Warren Buffett on Real Investment Risks – And What You Can Do About It

Around this time every year, the investing community will be awash in excitement over the many investing insights to be found in Warren Buffett’s annual Berkshire Hathaway shareholder letters.

This year’s edition, the 2014 letter, was made doubly special as it included a special section that detailed Buffett and Charlie Munger’s (Berkshire Hathaway’s vice chairman) thoughts about the company’s past 50 years and the next 50 years.

As is the case with all of Buffett’s shareholder letters written over the years (you can check them all out here – go on, it’d be great), there was also plenty of wisdom shared in the 2014 letter. One in particular stood out to me, and it concerned how investing risk is defined by large swathes of the finance community (emphases mine):

“Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions.

That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.”

Although volatility (the act of asset prices moving up or down over the short-term) is often confused with real investing risk, they are not the same thing. Real investing risk, while they can have different nuances for individuals at different stages of their lives, really only concerns these:

  1. The risk of earning an inadequate return; and
  2. The risk of suffering a permanent loss of capital.

I want to expand upon the second one here. There are many things that can cause a permanent loss of capital and one of them is financial weakness in the companies you hold shares of. Such companies can cause a permanent loss of capital because of:

  1. Bankruptcy;
  2. Forced sales of vital income-producing assets which would permanently damage the strength of their businesses going forward; and
  3. Massive dilution of existing shareholders’ stakes in the company due to the need for raising equity (the act of selling new shares) in order to raise capital to meet the firm’s financial obligations.

Fortunately for investors, there’s an easy way to deal with that particular source of risk – the risk of a permanent loss of capital due to financial weakness – and that is to focus on shares with strong balance sheets and the ability to produce free cash flow (the cash produced from the business that can be used to pay down obligations and reinvest in the business).

Companies like Vicom Limited (SGX: V01), Raffles Medical Group Ltd (SGX: R01), and Super Group Ltd (SGX: S10) are good examples of locally-listed firms with that particular set of strengths.

The first chart below shows how the cash and debt-levels for the trio have evolved over the past five years; as you can see, debt has remained minimal or at zero over that time frame for them. Those are signs that the trio possesses strong balance sheets.

Balance sheet history for Vicom, Raffles Medical, and Super

Source: S&P Capital IQ

The next chart below plots their free cash flows over the same period and we can see how the trio have mostly been able to deliver positive free cash flows throughout that block of time.

Free cash flow history for Vicom, Raffles Medical, and Super

Source: S&P Capital IQ

There’s certainly a chance that the trio of Vicom, Raffles Medical, and Super, can lose capital permanently for their investors through other ways.

For instance, their shares are not cheap with them being valued currently at between 19 and 32 times their respective trailing earnings. In contrast, the SPDR STI ETF (SGX: ES3), an exchange-traded fund which tracks the fundamentals of the market barometer, the Straits Times Index (SGX: ^STI), carries a PE ratio of just 14 at the moment.

But at the very least, given their rock-solid balance sheets and ability to produce free cash flow, the chances are very slim that the trio would go bankrupt, be forced to sell assets, or issue equity in dilutive ways over the next few years.

In any case, it’s not that tough to spot real investment risks. What may be harder though, is finding the truth – that volatility is not risk – amidst all that nonsense out there that equates volatility with real investing risk.

For more investing analyses and important updates about the stock market, sign up to The Motley Fool Singapore's free weekly investing newsletter, Take Stock Singapore. Written by David Kuo, it can help you grow your wealth in the years ahead.

Like us on Facebook to follow our latest hot articles.

The Motley Fool's purpose is to help the world invest, better.

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing owns shares in Berkshire Hathaway, Vicom, Raffles Medical Group, and Super Group.