Businessman Investor

Touching base with the rational business psyche of stock market investors

Friday, September 16, 2011

Capital Preservation and Rational Potency of Earnings

This is Part 2 of a Series. Go to Part 1: On Discount Rates, Required Rate of Return, and Conservative Purchase Price.

The idea behind capital preservation is defensively allocating capital in a safe investment position (thus, preserving your money’s worth) but at the same time exposing it to the prospect of profits (or capital gains)—Simply, it is earning without risking losing money. The cardinal concern shouldn’t really be profits—it should first be preserving capital. Profits only come secondary after making sure we don’t lose money. If we start concerning ourselves on this primary consideration, then we’d undoubtedly be diligent and be very cautious in our allocations.

Earning without risking losing money. Capital preservation should remain top priority, with earning profits only being an afterthought.
So if that be the case, then why not just easily opt to hold hard cash, you may think? Well that’s hardly the solution. Complacently leaving your cash lying in the room or under your bed or pillow would diminish its worth because of that value-sucking animal called inflation—the real enemy. Capital preservation is therefore achieved only through placements in value-enhancing instruments which, at the least, beats inflation.

In the realm of stocks, capital preservation can be ascertained by banking on very conservative assumptions of underlying value. Why underlying value? Because that can only be your best bet towards consistency and predictability. If you rely on market value, you’d be subjecting yourself to the whims, emotions, and ups-and-downs of the market. And that would certainly not preserve capital. (An aside though: take note that this is only true if we exempt arbitrage plays; in arbitrage scenarios, the pursuit of value is not found on the underlying business, but rather on the difference between prevailing market price and the publicly declared market tender offer—the arbitrageur viewing the discrepancy as his source of value gain). Nonetheless, certainty is key.

If underlying value is measured by way of book or equity value, then buying a stock way below its book value would warrant the investor a sense of capital preservation. Another method which I personally prefer is buying a stock below its perpetuity annuity value—that is, what its value would be if we assume it’s going to produce flat free cash flows at a certain safe level, and discounting them all back at a required, conservative rate. It’s that mindset or attitude which is focused on identifying a baseline level of value (or deep purchase price) which shall act as a cushion or guide against the dangers of paying up too much at an expensive price; it can also serve as a buy/exploitation trigger whenever the market is too depressed and feels like punishing the stock too much (when it comes to an excellent business, a falling price is never an issue—in fact, it’s always a welcomed opportunity).

The idea of rational potency of earnings, on the other hand, comes more of an afterthought after ensuring capital preservation. It can be deduced from the fact that the purchased investment instrument has in itself an underlying profit-producing asset. Hence, it is that comforting thought that when one is able to acquire an asset at a price level which warrants capital preservation, the profit-making capacity of the business would take care of your potential earnings. Or if you’re more conscious of it, it exposes you, the investor, to the potency or prospect of stock market capital gains without risking losing money.

We only speak of earnings in its potency or potential state because of the reality that value can never be precisely predicted. But while accurate projection can never be done, intuition or common-sense would dictate that it can be assessed, evaluated, or gauged as long as it remains within the realm of reason or rationality—that is, it never escapes what the underlying business, in its capacity as a real, operating economic unit, can realistically achieve. Thus, the term: rational potency.

After buying a stock below its equity value, you're better off now minding your net worth in book value terms, independently viewing each earnings report as an enhancement of your net worth regardless what the schizo market thinks. In using the equity perpetuity approach, rational earnings potency come from the fact that excellent businesses don't produce flat earnings—in fact, they grow them.

In a nutshell, what we intend to do as value investors is to earn satisfactorily without (or at least greatly minimize) risking losing money.

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The information presented here is for educational purposes only. Under no circumstances should it be construed as a recommendation to buy, sell, or hold any stocks. If you choose to use this information, you do so at your own risk.

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