Wednesday, February 17, 2010

Conservative Investing is Successful Investing

Mention conservative investing and what you often get are people who think that conservative investing means putting money away in the biggest, most stable enterprises which in turn guarantees safety of principal. If the invested capital happens to also appreciate in value, then even the better. But if not, at least being conservative helps one sleep better at night. That may indeed be true, but unless you're ready to ignore inflation, many investors have it backwards when it comes to conservative investing.

While it’s indeed true that enterprises like utilities are defined as conservative, simply buying the large, well known companies does not fulfill the goal of a successful conservative investment approach. Instead, such a viewpoint increases the confusion between acting conservatively and behaving conventionally.

Two Definitions

Conservative investing, when understood and applied properly, is not a low risk low return strategy. Investors must understand two definitions to appreciate the appropriate means by which to invest conservatively.

1. A conservative investment is one which carries the greatest likelihood of preserving the purchasing power of one’s capital with the least amount of risk.

2. Conservative investing is first, the understanding of a conservative investment is, and second, following a specific course of action needed to properly determine whether or not particular investments are indeed conservative investments.

Where many investors falter in attempting to invest conservatively is blindly assuming that by purchasing any security that qualifies as a conservative investment, they are in fact, conservative investors. In other words, such investors simply focus on the first definition.

Such a viewpoint is limited and costly. A successful conservative investment approach requires not only an understanding of what a conservative investment is, but more importantly the correct approach to take in order to identify what truly qualifies as a conservative investment.

Characteristics of Conservative Investment

If based on the first definition, investors already know what qualifies as a conservative investment, then one needs to know what characteristics define a conservative investment which is where the second definition comes into play. There are four broad categories with investors can use to identify a conservative investment.

1. The Safety Factor

Clearly any conservative investment should be able weather market storms better than most. In other to do this, certain characteristics stand out. First, a business should have a low cost of production. Being a low cost producer has the principle advantage that when a bad year hits the industry, the low cost producer has best chance of still churning out a profit or reporting a smaller net loss. Second, a business should have a strong research and marketing department. A company that can not compete by staying abreast of market changes and trends is doomed in the long run. Finally, management should possess financial skill as in doing so they will be well versed in things like per unit cost of production, maximizing return on invested in capital, and other essential elements of business success.

2. The People Factor

This is a rather self-explanatory qualification for a conservative investment. But take notice that excellent people can only be beneficial after a business has demonstrated the signs of quality above. Take note of Warren Buffett’s advice:

“When a management team with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”

A small company can succeed on the heels of one or two exceptionally talented people. But as a business grows, people throughout the organization must be counted if the company is to succeed and remain a conservative investment.

3. Business Characteristics

This third quality requires a little more work for investors but its well worth the effort. Here, the goal for investors is to determine what advantages or disadvantages may prevent the business from growing and earning more profits despite satisfying the first two conditions. Things to consider are the competitive landscape of the business. The existence of many competitors or the relative ease with which new competition can enter can affect the best of companies. The potential for excessive regulation could also be a game changer.

In essence, remember that just because a company satisfies the obvious conditions of being a conservative investment always remember to consider this third condition. The following examples will illustrate this concept further.

Those Who Fail and Those Who Pass

Great examples of those businesses that pass the test include names like Coca-Cola, Wal-Mart and Johnson and Johnson. These companies have demonstrated time and time again the strength of their franchises. Even more importantly, both of these companies will likely continue to have very favorable future prospects. Coke essentially competes with Pepsi and Dr. Pepper and no one else. More so, it’s unlikely that entrepreneurs are sitting in garages thinking about creating the next great soft drink company.

Because Wal-Mart exists and succeeds, that should raise a red flag for most other retailers, save for Target and a few specailty retailers. Remember Circuit City, which used to be number 2 to Best Buy in electronic retailing? It’s now bankrupt in no small part due to Wal-Mart. Toys ‘R’ Us was taken out in a private transaction a few years ago due to various competitive threats which likely included Wal-Mart's expansion of its toy department.

Of course once a passing company has been identified, the stock price matters only inasmuch as to determine the value gained. Today, names that pass and trade at very attractive prices include Kraft Foods, Pfizer, and Vodafone.

A Collective Approach

Investing conservatively is not about simply identifying large well-known businesses, but going through a process that identifies why a particular company qualifies as a conservative investment. And as you can see from the names above, being an conservative investor can lead to some of most dependable and respectable returns in the market.