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Decoding Warren Buffett’s Rule No. 1

Decoding Warren Buffett’s Rule No. 1
Blogs from Our Experts | May 30, 2017

One should not invest in a company where there might be a permanent loss of Capital.

“Rule No. 1: Never Lose Money. Rule No. 2: Don’t forget rule No. 1”. You all must have read these lines on a calendar or on a diary as a special quote by Warren Buffet and acknowledged or referred to friends at some point of time, especially if you are into the stock market investment. It takes only two minutes to think why Warren Buffet said these lines. Is it possible to “Never Lose Money”? Is Warren Buffet talking about “Stop Loss” concept, which various technical analysts advocate? Interestingly, there is another quote.

“Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market”.

~Warren Buffett

How contradictory is it? It took me a few years to understand and correctly (may be) interpret. I learnt this by committing a few mistakes in the stock selection while buying portfolios. However, the risk consciousness of my research house saved me.

The stock market price performances are bound to go through peaks and troughs and this is unavoidable. The stock market is first to get the blow in case of any Macro- economic, Geo- political or even nature’s uneven movement. In such a scenario, “Never Lose Money” seems only a blessed feeling and not reality.

To me, never lose money means one must not indulge in gambling or should not be frivolous while investing in companies if he doesn`t understand. In other words, one should not invest in a company if he feels that there might be a permanent loss of Capital. This is difficult to judge by mere Earnings that a normal investor track. The quality of Balance Sheet and Cash Flow play an important role in this regard as they show you the real picture of the company.  This picture becomes more clear to you when you meet the management or track their decisions and understandings regarding the allocation of the Company’s capital and investment in the business.

Let`s take two companies and judge. Shilpi Cable – since 2010, Sales multiplied 18 times, Net Profits multiplied 19 times.  This brought heavy interest to the investors and the company’s share prices zoomed by 733% (~ 8 times), from Rs 30 in mid-2015 to 250 in early 2017 (2 years time frame). A close look at the company’s balance sheet suggested that the companies faced capital crunch due to a high amount of debtors` outstanding in the books.  Also, the company routed the sales through subsidiaries whose activities were difficult to trace and raised many doubts on the corporate governance.  In 2015, when the market cap of the company went from Rs. 84Cr to Rs. 430 Cr, profits zoomed by 60% from Rs. 100 Cr to Rs. 160 Cr. On the contrary, cash flow from operations turned negative from Rs. 20 Cr to minus Rs. 45 Cr (outflow of Rs. 45 Cr). Also mind, the finance cost was Rs. 81 Cr out of debt of Rs. 450 Cr. To your surprise, since 2010 to 2016 ( i.e last 7 years), company sales totaled Rs 10945, profits totaled to mere Rs 531Cr and cash flow from operations only at Rs 51 Cr. What more we need to justify is the recent fall in the stocks from as high as Rs. 250 to Rs. 67 in less than a month on rumors of the company, declared to be insolvent.

Now let us take an example of Marico- The sales have multiplied by 3 times, profits by 4 times and prices by 6 times since the Yr 2010. Marico has a clear competitive advantage in terms of profit and loss account, balance sheet, and cash flow. The company’s p&l is levered in such a way that when the company undergoes huge raw material prices, the margin is protected through an increase in realization or decrease in advertisement cost. The company during the initial growth years invested in Gross Block. The tangible assets multiplied by ~3 times. Once the need of the capital for assets got stabilized, the company changed its Dividend Policy by paying out 60% of Net Profits as dividend compared to 14-17% payout in earlier years. So the balance sheet is in a good shape. The Return on Equity remained stable as a result of the proper allocation of funds by the management. The company’s cash flow is such that it has earned a profit of Rs. 3100 Cr in last 7 years out of which Rs. 2600 Cr is earned as cash flow from operations. All these factors make Marico a lucrative company to invest in.

My message is why to invest in a company which gives a bumpy 8 timers with clear indications of permanent capital loss when you have shares like Marico with efficient capital allocation.

To conclude, I would suggest, peep into the cash flow statements, the subsidiaries accounting, related party transactions, the balance sheet, read the management decisions properly apart from getting stuck only to the quarterly earnings which appear easy to comprehend but may have data that misguide.

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Vineeta SharmaHead of Equity

Vineeta Sharma has over twelve years experience in equity research and portfolio management. She has trained and managed a team of Equity Research Analysts as Head of Research at Narnolia Securities Ltd. Vineeta is a Qualified Chartered Accountant.

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