Never loose capital, no other rule counts. As institutional investors, we have typically seen that there exists an information asymmetry between institutional and retail investors. Retail investors have limited access to quality research and to add the intermediaries that serve them sometimes do not have their incentives aligned. Retail investors therefore are left with no option but to: 1. Either buy a stock at expensive valuations, 2. Invest in momentum behind a stock, 3. Or are caught off-guard when a management ill-treats minority shareholders. All these actions greatly increase the odds of a permanent loss of capital. We believe that the golden rule of investing is never loose capital, and all other rules comes afterward.
The following tools/framework can help a retail investors and anyone in general to reduce the odds of loss of capital:
Quality of a Management: In our discussions with a lot of retail investors, we have seen than what is often not in public knowledge is the quality/ethics of a management. Life would have been much simpler if we could tag a management as red/yellow/green based on their governance practices. Investors could however, use the following thumb rules (list is not comprehensive) to safe-guard themselves from corrupt/low quality managements:
Look for related party transactions in the annual report & stay away from managements that have either >20% of their sales or cost related to a group entity.
Stay away from companies that do not declare dividends/buybacks even though there is cash sitting on the books.
If total promoter remuneration/perks are greater that 2-3% of the top-line, it is a red flag.
If a company’s cash flow from operations is less than 50% of the PAT for the last 3-5 year period, such businesses are not attractive as they cannot recover their sales and capital gets stuck in working capital.
Stay away from turnaround and/or managements that are acquisitive. These have a very low probability of success even with a good management.
Quality of a business: Try to find companies that have a return on equity (ROE) > 15% for a 5-10 year period. Statistically speaking, companies that have a ROE >15% in the last 5-10 years, have compounded capital at a higher rate than the companies that have a sub-par ROE. Refer table below:
We can see from data mentioned above that investing in high quality businesses greatly reduced the odds of a permanent loss of capital to less than 2%.
Pay a conservative valuation: Retail investors investing in a mutual fund or a PMS should always check for its trailing Price to Earnings multiple (TTMPE) and check whether it is at a discount or a premium to the index. A significant mistake a lot of investors and fund managers make is to invest in high quality businesses at any price. The same increases the odds of a loss of capital or increases the holding period to recover capital. Retail investors often lack the patience to hold stocks for long and end up taking a capital hit. Best thumb rule for anyone is to not pay more than a TTM PE of 15x for B2B businesses and a TTM PE of 25x for a consumer facing business. The data below further backs this argument that in the short term (up to a 3 years of holding period), entry valuation is a significant determinant even amongst well managed companies. As the holding period increases to 5-10 years, entry valuation becomes less critical determinant to returns and capital protections.
To sum up, if we get the management and the business right, the odds of permanent loss of capital are less than 2%. Therefore, retail/SIP investors should focus on investing in clean managements running good quality businesses that are available at a reasonable price.