3 principles in preservation of capital

By Larissa Fernand |  27-08-19 | 
 
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Larissa Fernand is Website Editor for Morningstar.in. She would like to hear from you and welcomes your feedback.

Bharat Shah, Executive Director at the ASK Group, believes that every investor must have two fundamental objectives when investing – PRESERVATION and APPRECIATION of capital. These are the views he shared last year at the Morningstar Investment Conference.

Preservation is NOT about being able to guard against the daily market ups and downs. Nobody can. Even the smartest algorithms and machines are unable to do so.

Preservation entails that you work towards avoiding the possibility of a permanent loss of capital. To my mind, the permanent loss of capital really emanates if you violate the basic tenets of investing. This will encompass your behavioural tendencies as well as your stock picking strategies.

There are three sources that contribute to preservation.

Quality of the management 

It's easy to talk about quality of management.

You may be intelligent, and sensible, and logical. But sometimes the heart overrules all. When you heart rules over the head, you may fail. And that is why rotten businesses and rotten managements become attractive in the eyes of people.

It's not solely the intellectual capability that can comprehend whether a business or management is bad or otherwise. Discipline and temperament and character all come into play.

Investing is beyond intelligence. Wisdom plays a very important role. In fact, wisdom needs to be slightly ahead of the intelligence so that the raw intellect or intellectual capability remains under check.

Wisdom is very hard to define in mathematical terms but easy to perceive and realize. It transcends immediate logic or reasoning. Intelligence is mostly about immediacy while wisdom is about the long term; to be able to understand in the long run what are the right things to do even if in the short term it may be tempting to think of straying from that path.

The quality of the management is extremely crucial. Many factors come into play. Are they competent enough to execute? How do they treat minority shareholders? Are they known for their integrity? Are they visionaries? Do they have the ability to see the picture ahead? Is there sound capital allocation? Do they comprehend and balance the objectives of the business and interest of the shareholders through precise and proper capital distribution policies?

All these are the hallmarks of what good management is all about. Whether we talk of India or America or Europe, I would probably safely would say lack of quality of management is a rule rather than exception. That is why quality is so hard to find.

I firmly believe that more than 85% of the managements everywhere in the world – and I am not talking of any particular geography – are rubbish and not worth even relating to or not worth even bothering to be evaluated. Once we realize or once we agree on this, the task becomes much simpler because then we realize that there are only so few to talk to or so few to really understand.

Quality of the business

The fundamental capability of the business must be to create a predictable long-term superior economic value. Unless and until the business fundamentally is in a position or has the opportunity to create long-term value, those are not the businesses that you flirt with on a short-term basis.

Quality of the financial position

Typically, when we have taken care of a good management and a good business, quality or financial position usually is an outcome, but not always so. It's important to verify and ascertain that it is indeed the case.

Time to time, one has to continuously keep engaging and figuring out that the quality of the financial position is in sync with what you could perceive for a given business and for a given management whether actually it is so or not.

Innumerable instances exist where even good managements are not entirely impervious to stray. May not be in a deliberately recalcitrant manner or in a deliberately inappropriate manner but they could stray, they could make mistakes.

When we flirt with the quality, we expose ourselves to the biggest risk which is that of permanent loss of capital. So not only must we be very clear about what we mean by quality, but hunt for it, and hold on to it over various market phases.

Bharat Shah shared the above thoughts at last year's conference. Do join us this year for the 9th Morningstar Investment Conference to be held on September 17-18, at Hotel Sahara Star, Mumbai.

Chief Guest: Marc Faber

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