The Biggest Danger of Investing in Bad Businesses

Focusing on what can go wrong has long been a mantra of sound investing.

The legendary investor Seth Klarman put it the best in an investor letter –

We are big fans of fear, and in investing it is clearly better to be scared than sorry.

But chances are that even the biggest pessimists among us can have their focus on risk muted by extended periods of generally favourable market conditions.

Klarman wrote this in his 2006 letter to his funds’ investors, while warning about the impending crisis of 2008 –  

Given how hard it is to accumulate capital and how easy it can be to lose it, it is astonishing how many investors almost single-mindedly focus on return, with a nary of thought about risk. Lured into their slumber by … an investment mandate of relative and not absolute returns, as well as a four-year period of generally favorable market conditions, investors seem to be largely oblivious to off the radar events and worst-case scenarios. History suggests that a reordering of priorities lies in the not-too-distant future.

I am not warning of a 2008-like crisis coming our way, for I do not have such foresight. But the more I talk to investors and the more I see the kind of activity happening in the stock market and on social media, it tells me that many among us may be throwing caution to the wind, yet again.

Some are buying high quality stocks at any prices, and some are buying low quality ones just because high quality is not available cheap anymore.

And so, it is time to revisit what Ben Graham wrote in The Intelligent Investor –

…the risk of paying too high a price for good-quality stocks — while a real one — is not the chief hazard confronting the average buyer of securities. Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.

The purchasers view the current good earnings as equivalent to “earning power” and assume that prosperity is synonymous with safety.

Buying high quality businesses at expensive prices carries a risk of poor returns, but buying low quality businesses even at cheap prices carries a risk of permanent capital destruction. And there is a big difference between the two.

The very first thing I do when I am starting to read about a new business is to check for basic hygiene factors like –

• Simple business of reasonable size that I can understand (I avoid extremely small companies),
• Zero or low debt on the balance sheet (if some debt, then enough cash generation to repay interest on debt),
• Presence of pricing power that leads to high or better than average return on capital and return on incremental invested capital, and thus a clean balance sheet,
• Management without a shady past (I search Google for that, applying the company’s name plus keywords like ‘scam’, ‘fraud’, ‘cases’, etc.),
• Ample and profitable reinvestment opportunities, and
• Capacity to suffer bad times

Any business that fails on even one of these parameters is out of my sight in quick time. Most new companies I come across fall in this category of “quickly out of sight, out of mind.” I do not have the time or the inclination to read more on such businesses to create better reasons to not ignore them, even if that means losing out on a few potential turnarounds or ugly ducklings that may turn into beautiful ones.

Basically, I avoid any business that has more than a small chance of losing me capital permanently, and that keeps me at peace. Best, this has served me well for years now, and so I stay with it, whatever the market may be doing or however people around me may be behaving.

One of the key lessons I have learned over the years is that the biggest danger of investing in a bad business or in the one you do not understand or the one where you pay any price to get in is not so much that you will lose money. It is that you may make money.

And why is that a danger?

Because when you make money on such a business, your mind will draw patterns from your recent success, attribute that to your skill, and then lead you towards making similar, even bigger, trades in the future.

High stock market returns, especially when we achieve them in a short time, have a dangerous way of eclipsing our ignorance. Not just that, we often don’t know what we are doing. Worse, we don’t know that we don’t know what we are doing.

Mark Twain, the noted writer and an active investor, wrote –

There are two times in a man’s life when he should not speculate: when he can’t afford it, and when he can.

Despite that Twain did not have an inspiring career as an investor, I remind myself of his invaluable advice often, and thought I should remind you of this today.

Before I end, here is a video I saw of a recent interview of Charlie Munger where he warned that we may be in for some serious trouble in the future given the way central bankers have been printing money worldwide for many years now. Even when Charlie often uses the words “I don’t know…” while talking about a lot of such things he sees coming, just that he says this makes me sit straight and take notice.

Stay safe, and not just from the virus.

Regards, Vishal