Defense is the best attack

If you haven't read War and Peace you must. If you have, read Sun Tzu's Art of War and analyze Russian general Kutuzov's strategies. When you do that, you would come to realize that ‘defense is the best attack' isn't just a catchy title.

In the summer of 1812, when 7 lakh strong Grande Armée of Napoleon attacked Russia, Mikhail Kutuzov replaced Barclay as Russian commander-in-chief because Barclay had refused to take the battle head on and had made strategic retreat. The regular Russian forces were one fifth the size of invading army and engaging enemy forces on open flanks would have been suicidal for Russians. Kutuzov, despite his rhetoric to the contrary, continued his predecessor's strategy of retreating when odds were not in his favor and fighting minor battles opportunistically. By September, the Russians had retreated beyond Moscow and the empty city fell into enemy hands. The city was burned to ashes in a major fire. Having accomplished his mission Napolean started on his way back to France in October. Amid this seemingly stunning defeat, Russian commander Kutuzov managed not only to preserve a majority of his forces but to increase the strength by drafting a large number of reinforcements. He forced the retreating French army to take the same route from which they had come. The French Army(and retreating Russians before that) had already stripped the entire region of food supplies on their way to Moscow. On the way back, they ran short of supplies. As the unforgiving Russian winter arrived, the French army was literally eating their horses. With no cavalry and wagons left, the attacking power and logistics of the army were severely impaired. At this point, Kutuzov launched guerilla attacks and literally wiped out the enemy forces from Russian territory. When the Grande Armée reached France, it was a small force, a tenth of its original size; weakened by starvation, disease and casualties. This disastrous invasion marked the beginning of an end to Napolean's dream of dominating Europe. Three years later Napolean met his waterloo.

This extensive detour was meant to underline a strategy hugely successful in investing and many times in war. I call this strategy "defense is the best attack". Every time a stock jumps by 15% or more in a day, somewhere a heart sinks. "Why didn't I buy it?" Unitech Ltd, troubled real estate and infrastructure company, fell 90% in 6 months from its peak in May 2008. You were thinking of buying it but you didn't. The stock went up by 41.86% on Oct 27th, then again by 15% on Oct 28th. You cursed yourself for not buying it. You were neck deep in losses. You told yourself "attack is the best defense" and bought it at 49.1Rs. After all it was still 84% blow its peak. In coming months it sank back to 25 and so did your heart. Then came the rally and finally you got the chance to exit at no profit no loss. Sigh of relief.

Just forget it. You are not in casino. You worked hard in you college days to equip yourself with skills for a job. Then you toiled day and night to earn money and denied yourself many things to save the money you are investing now. Why lose it?

I'm never in the race to buy the stocks that can potentially give me 100% returns in few weeks. I'm after the opportunities that given me close to 100% probability of making above average returns in long run. Let me explain with an example.

On November 24th, Dredging corporation , a PSU monopoly in dredging business, was selling at 200Rs. It's a debt free company and it had Rs 663.60 Crs, as Net current assets at the end of last financial year which translate into Rs 237 per share. Last year it earned Rs 55.29 per share and in the current year, it has earned Rs 20.5 per share in nine month. So the stock was selling at 23% discount to the cash when I bought it. Can I lose money in this bet in long term. Highly improbable! Markets recognized this fact later and the stock is up by 85% in 6 months.

Can someone else lose money on this stock? Yes. If you don't have an idea of its worth, you CAN. Say you buy at Rs 235, still a good price and it falls down to 175(which it did). You may not have guts to stick to this stock at this price and may have sold at loss.

The trouble with small investors is that there are far too many people having guts to buy not-yet-in-business Reliance power in its IPO at 430, distressed Unitech at Rs 50 and tainted Satyam at 100 but there are no takers for buy a Dredging Corporation at Rs 200, way below its worth. I'm usually like a lone buyer at deserted counters where live elephants are selling for peanuts because everyone is busy bidding sky high prices for dead cats for the supposed aphrodisiacal properties of their bones.

These misplaced bets speak volumes about the misplaced confidence in the capability of the market to price assets correctly. When you look at 52 week highs, you giving looking upto a fool who thought the stock had got wings and it can defy gravity. In some corner of your heart, you are hoping that the same fool will be back, willing to buy at the same exorbitant price. Most people are once bitten twice shy. They don't lose money on the same things that cost them a fortune last time around. They discover new ways of losing money. Don't be fooled by such flights of fancy. Even ants get wings that last only for a brief nuptial flight!

Aggressive strategies which run a risk of significant losses can cripple you so badly that you may not be in a position to make good returns when markets revive. There is an interesting mathematical certainty of losing associated with flawed strategies which will be dealt in next article in Unfair Value.

The last part of my argument is that defensive approach not only protects your principal, it produces extra ordinary returns for you. These extraordinary returns come because you make reasonable gains when markets go up but you lose very little, if any, when they go down. If I were to quote the performance results of legendary value investors like Buffett, you may attribute their extra ordinary results to their brilliant minds but much of that brilliance is the brilliance of strategy adopted by them. That's why I would rather talk from my personal experience. During the boom from 2003 to 2008, I managed to earn returns slightly below the returns of Sensex even though my portfolio was much less volatile due to significant exposure to defensive stocks and some debt. However, the Sensex couldn't hold on to its gains whereas I did, by selectively pruning exposure into stocks which had become overpriced and increasing exposure to businesses that are bound to live through the this downturn. I did not sell my favorite stocks and bought more of the same on declines. The result is that in past 12 months, I haven't lost money even as Sensex has lost a third of its value and mid cap indices have lost close to half their value. I've been comfortably cruising above my targeted long term return rate of 2.5 times the risk free rate(currently 8%) and I've no reason to change my strategy or prescribe any other strategy to others.

To quote Sun Tzu, from Art of War. "The general who advances without coveting fame and retreats without fearing disgrace, whose only thought is to protect his country, is the jewel of the kingdom". Protect your portfolio. Don't get adventurous just because you want to show your friends how quickly you doubled your portfolio. Buy companies with wide moats sustainable competitive advantage around them, buy them at prices that leave a huge margin of safety, and you will never lose money.