Let's Talk Risks...

March 14, 2010 6:08 PM


Investing is pure risk. Companies can and do go bankrupt. Go to the library and look at a list of large companies from 1950—very few of them still exist. Go back another twenty years. Almost none of the companies from 1930 still exist. Your goal is to make sure that you only invest in things that will exist for at least the next few decades.

Lots of investments go to zero. Only invest in things that can go up 5-fold in 5 years (5 in 5’s). Otherwise, you’re taking on all the risk of a washout with none of the possible gain. If there is one lesson from the recent market crash, it’s that large well known companies are just as risky as smaller ones.

You will make mistakes when you invest. You need to have winners to offset the mistakes. Making 20% on a winner and losing half on a loser just won’t cut it. You need to make 500% or more when you’re right—that way losing half on a mistake will seem pretty irrelevant. Besides that, you need to focus on companies that cannot go to zero.

Buy companies with good balance sheets. Buy companies with low debt loads. Buy companies with earnings and cash flow. This all seem like common sense—but you’d be surprised how many people invest in things that have few if any of these characteristics. 

I only invest in things I understand. That means no technology or biotech. I don’t like to invest in things that are political as you can never predict what politicians are liable to do. I try to avoid things with legal risk or liabilities that I cannot calculate because anything can happen in a trial. I don’t invest in things that are losing globs of money today—but promise to make money in the future. I rarely ever do turnarounds and I NEVER invest in dying businesses that seem cheap.

I buy easy to understand businesses with great managements that have sizable ownership positions. I buy businesses where insiders are not paid much—yet continue to buy shares in the open market. I buy businesses with high returns on capital. I buy businesses that are rapidly growing yet are cheap because they are unknown.  

I try to only invest in what appear to be pretty sure things. The beauty of investing is that if you cannot find just the right set-up, you can sit there and do nothing. The most important thing is to not lose money. The best part about investing in smaller companies is that you can often find companies that trade for little more than their book value and for small multiples on earnings. These are companies with minimal risk—but plenty of upside. Stick to those companies—you’ll do well.

If you cannot understand how they make money—avoid it. If it’s promotional and makes big promises—avoid it. If insiders are selling shares—avoid it. If management salaries are high—avoid it. You can and probably should avoid the vast majority of publicly traded companies. Most are poor investments with management teams that are looking out for their own salaries and little else. Quite a few of the better known companies in the world are simply frauds. If you are to invest in something, it should be so damn obvious that it hits you over the head and you NEED to own it. Most importantly, make sure that the company you want to invest in is a potential 5 in 5. Otherwise you just aren’t getting paid enough for taking on all of the risks of something going wrong. Life is too short to take on risk for no reason.

Categories: Investment Strategy
Positions Mentioned: none
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