One of the most widely quoted pearls of wisdom of legendary investor Warren Buffett is: “Rule No. 1: Never lose money. Rule No. 2: Don’t forget rule No. 1”.
At first sight, this seems to contradict another of the great man’s gems: “Unless you can watch your stock holdings decline by 50% without becoming panic-stricken, you should not be in the stock market”.
However, the contradiction can be reconciled if we recognise that there’s a difference between seeing a decline in the value of your portfolio and losing money. Doubtless, if you sell out in a panic when stock markets have plunged by 50%, you’ll lose money — certainly on your recent purchases. But if you hold through the downs of the market — ideally buying more shares when prices are low — you should make money in the long run.
So, when Buffett talks of never losing money, he’s not referring to temporary “paper” declines in stock values. He must be referring to crystallised cash losses. However, that begs a pointed question: how can Buffett tell us to “never lose money” with a straight face when he himself has crystallised some notable cash losses — on Tesco, for example?
Should we write off Buffett’s Rule 1/Rule 2 dictum as a snappy — but empty — one-liner; or is there something of value behind it from which we can profit as investors?
I think the answer can be found in Buffett’s approach to investing. Many investors looking for opportunities begin by focusing on the potential upside: “This share could return to its former glory of Xp”, “This share could keep rising to Yp”, “I could double my money with this share by next year”, and so on.
Buffett, who views an investment as a purchase of a slice of a business and its future cash flows, begins by asking what could go wrong. Is there a risk the business could fail catastrophically with a permanent loss of his capital? He simply isn’t interested in the potential upside if he sees a major reason why the company might fail.
How many of us, when weighing up a potential investment, make the “Principal risks and uncertainties” section of the company’s annual report our first port of call? Or the balance sheet and cash flow statement? Buffett’s approach to investing suggests we would be well-advised to do so … before being seduced by alluring earnings growth, dividend yields, potential massive market opportunity and so forth.
If Buffett is right, most of us can improve our long-term returns by simply ruling out companies where there is a risk of the business failing catastrophically with a permanent loss of our capital. I would suggest that just by avoiding companies with high levels of debt and companies that have never generated positive cash flows we can significantly reduce the number of our investments that end up being 100% write-offs.
Of course, we’ll miss out on some big winners, but Buffett’s approach is all about having that mindset of “never lose money”. If we can eliminate total wipeouts, and the permanent destruction of all the future compounding value of that lost capital, then the odds of healthy long-term returns from the stock market are in our favour. Put another way, avoid the casino mindset of “punt”, “play money” and “risky bet”, and invest in well-capitalised, high-margin, cash-generative businesses — and we won’t go too far wrong.