In the previous part of this investor success story, you read about Venkatesh Jayaraman, his passion for investing and his investing methodology. In the following article, you will read more about risk management.
Read Part 1 here
The very definition of risk is subjective, a few most common ones being:
- English dictionary: danger or exposing to hazard
- Personal finance and financial planners: Difference between expected and actual returns from an investment
- Many investing Guru’s say it as “permanent loss of capital”
- Short term investors or traders would see risk as volatility in stock prices
- Aswath Damodaran sees it as “Danger + opportunity”
It is quite possible that the question you asked, the reply I make and readers reading this article all have a completely different understanding of risk. Hence for a common understanding, I would like to clarify how I see risk:
- The English dictionary meaning would be of little use to investment world – Ignoring it
- Definition by Personal finance as the difference between expected and actual returns from an investment
- Actual return could be higher than expected return – So it is still good for an investor, and not a risk!
- Depends on the individual: The same investment made in similar conditions by two different people with vastly different return expectations, leads to a situation where one sees the investments as much risky and the other may not on a relative basis. – It is subjective and I don’t go by this definition
- I am not a trader or a short term investor and hence the volatility is not a concern – Ignoring it
- So, the biggest concern in an investment is “permanent loss of capital” – This is what I see as risk
This is the only risk that I need to worry and take care. This is how I see further:
- Even with a concentrated diversification of a few stocks, is it possible that invested capital in all this ‘n’ number of stocks become “permanent loss of capital”? Not possible/Low probability
- Is it possible that a few stocks in the portfolio have “permanent loss of capital”? Yes. Possible
- How to avoid or mitigate this risk? Proper analysis to avoid companies with can suffer “permanent loss of capital” entering the portfolio
Here are a few things, which I believe will keep me away from such stocks that may suffer “permanent loss of capital”
- Invest only in something that I understand very clearly and have answers for a few basic things:
- What is the raw material?
- What are their products?
- How money is made?
- Who are the competitors?
- Would the sales plunge, if price of the product is increase (Evaluating the pricing power)
- Would the company products have growing demand in the years to come etc.
- Financial numbers: No bench marks, but look for the companies having the highest RoE, Net Margins, market share, no debt etc. So that even, if there are situations like the one we are facing now…and expected to be prolong, these companies will be the last to die
- Some kind of safety: Atleast 10-15 years of profitable history, good dividend yield, asset light model, huge cash generated, cash and investments on books
- At last, I do follow a methodological analysis which I discussed in my recent YouTube video serials “How to Analyse a Stock”, and don’t hesitate to discard an idea which does not meet the requirements of any of the stages of this framework.
I believe and have witnessed since 2016, that the above ensures that there is no “Permanent loss of capital”.
Even if such a low probable event should happen i.e. Permanent loss of capital in all the invested stocks, I have made necessary arrangements in my personal finance, such that it does not have any impact on any of my financial plans or life goals atleast for 3 years.
How I decide what to Invest in
I have discussed my approach to risk in detail in the above section. A few pointers to determine the kind of investments, I make are:
- An industry or sector where I have a good or reasonable understanding and poised for a reasonable to good growth in future
- Few companies in that industry – Monopoly or Duopoly (in the listed space), leading to less competition, better pricing power and healthy profits for all players
- Past proven performance in terms of sales growth, profit growth, margin expansion and betterment of operational metrics
- Not interested in mid or small caps, nor hunt for multi-baggers or 100x
- Both the above ideas are closely related
- Multi baggers most come from successful mid or small caps when identified much early in its life cycle
- These are extremely low probability situations in my opinion and was also numerically illustrated in one of the MOSL wealth creation studies
- High RoE coupled with (1) low dividend pay-out, (2) reinvestment opportunities and (3) same/better returns from reinvested capital
- Avoid companies which are in debt, making loss, past poor growth, asset heavy etc
- In the end, it should pass through all stages of the framework that I recently discussed in a YouTube Series “How to Analyse a Stock”.
All the above combinations may not fall in line for every stock. A few compromises with majority falling in line is ok.
Read Part 3 – Lessons learnt and tips for new investors