How to Protect Your Capital

No one wants to lose money.

But surprisingly, a LOT of investors see chasing returns as more important than protecting their capital.

They jump into tiny speculative stocks they know nothing about. And they bet sums they can’t afford to lose.

They’d be better off buying a lottery ticket. The chance of winning is worse than terrible. But at least they only lose a few bucks.

This is not to say you shouldn’t ever speculate. Intelligently buying small businesses with two or three variables working in their favour can lead to extraordinary results.

It’s not uncommon to see gains of 1,000% or more in a relatively short time.

But whatever you do, don’t speculate with sums you can’t afford to lose.

I feel this goes without saying. It’s just basic common sense. Yet, it doesn’t stop masses of investors betting tens of thousands they can’t afford to lose on speculative bets.

So where should you invest a majority of your wealth?

Invest in wonderful businesses

No…I’m not going to tell you to buy BHP or CBA.

These are not wonderful businesses.

BHP’s earnings are extremely unpredictable. Regulators have also put a cap on banking returns, including CBA.

A wonderful business is one that can grow earnings no matter what’s happening around the world. It’s a business that will be around for the next 10 to 20 years.

And it’s not all that hard to find these businesses today. I’ll bet you can name a couple right off the top of your head.

REA Group [ASX:REA] is a wonderful business. Alphabet, Inc. [NASDAQ:GOOG] is a wonderful business. Even the recently beaten down Facebook, Inc. [NASDAQ:FB] is a wonderful businesses.

But of course, just because these businesses are wonderful, doesn’t make them screaming buys. The far harder part is determining if these wonderful businesses are worth what they trade for in the market.

The sad fact is many of these stocks hardly ever go on sale.

Could this change soon?

Facebook’s stock just recently went on sale to the tune of 20%. Global interest rates are rising, making stocks more expensive. And then there’s talk about government regulation, which could harm future growth.

Is now the time to be looking at the wonderful businesses?

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Is now the time to buy or sell stocks?

Yesterday I wrote to you about international exposure.

Regions like Asia, South America and even Eastern Europe are all fast growers. As such, growth is lumpy from year to year.

But over time, businesses with exposure to these regions could see earnings rocket to the moon.

Money managers are well aware of this fact. It’s why many funds don’t hold just Aussie equities. Most hold a few businesses in Australia, some in the US and a couple in Asia.

Maybe the most sought after stock from the latter have been the big three: Baidu Inc. (ADR) [NASDAQ:BIDU], Alibaba Group Holdings [NYSE:BABA] and Tencent Holdings Ltd [HKG:0700].

The BATs, as some investors call them. They represent the Google, Amazon and Facebook of China. While these descriptions aren’t entirely true, it’s an easy quick way to understand what they’re about.

For years, you could argue all three have been wonderful businesses.

If we take a look at Tencent, the company has been growing sales and earnings every year since 2001. And this is not annual growth of 2-5%.

Tencent’s sales are up 484,136% and earnings have risen a whopping 829,792% in that time.

Had you got in early, you could have made more than 58,000% on the stock!

Even buying Tencent two years ago could have doubled your money.

Its why so many fund managers believe it was a must have stock.

The business is essentially a growth machine that doesn’t stop, or at least it was.

From South China Morning Post (SCMP):

The Shenzhen-based company may report its worst quarter in three years on Wednesday, with second-quarter net profit likely to rise by 6 per cent to 19.3 billion yuan (US$2.8 billion), according to Bloomberg’s consensus estimates. Revenue may rise 37 per cent to 77.66 billion yuan, the slowest quarterly increment since the third quarter of 2015, according to estimates.

The selling pressure on Tencent increased this week, after the company dropped the top-selling video game Monster Hunter: World from its WeGame platform, less than a week after its launch, in the latest case of Beijing’s tightening controls over online content.

The stock has fallen almost 10% ($62 billion down the drain) in the last few days.

So is this a screaming signal to buy?

Maybe. The stock still trades for 34-times earnings (not exactly dirt cheap).

But it’s important to point out why growth is slowing. It’s not because of decline demand or a complacent management.

Growth is slowing because of regulation.

The Australian Financial Review writes:

Tencent, the world’s largest gaming company, has had internet games banned and government approval for new games withheld because of concerns about internet gaming addictions among Chinese youth.

China has been tightening regulations on mobile payment apps and is seeking to establish a government-owned clearing system. These measures could have an impact on Tencent, Alibaba and Baidu.

These are the risks you take, especially when investing in emerging markets. Political and government changes can and do affect the businesses you buy.

The question is, can companies like Tencent put this behind them and continue to come up with new ways to grow sales…

I believe they can.

Even if these bans last forever (I don’t believe they will), Tencent is full of intelligent, hungry and bright people (most tech companies are).

While online gaming is a huge part of revenues, Tencent has so many other ways to grow earnings. Digital ads on their social app WeChat is one avenue.

I see it as a source of sales, not yet fully tapped.

As of 2017, digital ad revenues made up only 17% of total sales. What’s more, this kind of income stream is extremely profitable.

Their current gross margin on advertising dollars is over 35%.

I should say before I end, this is in no way a recommendation to buy Tencent.

Rather, I think it’s important to point out that investors invariably overreact, to good and bad news.

Is a 10% drop in Tencent’s shares warranted? Is this wonderful business a screaming buy?

I’ll let you decide.

Your friend,

Harje Ronngard,
Editor, Money Morning

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Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the stories that make a difference to your wealth. Whether you agree with us or not, you’ll find our common-sense, thought provoking arguments well worth a read.

Money Morning Australia is published by Fat Tail Investment Research, an independent financial publisher based in Melbourne, Australia. As an Australian financial services license holder we are subject to the regulations and laws of Corporations Act and Financial Services Act.

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