The Third Rule of Investing
Warren Buffett is famous for saying that Rule No. 1 in investing is “Don’t lose money” and Rule No. 2 is “Don’t forget rule No. 1.” The premise is that capital preservation takes precedence over capital growth, and if we are able to take care of the downside, the upside will take care of itself.
But what about making money? While Buffett doesn’t explicitly say it, Alice Schroeder, author of his biography, The Snowball, explains this brilliant yet simple nugget about Buffett’s investing strategy – Buffett doesn’t aim at making outsized returns – his aim is to make high probability 15% return on investment from day 1, and then take it from there. So while a lumpy 15% is better than smooth 12%, a certain 12% is better than uncertain 15%. This is a fine but very important distinction.
To reflect this on our portfolio, lot of times, we buy lottery ticket like stocks – high upside, seemingly low downside. Missing in the equation is what minimum return we can expect over medium term – say 3 years. If the threshold CAGR is at least high probability 15% (or 20% in Indian context), then only we should go ahead with the investment. Many times we think about investments with imbedded option value or stuff like UU (Unknown and Unknowable), while ignoring this basic element of investing. Mathematically also, investing in companies with certainty of making 20% a year is far better than those with a mere chance of making 100% if something happens.
So what are the investment situations which yield to analyzing the probability of making threshold returns?
1. Growing realizable intrinsic value of the business – earning/ book value per share with dividend payouts, with dividend yield becoming sizable to merit rerating of the stock
2. Management focused on creating shareholder returns (should not be too indifferent to market capitalization of the business though also should not be too interested in day to day stock price!)
3. Cheap enough entry buy price
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