STOP DON’T FORGET THE RULES EPISODE 1

STOP DON’T FORGET THE RULES EPISODE 1

As Warren Buffet said there are only two rules when it comes to investing in shares. The first is “Never lose money” and the second is “Never forget Rule Number 1”.

I qualify this slightly and say there is Rule 1A and Rule 1B and Rule 2.

When we talk about not losing money with shares we are talking about a permanent loss of capital because the business of the company has deteriorated as opposed to the share price fluctuations that occur over daily, weekly, monthly and longer periods such as bull and bear market cycles.

Also when we seek to avoid the risk of permanent loss of capital in practice this means avoiding the risk of permanent loss of capital as much is realistically possible. To never have a loss from a share investment is not a reasonable expectation. What we do want is for any losses that may occur to be relatively modest so that they are more than offset by the gains on other stocks. Like a batsman in cricket you don’t need to get a high score every time but the long term batting average is important.

As an aside how do we define risk? In investment academia (and frequently used by the managers of institutionally managed funds) risk is described as and measured by price volatility. The greater the degree of volatility the higher the risk. In investment technical terms this is called the standard deviation of returns which is a measurement of the amount of variation from the average. For those of you who are masochistically inclined have a look at Wikipedia for a discussion of standard deviation. To you and me absolute return (i.e. at the end of the day do we have a plus or a minus in front of the investment return) regardless of how volatile is the share price is much more important. I remember going through the global financial crisis having a number of discussions with clients that centred around there being some minuses in the portfolio. I didn’t once get a grizzle about there being too much or too little standard deviation in a portfolio.

Anyway getting back to the straight and narrow. There are always a number of risks with any share investment. The most important longer term one is that the business deteriorates on a longer term basis thus eroding the value of the company. Generally the value of a business over time is based upon its profits and profitability (its return on equity or ROE). Compare the performance since January 2000 of the below stocks and the All Ordinaries Index.

All of these shares would have been regarded at some time as blue chip (whatever that term means) stocks.

Now while the above ignores dividends it clearly demonstrates that how successful a business has been in increasing profits (and dividends come from profits) and its profitability is far more important over the longer term than what the market as a whole is doing or has done or might do. How did these stocks stack up from a green lights and red lights investing point of view? (See the blog Is Cash Trash? at www.lifestylefstas.com.au/blog for a ramble on green and red lights investing) .I wasn’t actually thinking anywhere quite as clearly as I do now in terms of green and red light investing back then but nevertheless I can remember my general views of these stocks at the time. And I don’t believe I am allowing hindsight to colour my views.

Telstra back in 2000 was a red lights investing proposition mainly because while it was a high quality business with a high return on equity profits were not growing and it appeared (and turned out to be) significantly overvalued during the tech boom. Qantas has been in that section of the market called the kennel club for as long as I can remember. Note the rise in share price in the 03-07 bull market. As they say every dog has its day. This is an example (if one was nimble enough to sell of course) of red lights investing where there was no accident at the time. AMP is more problematical. It was regarded as a high quality business at the time (and is today again a reasonable quality business) and probably would have appeared as a green lights investing situation at the time. What absolutely caned profitability and permanently destroyed millions of dollars of shareholder value was a disastrous UK acquisition which, until the wheels started falling off in the 02-03 bear market, wasn’t reasonably foreseeable. Clearly it wasn’t anticipated by AMP management (otherwise they wouldn’t have bought the darn thing) so the chances of investors like you or me foreseeing what happened would be quite remote. Both Commonwealth Bank and Woolworths have and continue to be high quality businesses that have increased profits while maintaining a high degree of profitability. And look at the investment performance. Both stocks have also substantially increased dividends (and at a much higher rate than the other stocks) over this time.

It’s the main reason why I don’t waste any time wondering whether the share market is going to go up or down (in any case knowing the direction of the market is not for mere mortals like us to know). Companies that increase profits while maintaining a high degree of profitability increase in value which sooner or later will be reflected in the share price. Although there can be long periods when the share price is well above or below the underlying value. Which is why share investment needs to be on a long term basis. Companies that don’t increase profits and/or have poor profitability do not increase in value and this also is sooner or later reflected in the share price. Whether the market rises or falls is irrelevant on a longer term basis. You can see from the above that the share price of Commonwealth Bank and Woolworths was impacted in the shorter term by the general trends in the share market at the time but recovered because the underlying value was there. AMP, Telstra and Qantas share prices also in the shorter term reflected general market trends but for company specific reasons didn’t recover.

So Rule 1A is to only invest in green lights situations.

Rule 1B deals with where we invest in a company that at the time appears to be a green lights situation but turns out (with hindsight which is always 100% correct of course) to be a red lights situation with AMP potentially being an example of this. To provide protection against the loss of capital in the situation where there is an accident with a green lights stock we consider using a stop loss on the original amount of money invested in that stock.

Which is where we will go in next month’s blog. After all this blog has gone on for long enough. Please get in touch if you would like to discuss anything in this or other blogs. My contact details are at www.lifestylefstas.com.au.

Regards

Curtis