1.

Preserve Capital: “The chance of gain is by every man more or less

overvalued, and the chance of loss is by most men undervalued. "Avoiding
permanent loss of capital is the number one rule." The trick in investing is not
to lose money. That’s the most important thing. If you compound your money at
9% a year, you’re better off than investors whose results jump up and down, who
have some great years and horrible losses in others. The losses will kill you. They
ruin the compounding rate and compounding is the magic of investing.
If you lose 50% on an investment you need to make 100% on the next one in
order to get back to breakeven, and that’s a difficult equation basically.”
The most important factor in long-term wealth creation is not losing money
and continuously compounding.
“When it comes to compounding, I’m not sure everyone understands that
percentage losses and gains are not equal.
An investor who earns 16% annual returns over a decade, will perhaps
surprisingly, end up with more money than an investor who earns 20% a year for
nine years and then loses 15% the tenth year.
Preservation of capital is key to survival in this business.
Thoughtful investors can toil in obscurity, achieving sold gains in good years and
losing less than others in the bad. They avoid sharing in the riskiest behaviour
because they’re so aware of how much they don’t know and because they have
their egos in check. This, in my opinion, is the greatest formula for long term
wealth creation – but it doesn’t provide much ego gratification in the short run.
2. Compounding: The following is an immutable, and what should be
perceived as sobering, law of compounding. A single 100 percent loss can wipe
out an entire lifetime of cumulative gains. Compounding is not an equal-
opportunity mechanism. Its rewards and penalties are asymmetrical.
Good investing isn't necessarily about earning the highest returns. It's about
earning pretty good returns that you can stick with for a long period of time.
That's when compounding runs wild.
Over a sufficiently long time, compound growth at a small rate will vastly
exceed any rate of arithmetic growth, no matter how large.

It is the quality of earnings which decides their sustenance, translating into

premium valuations. Two indicators of earnings quality are ROE and Dividend
Pay-out.
Wealth Creators Classification by ROE:
 Base ROE of 15-20%: 13 of the 22 companies in this group are Financials,
a business which cannot deliver supernormal ROEs but can deploy
almost unlimited capital and earn risk-adjusted returns well above cost
of capital.
 ROE > 40%: This is the group of Blue Chips, usually associated with
modest earnings and price performance. However, in an enabling
growth environment such as in India, even large Blue Chips can deliver
robust earnings growth (27% CAGR), which gets highly reward by the
markets
Wealth Creators by Valuation Parameters:
 P/E of less than 10x
 Price/Book of less than 1x
 Price/Sales of 1x or less
 Payback Ratio of less than 1x - (Payback is a proprietary ratio of Motilal Oswal,
defined as current market cap divided by estimated profits over the next five
years. We back-test this in 2006, based on the actual profits reported over the
next five years.)
Wealth Creators & dividends:
 PEs have a very high and positive correlation with pay-outs
 Payouts have a very high and positive correlation with RoEs
 High payouts coupled with growth is a potent combination for wealth
creation as it reflects several things
o The company's business is intrinsically highly profitable, and it needs
to retain very little of its annual profit to fund future growth
o The management has an attitude of sharing economic benefits with
minority shareholders
o Low risk of misallocation of retained earnings in unrelated
diversifications, risky overseas acquisitions
 Structural rise in pay-out ratios is a potential source of PE re-rating over
the next few years