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As institutional investors, we have typically seen that there exists an information asymmetry between institutional and retail investors. Retail investors have limited access to quality research and many other constraints to deal with.
Retail investors therefore are sometimes left with no option but to: 1. Either buy a stock at expensive valuations 2. Invest in momentum behind a stock 3. get caught off-guard when a management ill-treats minority shareholders. All these actions greatly increase the odds of a permanent loss of capital. We believe that the golden rule of investing is to never lose capital; all other rules come later. One way in which retail investors can make up for the information asymmetry as compared to institutional investors is by adopting a clear framework to investing and adhering to the rules. In our analysis, filtering stocks in the following order and then selecting can reduce the odds of losing capital.
Quality of a Management: In our discussions with a lot of retail investors, we have seen that what is often not in public knowledge is the quality/ethics of a management. Life would be much simpler if we could tag a management as red/yellow/green based on their governance practices. Investors could, however, use the following rule of thumb (list is not comprehensive) to safeguard themselves from corrupt/low-quality managements:
a. Look for related-party transactions in the annual report and stay away from managements that have either >20 per cent of their sales or cost related to a group entity.
b. Stay away from companies that do not declare dividends/buybacks even though there is cash sitting on the books.
c. If total promoter remuneration/perks are greater than 2-3 per cent of the top-line, it is a red flag.
d. If a company’s cash flow from operations is less than 50 per cent of the PAT for the last 3-5-year period, such a business is not attractive as it cannot recover its sales, and capital gets stuck in working capital.
e. Stay away from turnarounds and/or managements that are acquisitive. These have a very low probability of success even with good managements.
Quality of a business: Try to find companies that have a return on equity (ROE) > 15 per cent for a 5-10-year period. Statistically speaking, companies that have a ROE >15 per cent in the last 5-10 years have compounded capital at a higher rate than the companies that have a sub-par ROE.
We can see from the data mentioned above that investing in high-quality businesses greatly reduced the odds of a permanent loss of capital to less than 2 per cent.
The data was computed, by first shortlisting companies whose market cap was >₹200 crore five years and 10 years back, respectively. The companies that had a 5-year and 10-year return on equity >15 per cent were identified separately and their median returns were computed. Of these companies, the ones that yielded less than zero per cent returns were counted to compute odds of loss of capital.
Pay conservatively for value
Retail investors investing in a mutual fund or a PMS should always check for its trailing Price to Earnings multiple (TTMPE) and check whether it is at a discount or a premium to the index. A significant mistake a lot of investors and fund managers make is to invest in high-quality businesses at any price. The same increases the odds of loss of capital or increases the holding period for recovering capital. Retail investors often lack the patience to hold stocks for long and end up losing capital.
The best thumb rule for anyone is to not pay more than a TTM PE of 15x for B2B businesses and a TTM PE of 25x for a consumer-facing business. The accompanying data further backs this argument that in the short term (up to 3 years of holding period), entry valuation is a significant determinant even amongst well-managed companies. As the holding period increases to 5-10 years, entry valuation becomes a less critical determinant to returns and capital protection.
To sum up, if we get the management and the business right, the odds of permanent loss of capital are less than 2 per cent. Therefore, retail/SIP investors should focus on investing in clean managements running good quality businesses that are available at a reasonable price.
The author is the Founder of Prescient Capital
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