How to invest

Doesn’t sound right does it? And it’s not what Wall Street tells you either. If Wall Street is conventional, the Old School way is anything but conventional. High risk is considered to produce high returns. You are subject to those unpredictable variables which give you the “lose it” or “win it big” factor.

The House of Risk

We all know that the odds are against you in any casino. However, if there was at least one table in the whole house offering odds where they were in your favour, even by 1% you would be crazy to be sitting and gambling your money on a different table. Sure, the high risk odds offer attractive payouts, but as you keep gambling, the house always wins. The low risk bets, or odds that are in your favour, will leave you on top. Betting on the odds that are in your favour over and over again will obviously grow your cash pile. Probability tells you so, but far too many investors go for the odds leaning towards the house.
As Monish Pabrai puts it in his book Dhando Investor

Heads, I win; tails, I don’t lose much!

Look at The Proof

Great value investing strategies of Benjamin Graham, Warren Buffett and his coalition of “The Superinvestors of Graham and Doddsville” show that it is indeed possible to keep risk to a minimum while producing staggering returns.

Heard about Buffett’s rule?
Rule # 1: Don’t lose money.
Rule #2: Don’t forget rule number 1.

Low Risk in Businesses

Now let’s think as small business owners and see how this concept applies to businesses. If you were a business owner, you would be intent on reducing unknown variables in projects and when seeking business opportunities. You would constantly look at things from different angles and think of different possibilities. But that is not what we often do with our investments.

Reducing risk gives you a much clearer vision. It gives you, to some degree, predictability. You would not go after business opportunities based on gut feelings and rumours.

High Risk Example

I once worked for a start up that sold telecommunications equipment to Telco carriers. This startup was the middle man between different manufacturers and the customer. They had no control over cost or operations and being the middle man, the profit margin was thin compared to what they could have made had they been the manufacturer. Also being a startup, they had no loyal customer base and were willing to do anything to get business. You see the risk even on paper don’t you? But that is not all. The telecom industry since the early 2000’s has been a dynamic environment with technology changes every few years. This meant that the company couldn’t maximize on its product line with the life cycle being only a few years. They had to constantly find the next product for future technologies without knowing how those technologies will work out. This led to constant design and spec changes even at the manufacturing stage! No doubt, they burned through more cash than it could generate.

Find a Low Risk Business

Finding a low risk in business or investment is essentially the same. ‘The Dhandho Investor’ explains the following points nicely. With advice from Buffett, you want to do the following;

1. Focus on an existing business – Look at businesses with long history of operations that you can analyze. This is waaaaaaay less risky than a startup.

2. Buy simple businesses in industries with an ultra slow rate of change – Buffett tells us

“we see change as the enemy of investments…so we look for the absence of change. We don’t like to lose money. Capitalism is pretty brutal. We look for mundane products that everyone needs.”

3. Buy distressed businesses in distressed industries –

“Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives it good results.”

4. Buy businesses with a moat –

“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products and services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”

5. Bet heavily when the odds are overwhelmingly in your favour – if the market is offering you 10 to 1 odds in your favour for a particular company, would you bet on something else or bet heavily on that one bet and look to do it again and again?

6. Buy businesses at big discounts to their underlying intrinsic value – Minimize downside risk before ever looking at upside potential. If you were to buy an asset at a steep discount to its intrinsic value, even if the future turns out completely unexpected and worse, the odds of loss in capital are low. Ben Graham first brought this concept by stating that

“…the function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future.”

7. Look for low risk, high uncertainty businesses – This is a great combination. It produces severely depressed prices for businesses. Think back to the tech bubble. Had you bought great businesses such as Adobe, Apple, Cisco etc at the depressed prices, I’m sure you would be a millionaire right now.

Low risk DOES = High Return
Does buying $1 for 50c make sense?

If that $1 went down to 20c, an you bought it at 20c, is that considered risky? Wall Street obviously thinks so. They consider beta to be a measure of risk. If the price falls drastically, the beta is high and the stock is risky. Does that mean if the stock rises drastically, that is just as risky? In other words, beta is telling us that buying $1 for 20c is extremely risky. Pfft..

Wall Street takes pride in buying $1 for $3 and then selling that same $1 for $5. Completely ridiculous and that is what I consider risky. Yet this is the way people tend to operate with their investments.

Would You Buy My $1 for 50c?

Let me run through a final example.
A GREAT company is worth $1 but due to uncertainty in the industry, it is selling for 50c. People are afraid and they have been dump the company sending it down to 50c although the underlying fundamentals are identical. There is a possibility that Mr Market could get sick and extend his stay in hospital and send the price lower to 30c. So now people are selling $1 for 30c. Some intelligent investors start to load up on these $1 at 50c and when they see the price go down to 30c, they buy even more. Wall Street calls this gambling.

Days, months and years pass. Eventually, Mr Market is out of the hospital and feeling better about the economy and state of affairs. People notice this and start to buy back. They push the price of the company higher than the $1 it is worth. Throughout all this time, the fundamentals had never ch
anged.

The intelligent investor now unloads everything for a HUGE PROFIT!

Meanwhile, everyone is so delirious with enjoyment that Mr Market is back, the prices are pushed higher and higher. People start to take notice and that $1 has now become $2 and people are buying at $2 thinking it has the potential to reach the sky. I’m sure you know how it ends.

Which one is more risky?
1) Buying the $1 for 50c and then selling for $1 OR
2) Buying the $1 for $2 and trying to sell it for $4

Low risk does equal high return.

(edit: March 2, 2008)
I was reading one of my favourite manga (Japanese comics) and I came across this section which I found hilarious. Even boxers understand that low risk = high return.
Understandable in theory but difficult to carry out without discipline.