a number of things which you need to keep in mind:

1. Circle of Competence: Question yourself, do you really understand this business? If it’s a business which is complicated, move on. You really need to understand the business. It has to be in your circle of competence. Refer to Buffet’s quote above once again to understand what he means by Circle of competence. “What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence.”

Similarly he mentions “easily-understandable business” This is extremely personal, YOU NEED TO understand the business. For instance, I don’t understand the Biotech industry or the Textile industry, however I can understand software services, restaurants. Look for businesses which you understand. Maybe you love to play video games and understand the gaming industry who it’s leaders are etc. maybe that’s your thing. Buffet has often been criticized for not investing in technology companies, his reasons for not investing are simply because he doesn’t understand the businesses. There are thousands of listed companies to choose from, just make sure they are within your Circle of Competence. Learn all you can about the company, it’s products, it’s markets, it’s efficiency.

2. As Buffet says in his 1995 letter to Shareholders: In business, I look for economic castles protected by unbreachable “moats.”

Notice the wording here, “unbreachable moats”. Not “a Moat”, or a “good Moat”, he specifically says “UNBREACHABLE”. On another occasion he responded to a question on, what is the most important thing he looks for when evaluating a company. Without hesitation, he replied, “Sustainable competitive advantage.”

Unbreachable Moats

So how does one identify an unbreachable MOAT or a sustainable competitive advantage?

a) Often clues of an ubreachable MOAT are when a company’s product name changes the language you use, for e.g. in India Bottled water is called by the name “Bisleri”. This is one of the most famous bottled water products in India. Most often when you want bottled water at a store, people just say give me a Bisleri. Similarly, Coke changed the way people asked for a pop (soda) in the 1988 time frame.
b) There are other kinds of MOAT’s too, Barrier to Change being very expensive or put another way High Customer Switching Costs. For instance Microsoft has this advantage from the large installed base of it’s software worldwide. Almost any PC user would be able to read a copy of document prepared in Microsoft Word or Excel. Companies which have deployed Microsoft software, will find the cost of moving their entire platform to another product platform an expensive proposition and hence, they would continue with Microsoft’s software. It’s MOAT is largely protected by the Barrier to Change. Another similar example would be Paychex.

c) Toll Collectors – If you want to buy or sell something on-line you’re going to use E-Bay because that’s the location with all the buyers and all the sellers. Similarly Newspapers in some cities act as Toll bridges, if you’re trying to reach most of the people in the city.

d) Economies of Scale/Low Cost Provider – Wal-mart has enormous power over it’s suppliers to get rock bottom prices because they sell so much stuff. Nobody can touch their prices.

e) Secret (patents and trade secrets): IBM earns billions of dollars by virtue of the licensing it various patents. Companies such as Coco cola with it’s secret formula have a moat which most competitors find difficult if not impossible to breach.

f) Businesses which aren’t susceptible to Change – That’s one of the key things to look out for when identifying an unbreachable moat. A MOAT today might be gone tomorrow, patents are good but they can run out in time, however good characteristics of an unbreachable MOAT are businesses which have very little change.

This point is quite important and I’ll leave Buffet to explain this, as he said in the 1999 annual meeting:

Our own emphasis is on trying to find businesses that are predictable in a general way as to where they’ll be in 10 or 15 or 20 years. That means we look for businesses that in general aren’t going to be susceptible to very much change. We view change as more of a threat investment-wise than an opportunity. That’s quite contrary to the way most people are looking at equities right now. With a few exceptions, we do not get enthused about change as a way to make a lot of money. We’re looking for the absence of change to protect ways that are already making a lot of money and allow them to make even more in the future.

“When we look at a business and see lots of change coming, 9 times out of 10, we’re going to pass — whereas when we see something that is very likely to look the same 10-20 years from now, we feel much more confident about predicting it. Take Coca-Cola. It’s still selling a product very, very similar to one that was sold 110+ years ago. The fundamentals of distribution, talking to the consumer and all that sort of thing haven’t changed at all. Your analysis of Coca-Cola 50 years ago could pretty well serve as an analysis today.

“We’re more comfortable in that kind of business. It means we miss a lot of very big winners. But we wouldn’t know how to pick them out anyway. It also means we have very few big losers — and that’s quite helpful over time. We’re perfectly willing to trade away a big payoff for a certain payoff.”

Margin of Safety

One of the most important concepts to ensure Rule #1, is the concept of Margin of Safety. You may feel confident that you’ve got a company which has great numbers, an unbreachable Moat, however, determining the value of a company isn’t an exact science. You might use a DCF(Discounted Cash Flow) method or a PE based valuation, or a Sum of the Parts etc. However these give you a range in which the company is valued. As Buffet said in his 2000 letter to shareholders

Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business”

The Intelligent Investor knows that he needs to build in further protection to follow Rule #1 completely. It pays to make sure there’s a decent ‘margin of safety’ between your estimate of intrinsic value and the price you pay for a stock.

In closing, I’d like to refer to what Buffet said in his 1990 letter to shareholders:

“In the final chapter of The Intelligent Investor Ben Graham said: “Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety.” Forty-two years after reading that, I still think those are the right three words.”

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Responses

  1. Beautiful post Sanjay. It really confirms what I’ve been reading from Joe Ponzio and other sites with similar subjects. Did you read the Intelligent Investor yet? I have it, but haven’t found the time to read.

    I remember reading somewhere that one of Graham’s final words were that investing is really really simple. It doesn’t have to be complicated at all.

  2. Hi Peter,

    Thanks for your comment.
    I’ve read the Intelligent Investor, though I must say the first time I started reading it I stopped after about 1/3rd of the book, I just felt it was over my head.

    Some time later, I read Phil Town’s Rule #1 book, which really kind of awakened me, and then I re-read from start the Intelligent Investor and it made so much sense!!! It’s a good book, definitely something you need to read and then re-read. Warren Buffet always recommends it!!! Though I find reading Buffets letters to shareholders more easier to read and enlightening.

  3. I need to start reading Intelligent Investor and Buffets letters!

  4. Hello Sanjay:

    I have been following your blog since the day I had my hands on Rule #1 book which is just about a week ago!!!! I find your blog very interesting and enlightening as well. Being an Engineer I find it a bit hard to digest investment principles.

    I have been trying to do a Rule 1 test on Infosys. Is there any way you can do a Rule 1 test on Infy. I just need to compare your numbers with mine. I tried to compare mine with those on Phil’s blog…but I guess the numbers are a bit outdated. I just want to see if my growth rates, MOS and the Sticker Price match that of yours. BTW, I use MSN to get those numbers!!!!

    I have another request… do you trade in India…if so, how do I start trading in India. I am a resident of Canada…currently on vacation.

    Looking forward to your reply and please do not forget those numbers [I guess it is quite easy for you as you seem to be investing for quite a while]!!!

    Thanks for the BLOG!!!

    Mallinath

  5. I know my reply might sound strange to you. However this is it….

    It really doesn’t matter if your numbers and mine don’t match! In doing a Rule#1 calculation you might take a PE different from what I might.

    Your valuation of a company will be different from someone else’s. Refer to Charlie Munger’s response “When we try to determine a company’s intrinsic value or its stock’s margin of safety, there’s no one easy method. We use multiple techniques and models. Lots of experience is helpful. You can’t become a great investor without experience.” (Full article available here http://bankstocks.com/print.asp?id=9881373)

    In addition, As Benjamin Graham said, Margin of Safety… make sure you have a large MOS.

    Specifically when it comes to the IT Industry, Remember what Buffet says ““When we look at a business and see lots of change coming, 9 times out of 10, we’re going to pass — whereas when we see something that is very likely to look the same 10-20 years from now, we feel much more confident about predicting it.”

    I’m from the IT industry myself, and let me share one thing about the IT industry, it’s currently in it’s nascent developing stage, in my 15+ years of experience in the industry, I’ve learnt there is just too much change, and the amount of change in the way technology is evolving is just amazing. Amazing for the users of technology, not necessarily for the investor.

    These very changes and evolution are dangerous from an Intelligent Investor’s perspective. So even though I like Infosys, Apple, Microsoft as companies, I’m not sure what the future would be for these companies and hence not sure what the correct valution would be.

    I trust that helps answer your question.

  6. Hi Sanjay,

    Found your blog a good refresher to the book Rule # 1, which I read a couple of months back. Though the book made a lot of sense to me, I have been struggeling to get the past 10 year number especially for Cash flow but they are not easily available. The other number which I found difficult to get was expected growth rate by the experts for next 5 years.

    I get my other numbers from Economic Times as MSN and Yahoo don’t follow Indian companies so closely. I also got in touch with Share Khan but they were unable to provide more than 5 years of data.

    I hope you read this post and reply as its been 10 months since your last comment.

    Thanks for the earlier blogs.

    Neha

  7. Hi Neha,

    For some reason, WordPress had blocked your comment, not sure why.

    Anyways better late than never right 🙂

    Check out http://investing.businessweek.com/research/company/overview/overview.asp

    They cover India companies as well, same with Reuters.

    As I mentioned in other posts and replies to comments, as of now I haven’t found a single site which provides free 10 year data for Indian listed companies.

    Regards,

  8. Hi Sanjay,

    Your blog really helped me to understand Rule #1 in a better way. The book presented a completely different ideology to investing in stocks. Initially I felt it was too simple too be true! 🙂
    But as a read on the logic behind the methodology made me understand that it could definately be useful. I am a first time investor and was totally comfortable with the book as well as your blog.
    However I also faced a similar problem with data about the Indian Companies not being available. Some sites provide 5 years of data but nothing more than that. Neways i look forward to more interesting reads on your blog and hopefully I will be able to contribute a bit as well

    Cheers!

  9. […] (You can read the post I had made earlier where I’ve covered what a Moat is in detail Rule #1 Don’t lose money) […]


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