Stock Markets are volatile ...

In his 1962 letter to partners of Buffett Partnership, Warren Buffett writes –

"I cannot promise results to partners.  What I can and do promise is that –
a) Our investments will be chosen on the basis of value not popularity;

b) We will attempt to bring risk of permanent capital loss (not short term quotational loss) to an absolute minimum by obtaining a  wide margin or safety in each commitment and a diversity of commitments; and

c) My wife, children and I will virtually have out entire net worth in the partnership."

It is a testimony to Warren Buffett’s wisdom and foresight that his words way back in 1962 are still as relevant today. In fact, every word of the above quote is insightful.

“I cannot promise results to partners”

Investors would do well to understand this fundamental truth about equity investing – there is no guarantee not only of returns, but even safety of the capital invested. Equity investors need to be more skillful than the market to ensure safety of capital and reasonable return on investment. Risk-averse investors should invest primarily in bank fixed deposits, and that too of credible banks!

“Our investments will be chosen on the basis of value not popularity”

It is said that, in stock markets, most people know the price of everything but the value of nothing. As Warren Buffett himself has said, “Price is what we pay, Value is what we get.” Thus, before investing in any stock, it is most important to have a clear idea of its value. Mere popularity of a stock is no guarantee of its investment performance.

“We will attempt to bring risk of permanent capital loss (not short term quotational loss) to an absolute minimum”

This is the core of the quote. There are two kinds of risk associated with any stock –

1. Permanent Capital Loss; and

2. Quotational Loss.

Permanent Capital Loss

Permanent Capital Loss refers to a massive fall in stock price because the value of the underlying business is significantly eroded. The proxy for value is a company’s profits and profitability. Value erosion (i.e. lower profits), and hence, Permanent Capital Loss in a stock may happen due to a variety of reasons, both industry-specific and/or company specific.

Quotational Loss

Unlike Permanent Capital Loss, Quotational Loss is merely a short-term fall in the stock price with the underlying value broadly intact. Some reasons for Quotational Loss are –

• Fall in the broader market itself

• Very high valuations

• A minor setback in the company’s fundamentals e.g. lower-than-expected profits for a quarter or two, fire in the company’s plant, slight delay in new project, etc.

Thus, Quotational Loss in a stock offers an excellent buying opportunity due to unilateral lowering of valuations. However, buying during the Quotational Loss phase demands two things from the investor –

1. Fundamentally, a high level of conviction that the setback is temporary; and
2. Behaviorally, a high level of courage and patience. It requires going against the popular saying, “Don’t catch a falling knife!”

Examples

Consider two companies from the same sector, IT – DSQ Software and Infosys. The profits and stock price of both companies hit a high around year 2000, led by the Y2K opportunity and dotcom boom. Post the bust, stock price of both companies collapsed. However, DSQ went into oblivion – it reported huge losses, its stock price never recovered, and the company ended up getting de-listed. Thus, there was a Permanent Capital Loss.

In contrast to DSQ Software, Infosys’ profit went from strength to strength. As a result, its stock price recovered within two years of the dotcom bust, and soon cross the previous high. Thus, there was only a Quotational Loss. In effect, the sharp 50% fall in in stock price was a great opportunity to buy Infosys in March 2002 at P/E of 31x versus P/E of 206x in March 2000.

“… by obtaining a wide margin or safety in each commitment and a diversity of commitments”

Coming back to Buffett’s quote, there are two ways to avoid Permanent Capital Loss –

1. At the individual stock level – By building in a wide margin of safety i.e. value significantly higher than price; and
2. At the portfolio level – By using the principle of diversification i.e. owning a basket of stocks. This way, even in the unlikely event of a Permanent Capital Loss in any stock, the impact on the portfolio is muted.

“My wife, children and I will virtually have our entire net worth in the partnership”

This part of Buffett’s quote is not related to the topic of Permanent / Quotational Loss. Rather, it refers to an important concept called “Skin In The Game” i.e. in any active, what is the level of a person’s participation in both the gains and losses.

This topic merits a separate discussion in itself. For now, there are two key implications for investors –

1. Choice of companies to invest in:  Investors are generally better off investing in companies where the management has high Skin In The Game i.e. management fortunes are closely linked to fortunes of the company. This is typically so in owner-managed companies or where the senior management has a significant level of compensation by way of stock options.
2. Choice of portfolio manager: Those investors who choose to invest via mutual funds are better off checking whether their portfolio manager has high Skin In The Game. The question to be asked is – Does the portfolio manager stand to lose if I lose value in my portfolio? If the answer is yes, your money is in fairly safe hands.

In conclusion …

We come back to where we started – Several Midcaps have seen prices fall by over 25% in a matter of just six months. So, what should the investor do in such a situation? The answer –

• Evaluate the likely reasons for the price fall.

• If there are signs of a Permanent Capital Loss, cut your losses and run.

• However, if it is just a Quotational Loss, back up the truck and load.
You will most likely end up with a Permanent Capital Gain!

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