5. Investment Framework
The lack of a sound, rational framework is one of the most important reasons why most fund managers perform poorly for their clients. Our sound investing framework is built after years of experience and research and based on the following 7 key components:
What do we mean by probabilities? Well, it is chances or odds. Just like when we toss a coin, the probability of getting a head is 50% and the probability of getting a tail is also 50%. However, investing probabilities is not like that and we will illustrate this in greater detail in 5.2 abd 5.3.
5.2. Compound Return
We believe in the simple magic of compounding. Table 1 below illustrates its power.
Compound for 15 years
Table 1: Compound Return of CDAM
Assuming an investor starts off 15 years ago in 1990 with RM1.0million. If he had invested that sum in fixed deposits, bearing an interest of say 3% per annum, its capital would have grown to RM1.6mln by now. However, if he is able to consistently generate a 99% return, his investments would be worth around RM30 billion. Well, it is easy to be seduced by the RM30 billion figure but realistically, the chances of achieving it are almost impossible. On the other hand, if you had invested with us, based on CDAM’s track record of 22.32% compound return, your RM1 million will be worth more than RM20 million by now.
So, coming back to probabilities. What are the chances of an investor achieving a return higher than Warren Buffett’s? What are the chances of achieving a 22.32% compounded return? Lastly, with the KLCI currently trading at close 13-14 time PE, the chances of CDAM achieving a 24% or higher compound return are higher if you invest now because you are starting from a lower base.
5.3. Arithmetic of Investing and Asymmetries of The Stock Market
The principle underlying the arithmetic of investing and the asymmetrical nature of investing is best summed up by Warren Buffett’s famous 2 rules.
Rule No 1 : Never Lose Money
Rule No 2 : Never Forget Rule No. 1
The 3 examples below clearly illustrate the importance of appreciating the arithmetic of investing and its asymmetrical nature.
Start with RM1.0 million in February 1997.
Lose 67% or RM670,000 by July 1998.
Just To Break Even Again
The investor needs to make RM670,000.00 or 203%.
This above example is based on the actual KLCI readings. For period one, if you had started investing in Feb 1997, at the peak of the market, with RM1.0 million, by July 1998, you would have lost 67% of RM670,000. In order to break even, you need to make RM670,000 or a 203% gain.
Coming back to probabilities, what are the chances of you losing 67% and what are the chances of you making a 203% gain? How fast will it take you to lose 67% and how long will it take you to gain 203%?
Based on the average investor’s experiences, most of them have yet to recover from their losses suffered 7 years ago in 1997/98.
The second example starts with period 1 when you had RM10,000. You managed to double your money in period 2. In period 3, you made a loss of 50%, bringing you back to square one.
The third example also starts with RM10,000 in period 1. This time, you managed to triple your money in period 2. However, in period 3, you lost 66% and in the process, wiping out your previous 200% gains.
What these examples illustrates is that investing, like most things in life, is not symmetrical. In addition, by losing an additional 16 percentage points, you have wiped out the entire additional 100 percentage points gain.
Coming back to probabilities. What are the chances of you making a gain of 100% as opposed to a loss of 50%?
The second example shows that once you make a loss, it is very difficult to recover your losses. That is why Buffett’s Rule No.1 is so important and that is why we are so proud of our achievements during the bearish years in 1998, 2000 and 2002.
The third example shows that it is very easy to lose everything you have made. So, by not losing, you are actually already richer than the next person.
5.4. Conservative, Not Conventional
Conventionalism is often confused with conservatism. By doing what is conventional, investors think they are acting conservatively. There are 2 schools of thought in investing. One takes on a more theoretical and quantitative form and the other takes a more business-like approach. Both differ in their interpretation and treatment of risks.
Those who have studied finance would have learned about Modern Portfolio Theory, which generally defines risk as the volatility of the share price against the general market index. The more volatile the share price, the riskier the company. Hence, the conventional way of reducing risk is to diversify. Looking at table 2 below, if you increase the number of stocks in the portfolio, the risk is lower.
Reduction in Residual Risk as The Number of Stocks Rises
|Number of Stocks
||Reduction in Residual Risk
Source: Stock Market Probability, J.E. Murphy, JR.
If you follow the conventional theory of diversifying and invest in 20 counters but all are in the banking industry, does this mean you are being conservative? Definitely not, because in a financial crisis like in 1997/98, all 20 of the stocks will be affected. On the other hand, if you invest in 20 counters in 20 different sectors but all are speculative in nature, you are also not being conservative.
What we are saying is that if you are diversifying for the sake of diversifying, you are only acting conventionally and not conservatively. Just like in a business, there are many globally successful companies such as Coca Cola, Toyota and Microsoft that are very focused on what they do best, and have done very well. On the flip side, there are many companies that diversified into various businesses but ended up horribly wrong. So, the question is, if Microsoft diversifies into, say, the construction business, would its risks be reduced? Definitely not.
We, at CDAM define and treat risk differently, in a manner that is conservative and not conventional. When we invest in a stock, we look at it as investing in a business. When we talk about risk, we refer to the company’s balance sheet strength, its competitive advantages, the barriers to entry, the long-term economics of the business and the capability of the management and so on. Hence, by recognising its business risks, we are able to identify the potential risks to our investments. Thus, rather than diversifying as what conventional fund managers would do, we act conservatively by indentifying the potential business risks that are involved when we buy into these businesses.
“Investing is most intelligent when it is most business-like”
Lastly, with our value investing philosophy, we incorporate a margin of safety into our investment. At CDAM, our risk management is premised on our value investing approach. While this may not be conventional, we believe that it allows us to be conservative.
5.5. Margin Of Safety
Simply put, buying a company worth RM1.00 for RM0.50 provides a margin of safety. For example, when an engineer designs a bridge to carry a 7-ton lorry, does he design it to withstand only 7 tons or 14 tons? By building a bridge that can carry 14 tons, you have built in a safety margin. So, even if the lorry driver decides to carry heavier goods, the structural integrity of the bridge is not compromised.
Similarly, CDAM is always looking for counters with a margin of safety. The logical corollary of value investing is that it builds in a margin of safety. A margin of safety allows an investor to be brave when others are fearful and to be fearful when others are brave.
5.6. Low Risk, High Return
The conventional advice is that high returns can only be obtained by taking high risks. At CDAM, we add value to the investing process by seeking “low risk, high return” investments for our clients.
5.7. Investment Approach
As explained in 3.2, our investment philosophy is best summed up as “Intelligently Eclectic.”
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