As much as it is logical, protecting your investment from downside risks is often overlooked by many investors - large and small. The temptation of making it big frequently overshadows common sense - both for companies that invest billions and for individuals who invest pennies. Think of the global mining companies that kept throwing billions on expanding capacities over the past few years, in an almost suicidal way, only to write off the value of much of their assets when the inevitable market overcapacity hit. Or Microsoft that paid USD 7 billion for Nokia's dying handset business in 2013, only to write it off less than two years later. While many individual investors look for the white elephants that will enrich them overnight. In all of these cases, investors aspire for quick gains, losing sight of obvious pitfalls in their choice of investments.
How can you minimise your risk and expand your margin of safety while still ensuring a reasonable return on your investment?
1.Assess leverage and cash generation capacity
Make sure the company you are investing in will not go bankrupt or be distressed in the foreseeable future. Many of the visible opportunities are companies that face the risk of distress because they live hand to mouth or, worse, keep accumulating debt to survive. And because these companies have probably faced weaker share prices, they become tempting. But for a company to give you a good investment return, that business should not just be making ends meet. It needs to be consistently self-sufficient in cash generation, and generating significantly more than it consumes in cash. Otherwise, where would the return for investors come from? Where would the company pay dividends or buy back shares from? How would it make acquisitions and investments that keep it growing? To make sure the company will not be financially distressed, you have to make sure there is excess free cash flow after payment of debt and interest obligations. To confirm your findings, check the credit ratings of major rating agencies and read their rating reports. But take the ratings with a pinch of salt, as credit agencies are often late in downgrading ratings of companies, and could be overly optimistic.
2.Assess sector and business potential
Avoid sectors that are in perfect competition and companies that are in perpetual decline. Food retail in the United Kingdom is one such example; the sector is in a state of intense competition with significant overcapacity from traditional and online retailers, all of which keep expanding capacities much faster than the expansion in demand. Companies that have been in perpetual decline include the likes of Blackberry and Marks and Spencer. Investors and analysts keep waiting for that quarterly result that will show the decline has stopped. That quarter usually never comes, and if it comes it will be either an exception or will be already after the company has lost a significant portion of its peak sales. The old saying says do not bet on a losing horse. I would expand that to do not bet on a company losing market share, losing sales, losing direction, and, definitely, not losing money.
3.Avoid the 'C' word
Avoid companies that have no control on the price of their products, and where the price of their products can fall by 20% or more in a year. This category will mainly encompass companies that produce and/or trade raw commodities. Would you feel more comfortable investing in an oil production company that produces one product whose market price can drop 50% in one year or in Procter & Gamble that produces hundreds of products whose market prices are likely to only keep heading north?
4.Understand in depth what you are investing in
Make sure you understand your investment to a high degree of comfort. Understand what the business model is, understand its past, present and future, understand the risks, understand the upside, the valuation and the return parameters. For example, I do not invest in financial services, such as insurance and banks, because I have no way of understanding clearly the content of those businesses or to assess the risks.
5.Leave emotions aside
Remove emotions and 'likeability' of companies from the assessment process. You should not invest in Apple just because you like your IPhone or invest in Citi because you bank with them. The same as you should not ignore Gap just because you do not like their clothes. Especially with consumer goods, brand names, and services that you use, it could become very tempting to assess the investment based on your personal experience. In consuming, you can choose the product or service you feel for, but in investing, you have to leave feelings aside and to be as objective and factual as possible
6.Keep your eyes and ears open
Never ignore negative views from equity analysts, credit analysts and other market commentators. You can ignore the positive views, but not he negative ones. As an individual investor, you are unlikely to have an absolute understanding of all aspects of the business, forecast, industry, regulation and risks - that is why you need to compliment your knowledge from specialists market analysts.
7.Be conservative with business outlook
Temper your expectations for business and share price growth. It is very unusual, almost impossible, for management of companies or equity analysts to have anything close to an accurate prediction of profit and cash flow levels three years down the line. So assume a company you are investing in today will not grow much in the future - even if market growth expectations are phenomenal. That way, you will create a buffer of safety for yourself, and any upside will be a bonus.
8.Expect the worst while hoping for the best
Always assume your investment can lose 10-20% or more of its face value in the 2-3 years after you first invest, and see if that is something you can digest and if you can be patient with. If you will panic or cannot take such a drop, then you should be very careful about considering investing. Even if you invest in the best company in the world with the cheapest valuation, a steep market slide like what happened in 2008-2009 will not leave any short term survivors.
9.Pace your investment
Avoid picking a particular point in time for making all your investment - do it in stages over months or years. No one, including Warren Buffet, knows when exactly would be the bottom share price for a company. Avoid significant purchase of shares when the market and/or particular share price is close to its peak (with certain exceptions).
10.Assess what is the return that is good for you
Make sure that the share you are buying gives a reasonable return based on the earnings and cash flow of the company today, and the conservative expected return in the future. Avoid making 'bets' on companies that have no solid present or past, only fantasy expectations for exponential future growth. See what is the minimum return that would be satisfactory for you - 3%, 5%, 10%? In your analysis, try to make sure that this minimum return is as certain as possible.
11.Do not put all your eggs in one basket
Diversification is key if you are intending to build a portfolio rather than only investing in a specific company. Diversification is best done when you carefully select each investment, based on the principles above, and you do not have overexposure to a particular sector or market.