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The Joys of Compounding by Gautam Baid

To Finish First, You Must First Finish

Without a doubt, some people have become extremely wealthy through the use of borrowed funds. However, it has also been a means of becoming extremely impoverished. When leverage works, your gains are multiplied. Your spouse thinks you're brilliant, and your neighbours are jealous. However, leverage is addictive. After benefiting from its wonders, very few people return to more conservative practices. As we all learned in third grade—and some re-learned in 2008 financial crisis—any series of positive numbers, no matter how impressive, vanishes when multiplied by a single zero. History has shown that leverage, even when used by very smart people, frequently results in zeroes.

 

Leverage, of course, can be lethal to businesses.

 

Companies with significant debts frequently believe that these obligations can be refinanced as they mature. In most cases, this assumption is correct. Occasionally, however, due to company-specific issues or a global credit shortage, maturities must be met by payment. Only cash will suffice for this. Borrowers then realise that credit is similar to oxygen. When either is plentiful, its presence is unnoticed. When either of them is absent, that is all that is noticed. Even a brief lack of credit can bring a company to its knees.

 

Maintain adequate liquidity (cash reserves) so that you are not forced to sell assets during times of market turbulence and sharp drawdowns. Create an emergency fund equal to two years of living expenses and gradually increase it to five years as your exposure to equities increases over time. Risk exists when you need to spend money but are unable to do so.

 

Nothing is worse for an investor than selling an asset at rock-bottom prices in order to raise funds for a necessary purchase. This is the primary distinction between those who become wealthy and those who do not—the wealthy invest in assets that generate recurring cash flow for them.

 

After recovering from a bear market, how much you can retain is far more critical than how much paper profit you make during a bull market. But the quality of business matters the most in maintaining long-term wealth.

 

Businesses with staying power have stable product characteristics:

  • Substantial competitive advantage  
  • Fragmented customer and supplier base 
  • Prudent capital allocation
  • Growth mindset with a razor-sharp focus on long-term profitability and sustainability.
  • Corporate culture of intelligent and measured risk-taking  
  • Cash-rich promoter family or parent company that can infuse capital during periods of high stress  
  • Highly liquid balance sheet, and both the willingness and the capacity to suffer by investing for the long term at the expense of short-term earnings. 

These companies thus have higher longevity, higher duration of cash flows, and therefore higher intrinsic value.

 

From the perspective of an investor, staying power stems from a strong passion for the investing discipline; a constant learning mindset; a long remaining investing life span; low or no personal debt; frugality; discipline; a solid understanding of human behaviour, market history, and cognitive biases; a patient, long-term mindset; and a supportive family whose importance is greatly appreciated during the market's periodic rough patches.

 

The author says that an investor may have a good chance of making money if he clones and "copies" someone else's investment ideas, especially if they have a track record.

 

It's only natural for us to act in this manner, especially when we are under the influence of an authority figure. 

For example, copying trades of fund managers is because an investor admires them and has a track record of past success.

 

The issue arises when investors blindly imitate what others do.

 

It's OK to admire and respect other investors, but one should only buy a stock if the company is within the area of expertise of an investor and has a high margin of safety.

 

Instead of buying a stock based solely on a recommendation, the author advises developing to think independently and conduct own research and due diligence.

 

Even when someone invests based on their original ideas, mistakes are unavoidable. But, at the very least, they own them, and there's a good chance they will be able to learn something valuable from them.

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Units 28/35