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Dear Reader,
It won’t be wrong to call Benjamin Graham and Warren Buffett as the Newton and
Einstein of investing respectively.
No other investor has done as much to take the complexity out of investing as these
two gentlemen.
And of course, not to forget their market beating systems that are both timeless as
well as mighty effective.
How about starting this report by highlighting how both these gentlemen define
investing?
Here’s how both Benjamin Graham and Warren Buffett define the term.
Graham first.
Ben Graham has put safety before return. He has given more priority to protecting
the investment corpus than trying to earn big returns on it.
While he hasn’t defined investing per se, he has what he calls his only two rules for
investing.
The similarity with Ben Graham’s definition is hard to miss. The greatest investor in
the world also swears by safety first. Even he prioritises the return of capital over
the return on capital.
Does this not fly in the face of conventional wisdom? Is it not counterintuitive to how
most investors think?
Most investors believe that higher returns are not possible without higher risks.
Their mantra is to maximise the upside and not worry about the downside too much.
We don’t have to go too far back to find out how dangerous this approach is.
Investors lost a bundle in mid and small caps in 2018 and 2019 precisely due to this
approach.
They piled into these stocks without worrying about the downside at all.
All that mattered to them was the promise of a huge upside. But as Graham and
Buffett show, this is not how it works in investing.
Trying to maximise upside without protecting the downside is a recipe for disaster.
Unfortunately, the lesson had to be learnt the hard way. Most investors who
prioritised returns over safety of capital, lost their shirts in the crash.
In fact, go back to any crisis in the stock market and the exact same pattern plays
itself out repeatedly.
Those investors who don’t build any downside protection suffer the most. They are
the ones who end up with poor long-term returns.
It won’t be wrong to say that my mission in the Double Income Project is to strike
the right balance. The right balance between maximising returns and minimising
downside. I will be wary about risking too much in the quest for extra returns. I will
also be mindful of being too conservative in the name of safety of capital.
Luckily, my Income Supervisor Map is just the right tool for us on this journey.
It is a blend of the key philosophies of three of the biggest legends in the investing
world.
My Income Supervisor Map borrows from the key investment principles of these
titans of investing.
And the result is a fantastic blueprint that could double your income in the quickest
possible time.
What exactly is this Income Supervisor Map and what exactly does it borrow from
each of three legends? Well, let us find out.
I am not going to bore you with the details of the speech. You can read it in its
entirety here.
The investor must recognize that there are uncertain and hence speculative
elements in any policy he follows — even an all-Government-bond program.
He must deal with these uncertainties by a policy of continuous compromise
between bonds and common stocks, and by adequate diversification.
No one can predict the future. No one has a crystal ball. Thus, the best way to
prevent your capital from getting totally wiped out is to have some of it in stocks
and some of it in bonds.
I know this approach will do a world of good to our principle of safety first. After
all, the capital invested in bonds will be safe even if there is a huge stock market
meltdown.
Will this approach ensure we not just minimise downside but also maximise upside?
You see when markets are cheap, you should maximise your stock exposure and
when they turn expensive, you should maximise your bond exposure.
In other words, when there is a high probability that stocks would do well over the
next 1-2 years, stock allocation can be high. It can go to as high as 70%-75% with
the remaining in bonds.
This rule kills two birds in one stone. It tries to maximise upside and at the same
time, doesn’t throw caution to the winds. It ensures at least 25% of the capital is
invested in bonds at all times.
Graham didn’t pluck this rule out of thin air. He very well knew there is a vicious
correction in the market every few years. This tendency may not change because
human nature is what it is.
It is one of the best ways to outperform the market in the long run.
My Income Supervisor Map has thus taken inspiration from this Graham strategy.
When markets are cheap, it can have as much as 75%-80% in stocks.
And when they are expensive, as much as 40% of the corpus will be recommended
to be invested in bonds.
Please note that the allocation will be reviewed every year. Fresh allocations will
be recommended based on the broader market valuations prevailing at the time.
I believe this one rule will go a long way towards achieving our long-term goals.
With the broader allocation out of the way, let’s turn our attention to individual
stocks.
What are the kind of stocks that will make up the stock portion of the corpus and
how much to be invested in each stock? Well, here’s where Warren Buffett comes
in.
There’s no doubt that Coke has played a stellar role in Buffett’s rise as one of the
best investors in the world.
But as per Buffett himself, his big aha moment came after his investment in a much
smaller company. It was See’s Candies that presented him with a life altering insight.
Here’s him.
We have made a lot more money out of See’s than shows from the earnings
of See’s, just by the fact that it’s educated me. If we hadn’t bought See’s, we
wouldn’t have bought Coke. So, thank See’s for the $12 billion. We had the
luck to buy the whole business and that taught us a whole lot.
If Buffett wouldn’t have bought See’s Candies first, we would have perhaps never
bought Coke.
But what’s so special about See’s. Why did Buffett go ga-ga over this investment
of his?
Well, simply because no business comes closer to being called a dream business
than See’s Candies.
When Buffett bought See’s in 1972, it was earning US$ 5 m in pre-tax profits on US$
8 m of capital.
What was the situation in 2007? Pre-tax profits had gone up to US$ 82 m.
And here comes the shocking part. The capital invested in the business went up
from US$ 8 m to a mere US$ 40 m.
So, in 35 years, the company earned an extra US$ 1.35 bn in profits by investing a
mere US$ 32 m in incremental capital.
Yes, I am going to look for stocks that are huge cash generators. Stocks where the
underlying business is mostly self-sufficient when it comes to funding growth.
They should generate enough cash so as to fund their entire growth without
resorting to borrowings.
And this is going to be my number one criterion for recommending a stock in the
Double Income Project.
If the stock does not pass this test, I will most likely give it a miss.
And if it does pass the test, it will be subjected to other parameters. I am talking
about parameters like competitive advantage, management quality, and margin of
safety in valuations.
So, for the stock component of the Income Supervisor Map, I am going to recommend
an allocation of maximum 60% and a minimum of 25%.
The group of stocks that will find their way into the service will of course be strong
cash generators.
The plan is to not have more than 4%-5% allocation to each stock at the time of
recommendation.
The buying and selling would of course depend on the discount and the premium
to our understanding of the true value of these stocks.
Worth pointing out this allocation is extremely crucial. It is this allocation that will
play a key role towards meeting our return objectives.
And what better way to identify stocks for this allocation than to lean on Warren
Buffett’s time-tested strategy.
So, we have now taken care of the 65% of the overall allocation on the lower side
and 80% on the higher side.
What about the remaining 20%-35% allocation for our Income Supervisor Map?
Where should this money be invested?
This is where our third guru, Jack Bogle enters the scene.
This is a boon as well as bane. A boon because mid and small caps usually provide
greater returns than large caps. They give you that extra edge.
The higher returns are mostly accompanied with higher risks. This is why you need
a counterbalancing force. In other words, you need the stability of large caps even
if it comes at the expense of slightly lower returns.
And this is exactly what I intend to do with the remaining 20%-35% allocation in the
Income Supervisor Map.
When the broader market will appear to be attractively valued, the allocation to
stocks will go to as high as 80% out of which, 20% will be invested in large caps.
And when the markets turn expensive, stocks will account for only 60%, 35% of
which will be allocated to large caps.
Well, there’s a small twist here. Rather than pick the large caps ourselves, we are
going to recommend a Nifty index fund.
Yes, that’s right.
For the first time in the history of Equitymaster, we will recommend a low-cost index
fund that tracks the Nifty benchmark.
Bogle believes the odds are heavily stacked against an investor whose goal is to
earn market beating returns. This is even more difficult in the case of large caps.
If a statue is ever erected to honor the person who has done the most for
American investors, the hands down choice should be Jack Bogle. For
decades, Jack has urged investors to invest in ultra-low-cost index funds.
In his crusade, he amassed only a tiny percentage of the wealth that has
typically flowed to managers who have promised their investors large
rewards while delivering them nothing – or, as in our bet, less than nothing
– of added value.
Indeed. Bogle revolutionised investing and argued there is no point in looking for a
needle in a haystack. His advice was to buy the entire haystack.
And this is precisely what we are going to do to the large cap component of our
Double Income Map.
Luckily for us, the proliferation of these funds in the last few years gives us plenty
of options to choose from.
I believe a low-cost index fund will be a vital cog in our double income strategy.
After all, the stock market has returned close to 15%-16% per annum over the long-
term. Thus, if history repeats itself, these returns could be ours for the taking.
A map that can display both conservatism as well as aggression depending on the
market environment.
This allocation will of course vary from person to person. For something that works
best for you, we recommend you talk to your investment advisor.
Worth highlighting that implementation will be the key here. The strategy behind
the map is a very sound one in my view.
If followed with discipline, it can serve an investor for a long time to come.
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