Investing mistakes can be costly. Every pound of capital permanently lost is a pound that’ll never compound and multiply. As such, a permanent loss of any part of your capital is something to avoid, if you possibly can.
Now, there are a few things directors do in managing companies that are directly comparable with what investors do. Unfortunately, in these areas, many directors make capital-destroying decisions. Here, I want to tell you how to avoid making the same mistakes in your investing.
Holding a buffer of cash is necessary “to guard against external calamities,” as Warren Buffett has put it. One of the responsibilities of directors is to decide how much cash is prudent for their company to hold.
Financial crises, recessions, and even pandemics, are not ‘black swan’ events. These external calamities may happen with varying frequency and severity, but they do happen. Yet, time and again, we find companies going into such events with what proves to be an inadequate cash buffer to weather them.
A cash crisis is never good. It can mean selling valuable assets at distressed prices, taking on debt at punishing interest rates and, in some cases, a wipeout of equity capital.
Buy high and sell low!
I’ve looked in dismay at the number of companies buying back their own shares in recent years. After one of the longest bull runs in history, more and more seemed to decide that allocating cash to buybacks was a good idea. Billions of pounds. I’m sure many directors would love to have that cash sitting in the bank today.
Now, there’s nothing wrong with buybacks, if the stock is undervalued. However, as Buffett has also noted: “Blindly buying an overpriced stock is value-destructive, a fact lost on many promotional or ever-optimistic CEOs.“
To make matters worse, having bought back shares at high prices, many companies are now having to raise cash by issuing shares at low prices. In other words, buying high and selling low. The polar opposite of what successful investors do.
How to avoid these investing mistakes
Investors should hold an adequate cash buffer to guard against any external calamities in their own lives. How much is adequate will depend on your circumstances. Personally, I’m a belt-and-braces sort. Adequate, and then double it, might be my motto.
The point is, you don’t want to find yourself having to sell valuable long-term assets, like stocks, at distressed prices for want of near-term cash. In other words, you want to avoid being in the position many directors have put their companies in today.
On the buying high side, identifying good businesses, and being disciplined about the price you’re willing to pay for the stock, is important. While CEOs were going share-buyback crazy, Buffett maintained his valuation discipline. He said last year: “Prices are sky-high for businesses possessing decent long-term prospects.“
Similarly, in an article in December, I wrote: “If you’re seeing bargains in the market, left, right, and centre, I think it’s probably wise to tighten up your investment criteria a bit. You may find this gives you some ‘dry powder’ to take advantage of a market crash, if it does happen.”
In summary, an adequate cash buffer, and disciplined stock valuation, are the keys to avoiding the investing mistakes many directors make.
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G A Chester has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.