7 Rules to Minimise Losses and Maximise Gains

Be a Better Investor Part III: 7 Rules to Minimise Losses and Maximise Gains

Irving Soh
Irving Soh
  1. Always have a buy rule
  2. Always have a sell rule
  3. Always check for management and insider skin in the game
  4. Always check for low levels of debt
  5. Always make sure your potential reward outweighs your potential risk 5 to 1
  6. Always identify WHY the company is currently undervalued or has the ability to grow
  7. Always understand the macro environment on at least a basic level

#1 – Always have a good, research supported buy rule

Of all the things an investor requires to both maximise gains and minimise losses, a buy rule is the most important.

A lot of research has been carried out on the best ways to approach buying a stock. There a variety of valuation models which go on to inform an investor on when a company is ripe for purchase.

I personally use either the Acquirer’s Multiple or the CNAV formula. Both formulas have one goal – to buy cheap companies so cheap that even if they are temporarily distressed, there won’t be an issue.

Figuring out a buy rule is the first order of business for any investor. I highly recommend you find yours. Some of the important criteria to note is that the buy rule should be thoroughly researched. Is it empirically supported to give decent returns?

Both the CNAV formula and the Acquirer’s Multiple formula have been empirically tested and have fantastic results – that’s why I stand by them.

Whatever your buy rule is, find one that has been tested. And stick to it.

#2 – Always have a sell rule

Right after having a buy rule, have a sell rule. A sell rule is important because it defines what happens in case something happens.

In my case, my sell rule falls into four categories:

  1. The company has appreciated to fair value. Sell to realise profits.
  2. The company has hung around for three years and while its cheap, has done nothing. No catalyst is upcoming that can be seen, and no major industry changes can be seen to turn its fortunes back towards fair value. Sell to rotate capital into better opportunities.
  3. The company’s fundamentals has been corrupted. Increasing debt. Negative free cash flow. CEO was found doing something he shouldn’t have. Whatever the case is, there’s always a fundamental reason to own a company beyond the fact that its cheap. When you initially check out a company, you should note why you are buying it. If the fundamentals have turned for the worse and your thesis have proven false – sell. Don’t think twice.

#3 – Always check for management and insider skin in the game

I’ve spoken at length about management and skin in the game here. You should refer to this article if you want to understand more. In summary though, management should own shares in the company or somehow have a portion of their wealth in the company. If management is in the same boat as you are, they are unlikely to want to sink that boat. Refer to the article to check how we derive if they have skin in the game and use it to find companies with a high probability of profit.

#4 – Always check for manageable debt

Plenty of academics argue about what level of debt a company should have, to which my answer is “a balanced amount”.

No. I’m not trying to quote Thanos.

One of the advantages of being a corporate entity is that you have the potential to issue debt to grow and otherwise fund purchases necessary for the business. To not have any debt at all signifies a company that can no longer grow.

But while some debt is good, overly large amounts of debt is bad.

A student taking out $40k worth of loans to go for university is a decent reason to get into debt. He/she is likely to earn it all back in the years to come and have the ability to pay it off.

A person with $4k salary buying a $1 million wedding is a bad idea. That wedding is unlikely to pay off itself. If at all.

In similar ways, a business should only get into debt in order to earn greater profit and if the return on getting into debt is greater than what the debt costs.

This is simple logic. Ideally, a company should not get into more debt than 2 years of operating cashflow. Some of the simple rules of thumb you can use is less than 0.7 debt to equity ratio.

I will be content that this can be challenged if you have an idea of what is the “Norm” within any particular industry, but you need to be extremely aware of what you are doing or face the consequences of losing your capital entirely.

Debt is a key killer of companies. Too much is always bad.

#5 – Always make sure your potential reward outweighs your potential risk 5 to 1

When I say 5 to 1, I mean that for each dollar you invest, look for how that dollar comes back to you as $5.

Yes. It won’t be easy. You will not find it all the time. In fact, most of the time, these finds are impossibly rare and if you do find them, should be treasured and taken advantage of properly.

But the risk:reward ratio is to protect you from your losses.

Investing is all risk.

Companies that are here today can be gone tomorrow. Go back 50 years and try to find some of the companies listed in the States – most of them are dead and gone. Such is the way of business, most companies, even (or perhaps especially?) public ones often don’t make it.

That means there must be a reasonable assumption to the dollar risk you take on. You’re going to be wrong once or twice. Hell, you’re going to be wrong a whole lot if you live long enough and stay invested long enough.

Your possible rewards cannot simply be big enough to justify investing. They have to be big enough to justify possible losses in other investments. If I’ve made no sense thus far, let us run a painfully clear scenario.

Let us assume you invested in ten companies, at $1 each and earned 10% on every company but one. In the last company, you lost the dollar. It completely imploded and the value of the stock is now zero.

So, you started with $10 and now you have $9.90 (9 companies, at 10c gain each from based on 10% on $1).

You’re poorer than you started.

Do this long enough, and you will erode your wealth.

Instead, if you invested with a 5 to 1 ratio, you could lose on HALF your investments and still have more money.

10 companies at $1 each. 5 companies died. 5 companies went on to reward you 5 times the amount invested, gives you an ending sum of $25.

You started with $10. So essentially for the year, you 2.5x your money.

It’s simple mathematics – yet not one bothers to try this because they have been inoculated by the media and the world that “you’ll be lucky to make 30% returns consistently”.

Yes, I’ll admit. It’s really difficult. But it has to be done regardless. Your rewards must always outweigh your risks. At the minimum, your reward should ideally be twice what the risk is. Which also means every dollar invested should have a possible reward of $3. That way even if you’re wrong on half of 10 different investments, you’re still up 50% for the year.

Don’t ever forget your risk-reward ratio!

#6 – Always identify WHY the company is currently undervalued or has the ability to grow

If a company is undervalued and looks beaten down, there’s probably a good reason why. Do a check. Find the obvious reason. Then dig deeper. A favourite character of mine in a cartoon series always says “look underneath the underneath”. If you can’t understand why something is undervalued, stay away. That’s why I prefer cyclical companies. Cycles are understandable – they’re the reason companies are either undervalued or overvalued. Find the broken leg in the company that’s causing the share price to be broken down and see if that reason can be fixed. Some times, it’s not obvious – and that’s ok. You can always stay away. You don’t have to spend your capital and guess. If you’re a retail investor, you need to pick the best chances. Don’t swing at things that are uncertain. Try to establish as much information as you can – and never ever be cocky enough to think you have it all figured out. Life has a funny way of throwing a monkey wrench in your thesis just when you think everything is going smoothly.

If a company is set for growth – why? What are its competitors doing? Are barriers to entry low? What drives growth? Ability to scale? A sponsor? A charismatic sales team? A new platform? A new business advantage protected by an IP? The best designers/engineers in the industry? Evidence of long term forward thinking? Evidence of a big industry that is shifting (the explosion of data in the world for example drove the prices of data centers, and data center reits higher, EQUINIX for example went from $79 to $590)? What’s the growth driver and how does the company plan to execute? What’s the execution track record?

These are all questions you have to answer at the very minimum. Sometimes, these questions are not easy to answer. But you can bet that the more difficult it is, the less people will be able to answer it, and the greater an edge you will have against the rest of the field.

#7 – Always understand the macroeconomic environment on a basic level

Yes. I know. You don’t have a finance degree. But take the basic steps. Understand how interest rates affect the market. Understand how the economy works. What are the roles of bonds? Of the repo market? What is the world’s reserve currency? How does the system work? How does cash flow in the world?

If you understand the cashflow of the world and can develop a habit of trying to guess where the cash will flow next, you can make a gigantic killing. This is much harder than it seems and no one ever has all the answers, but you don’t have to be exactly right. You just need to be kind of right and definitely not exactly wrong. When interest rates are rising, you don’t want to be in a bond or anything that’s bond-like like a REIT. When interest rates are dropping, the yield spread between a REIT and the low interest rates drive share prices higher since cash is cheap and yields are favoured. That’s also why the Singapore REITs have gone up so much in the past years. We’ve had a decade of low interest rates and whether it can continue is a big question all of us have to answer – my guess is there’s inflation, massive fiscal stimulus, then interest rates climb precipitating a market correct/collapse. That’s just my educated guess.

Whatever comes, I’m still going to stick to dirt cheap, roadkill companies left for dead with heavy insider ownership and insider buying with a clear future catalyst/industrial trend at its back. Anything else is a pass for me.

Let’s recap.

  1. Always have a buy rule
  2. Always have a sell rule
  3. Always check for management and insider skin in the game
  4. Always check for low levels of debt
  5. Always make sure your potential reward outweighs your potential risk 5 to 1
  6. Always identify WHY the company is currently undervalued or has the ability to grow
  7. Always understand the macro environment on at least a basic level

I took the time to write about this because I think there’s a lot of confusion out there about the various styles. This is more of a general guide that is meant to set you out on the path and how to actually approach investing. I hope it has helped.

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