What we need to defend and grow our Financial Castle

This is an article long in the making. Much has happened since I first started writing this article in Nov, 2019. Four months feels like a long time for those who watch the stock markets. Well, one month feels like a long time (US indexes hit the highest in mid-Feb and down over 20% by mid-March, 2020). In fact, even one week feels like a long time (since Oil prices tanked 30-40%). Now, as I put finishing touches to this article, FED has announced interest rate cuts to 0-0.25%, which are lowest in US history and we still have a virus that is rapidly spreading throughout the world putting both lives & livelihoods at stake.

I clearly remember what a distant uncle of mine told me two decades ago. As I lay in bed recovering from my first major knee surgery as a teenager, he told me clearly, "Yedu, in the long run you will be fine. But, you will not be the same."

In the long run, we will all be fine. But, we will not be the same.

In most countries, when a crisis of unimaginable proportion hits, the army is called for help. The army consists of people who are among the most courageous, strong, healthy, disciplined and self-sacrificing when compared to the common population. What can we as investors do to raise such an army of companies to defend our financial castle?

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I am frequently asked about what it means to build a portfolio of companies and why one should do it. After all indexing is a pretty safe bet. For me, the chance to build a collection of businesses that reflects my family's dreams, desires and destiny is a challenge worth pursuing any day. But, this comes with some risks and I think about those risks almost all the time. Warren Buffett says, "It takes twenty years to build a reputation, but only five minutes to ruin it". In the same way, it takes several decades to build wealth, but only few weeks, months or years to ruin it. My philosophy has been to find the best businesses that have long runways at the lowest possible risk. As with all articles I write, my hope is that someday my kids would enjoy reading it and can take something of value from these words.

"It takes several years to build wealth, but only few weeks, months, years to ruin it"

Anyone whose goal is financial independence, increasing their net worth or even preserving it, should be worried about the potential destruction of wealth as the worst case scenario. According to the legendary investor Warren Buffett, risk in investing is defined as potential for permanent loss of capital. Mr. Buffett says high volatility does not necessarily mean high risk, unlike what conventional financial wisdom teaches everyone. Hence, a stock that is very volatile may or may not be risky compared to a stock that is not so volatile or a bond which has a fixed coupon attached to it.

This brought me to the question - What can an individual investor do to build something that can protect his/her net worth from permanent loss of capital but also compound at high rates in good times? If the wealth of investor can be thought of as his/her financial castle, then maybe the answer lies in building a small army of companies. An army that not only grows but also is strong enough to tide over any misfortunes caused by human or natural causes like war, famine, political turmoil, trade wars, recession, inflation, deflation, hurricanes, floods, earthquakes and viruses.

"Risk in investing is defined as potential for permanent loss of capital" - Warren Buffett

I love the concept of "MOAT" as defined by Warren Buffett and Charlie Munger. A strong “moat” around a medieval castle was supposed to defend the castle against all enemies. Additionally, in my opinion, to defend his/her castle the investor needs an army as well. A very good, battle tested army. This means in business terms prior history of navigating recessions, price wars, labor wars, regulations, fines, competition, reputation damage and maybe even a global pandemic. It is not necessary that every member of this army be battle tested, but, at least the most important ones. The army in financial terms is a collection of businesses, each one having unique properties and skills just like the various constituents of a well-trained army in real life.

Can this so called Army protect the investor from permanent loss of capital, while also expanding his/her financial empire? Let us find out the answer by closely examining the unique properties that define this army.

1. Attack dogs - The best defense is always a great offense. Like in an actual war, you need few very fast, nimble young businesses with excellent growth rates to lead your army in front lines. They need to scout far and wide. Be innovative, cause maximum disruption in business models of their competitors (think opposing enemy lines). Would you rather own a business that is easy to get attacked or get disrupted or a business that is the disruptor and recking havoc across enemy lines? The answer should be obvious. If it is not obvious, you need some of the latter, especially if they are profitable with huge tailwinds. (Ex: $FB, $NFLX, etc.)
2. 5-Star Generals - The investor would be well served to own businesses run by the best managers or capital allocators. It is even better if the company is run by founders with massive skin in the game as their incentives would be aligned to that of the individual shareholder. Since the founder built the company, knows it's customers' needs and also understands the competition the best, he/she can be considered a battle-tested general. I ask this question myself, would I like to have the best battle tested generals on my side or the other? Especially if they are on industries with wide-moats, like your strong castle. They would have all the weapons - money, people, customers, economic moat to withstand any attack. (Ex: $AMZN, $BRK.B)
3. Cavalry - Some of your best hardened fighters are found in the largest part of the army - the cavalry. This is where you would find the biggest and best companies that are the economic engines of the world as things stand presently. What the investor is looking for is dominant highly profitable large companies with high returns on invested capital, growing revenues, margins, good management and culture that promotes serving the customer. (Ex: $MSFT, $AAPL, etc.)
4. Heavy Armor - Like the tank, aircraft carrier and the bomber, these companies are large, stable and been around for decades. These companies also return huge chunks of capital to their shareholders in terms of dividends and buybacks. For example, there are very few companies in the prestigious list of being considered dividend aristocrats and kings. They offer great source of sustained and growing income streams, which can be beneficial during any battle or war. It is in the investors best interest to study them and figure out what might keep them around for several more years or if there are any new entrants to this list to hold for long time. (Ex: $KO, $MCD)
5. Defenders - Every championship team in any sport has a great defense (In cricket, this is a bowling attack - West Indies in '80s, Australia in '90s-00s. In NFL, this is '13 Seattle Seahawks or '85 Chicago Bears. In football, it is Italy and their stifling defence). Investor would be well-served to have few companies which are good defenders. When all things fail, these companies would help you sleep at night knowing they’re the last line of defense protecting your castle. I would call these companies recession-proof. (Ex: BRK.B, $COST, $WMT)
6. Air Support - Whether the battle is in land, air, water or space, calling in air support has proven to be a vital part of any modern war. In real-life terms, think of this as calling a life-line or phone-a-friend to . An investor should always be humble to know that he/she doesn’t know everything and can learn from someone else at all times. Just studying the portfolios of other great investors to see how they are preparing themselves for battle is what I mean by calling in air support. You don’t always have to do it all alone. Cloning works best, if you know the reason behind it. Developing that circle of competence to understand various businesses is the investors job. 
7. Reserve Force - I think I kept the most important asset to the last. No empire can survive if it cannot dig deep into it's coffers in times of extreme distress. Cash (or Gold in case of empires) is thus extremely valuable since that is the resource required to built the army in the first place. If cash is not around when you need it the most, then years of financial struggle is sure to follow. This is true for individuals as well as companies. Companies that rely on debt for their operations can suddenly look at extinction when credit dries up, as it often does during recession. Cash is King, especially if others run out of it. (Ex: BRK.B, GOOG)

If an investor builds an army with companies that has the above 7 characteristics, then she/he has a fighting chance of survival and defending their castle. If the investor finds companies that may fit into more than one of these categories, it can have a "lollapalooza effect". For example, if you find a young nimble company with long runaway ahead of it, run by an outstanding founder CEO with a large stake and is recession-proof, then hold on to it.

Avoid Leverage - One of the most important things for individual investors to avoid like the plague is the use of leverage in investing. Margin calls can tend to wipe-up the investor and their hard earned capital.

Think of companies you own as Allies in your war on poverty and ignorance. I am not sure if this army needs to be size of 5, 10, 15, 20 or more companies. That is up to the individual building the army to decide based on the time he/she has to nurture this army. In other words, how much time the investor has to spend to research and read up on all the details of the companies in their portfolio.

Whether you like it or not, the beast (the dragon) would come eventually to destroy your castle. The army better be prepared to face it and come out unscathed at the other end. Do you have your army? If not, what are you waiting for??

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Yedu Jathavedan