Warren Buffett’s maxim on investing is often quoted. “Rule Number 1: Never lose money. Rule Number 2: Never forget Rule Number 1.” Like most such statements there is wisdom there, but it doesn’t tell the full story. All investors will see declines in the value of their investments from time to time. It is important however to differentiate between a permanent loss and a temporary price fluctuation. Price fluctuation or volatility is a common occurrence and cannot be avoided. Prices change every day. Permanent losses on the other hand, should be rarer but even they are sometimes unavoidable.
The aim of managing an investment portfolio is to ensure that it meets the investor’s financial objectives now and in the future. That will generally involve achieving a reasonable return on investment over time and avoiding, to the extent possible, permanent loss of capital. To do that, we believe that there are three key elements to building a successful portfolio. The most important factor to be considered is the quality of the business being acquired, ranking highly in such measures as competitive advantage, profitability, management skill and financial stability. Of course, businesses that will “tick all the boxes” for quality are very rare and investors must often assess whether strength in one area can sufficiently offset some weakness in another.
Next is price. Even the highest quality business would represent a poor investment if the price is too high. Ideally, shares would be acquired for a price less than their economic value but paying full price for a high-quality business may still meet our objectives. Overpaying however, would be a blatant violation of Buffett’s Rule No. 2.
The third major factor is to keep some cash on hand. On a day-to-day basis, cash acts as a drag on investment results as it returns virtually nothing after inflation and may produce a negative return in taxable accounts. Its availability however, can have considerable value in the right circumstances. Price volatility can offer opportunities to acquire shares of quality businesses at attractive prices. If the opportunity can only be acted upon by selling shares of another quality business in the portfolio at a depressed price, little is accomplished. Having cash available allows the investor to take advantage of opportunities as they arise.
When referring to cash here, we are referring to the cash that is part of the portfolio allocated for longer-term investment purposes. Cash that will be required for near-term spending should be reserved solely for those purposes and would not generally be available for investment.
Quality, price and cash – three keys to the success of your portfolio this year or any other year.