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Focusing on what can go wrong has long been a mantra of sound value investing.
We are big fans of fear, and in investing it is clearly better to be scared than sorry.But chances are that even the biggest pessimists among us can have their focus on risk muted by extended periods of generally favourable market conditions.
“Given how hard it is to accumulate capital and how easy it can be to lose it, it is astonishing how many investors almost single-mindedly focus on return, with a nary of thought about risk. Lured into their slumber by … an investment mandate of relative and not absolute returns, as well as a four-year period of generally favorable market conditions, investors seem to be largely oblivious to off the radar events and worst-case scenarios. History suggests that a reordering of priorities lies in the not-too-distant future.” Steve Klarman the legendary investor wrote this in his 2006 investors letter while warning about the impending crisis of 2008.
Maritime Capital is not saying that a 2008-like crisis is coming our way , for it does not have such foresight. Given the kind of activity happening in the stock market and on social media, it says that many among us may be throwing caution to the wind, yet again.
Some are buying high quality stocks at any prices, and some are buying low quality ones just because high quality is not available cheap anymore.
At this time it may be good to revisit the words of Ben Graham a value investing Guru – …the risk of paying too high a price for good-quality stocks — while a real one — is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.
The purchasers view the current good earnings as equivalent to “earning power” and assume that prosperity is synonymous with safety.
Buying high quality businesses at expensive prices carries a risk of poor returns, but buying low quality businesses even at cheap prices carries a risk of permanent capital destruction. And there is a big difference between the two.
The very first thing we do when starting to consider a new company or share is to examine its business model and thesis –
- Simple business of reasonable size that I can understand (I avoid extremely small companies),
- Low debt on the balance sheet (if debt, then enough cash generation to repay interest on debt),
- Presence of pricing power that leads to high or better than average return on capital and return on incremental invested capital, and thus a clean balance sheet,
- Ample and profitable reinvestment opportunities, and
- Management without a shady past
- Capacity to suffer bad times
Any business that fails on one of these indicators will not be considered by Maritime Capital. Most new companies we examine are “quickly out of sight, out of mind.” We do not have the time to squander on such businesses to create better reasons to not ignore them, even if that means losing out on a few potential turnarounds or ugly ducklings that may turn into beautiful ones.
Maritime Capital stays away from any business that has more than a small chance of losing investors capital permanently, and that keeps us sane . Best, this has served us well in constructing equity portfolios for our clients, and so we stay the course, whatever the market may be doing or however people around us may be behaving.
One of the key lessons from our professional experience is that the biggest danger of investing in a bad business or in the one you do not understand or the one where you pay any price to get in is not so much that you will lose money. It is that you may make money.
And why is that a danger?
Because when money is made on such businesses, patterns are drawn from the successes, may attribute it to skill, and then lead towards making similar, even bigger, trades in the future.
High stock market returns, especially when achieved in a short time, have a dangerous way of eclipsing lack of comprehension. It arises from not knowing what you are doing. Worse, you don’t know that you don’t know what you are doing.
Mark Twain, the noted writer and an active investor once wrote “There are two times in a man’s life when he should not speculate: when he can’t afford it, and when he can.” This is invaluable advice which Maritime Capital reminds itself of everyday.
Written by Varun Maharaj MSc (Finance), CPA, CIM, LPC.