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Issue 109, 09 August 2002

Investor's College The investment equation In the first of a series, we introduce the critical issues of capital preservation and price volatility. Investing is all about laying out money now to receive more back in the future. So the key questions are - how certain are you that you'll get your money back at all? If you do get your capital back, what sort of return are you likely to receive and when are you likely to receive it? And, finally, how do alternative investments stack up against the one you're considering? This can be termed the investment equation. And in this article we're going to discuss the first question. Over the next few issues we'll consider the others. Return of capital Before worrying about return on your capital, worry about return of your capital. So, let's consider the first question - what are the chances of getting your money back over time? Well, if you're concerned about protection and growth of your capital over the long term, the quality of the company's underlying business and assets should be your main consideration. That sounds like straightforward advice but, for some reason, it's logic that escapes many academics and professional fund managers. Many of them look to the share price to assess risk (beta). We think this is dead wrong. For example, the value of companies like SecureNet and Great Southern Plantations are certainly not changing as fast as their share prices. Their main assets, cash and land respectively have quite stable values but, strangely, their share prices do not reflect this fact. Our feature article on thinking about market prices in issue 90/Oct 01 introduced Ben Graham's instructive parable of Mr Market. There we explained that you should aim to take advantage of the psychotic Mr Market rather than rely on him as your guide to intrinsic (real) value. And this is where we believe the rocket scientists get it wrong. Precipitous falls in stocks like CSL tell you that the market has bouts of irrationality. As we pointed out Investor's College article in issue 96/Feb 02, at $50 the market was pricing in more than 20% annual growth over the next ten years for this stock. High expectations Now, although CSL is a sound enough business, investors had such high expectations that they were bound to be sorely disappointed sooner or later. It just happened that the disappointment arrived sooner than even we had expected. So if you want to preserve your capital, you must form your own opinions and stick to them. You may look silly in the short term (as we have done with Woolworths) but you will give yourself a greater chance of avoiding wipeouts on such stocks. Over time, such expensive stocks have proved less attractive investments than 'value' stocks with more realistic valuations. Now this statement may seem to contrast with our 'Rolls Royce' stocks such as Macquarie Bank, STW Communications and Westfield Holdings, where we retain favourable recommendations. We believe such stocks are the exception to this rule. Their excellent businesses combined with outstanding management give us confidence they will justify their high price tags. We shall see, shan't we?

C o p y r i g h t Š 2 0 0 6 The Intelligent Investor . Published by The Intelligent Investor Publishing Pty Ltd. ABN 12 108 915 233. Australian Financial Services Number 282288.

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