Raamdeo Agrawal, co-founder of Motilal Oswal financial services, has written a letter to investors on how to evaluate the damage to stocks in cases of extreme price movement to the downside and how to assess its place in your portfolio.
Agrawal also has written extensively about investor strategies.
“Every investor is a value investor so you have to chase the value and not the price. Price will keep moving up and down. The loss is in the price, not in value,” Agrawal said.
"Our investments will be chosen on the basis of value, not popularity," he wrote.
Here is the full text of Raamdeo's Agrawal's letter to investors:
Dear investor friends,
Over the last 3 years, the Nifty Midcap Index (12% CAGR) has outperformed the Nifty (8% CAGR). However, 2018 year to date, the Midcap Index is down 14%. Thus, 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?
I address this using the concept of Permanent Capital Loss and Quotational Loss.
Permanent Capital Loss versus Quotational Loss
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 –
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 –
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.
Major reasons for Permanent Capital Loss
|· Disruptive competition· Emergence of a new substitute· Change in government regulation(e.g. price regulation, import duty changes, etc)||· No clear growth strategy· Mega acquisition gone wrong· Mismanagement or Fraud· No – or weak – succession plan|
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 –
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 –
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.
Value erosion (i.e. profit collapse) in DSQ …
… led to Permanent Capital Loss in its stock
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 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.
Sustained Value creation (i.e. profit generation) in Infosys … … meant the stock price drop was only a Quotational Loss
“… 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 –
“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 –
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 –
You will most likely end up with a Permanent Capital Gain!
I welcome your feedback and suggestions for improvement. Please email the same to firstname.lastname@example.org.
Note: The source of all data used in this bulletin is MOAMC internal analysis, unless otherwise mentioned.
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Disclosure: Motilal Oswal is is one of the four launch partners of CNBCTV18.com.
First Published: IST