Investors’ Focus on Downside Risk as Relevant as Ever

This blog below was originally posted in May of 2019; in fact, it was the second blog we ever published. However, with volatility returning to the markets as investors weigh the potential impact of the coronavirus (also known as the Wuhan coronavirus), we deemed the concepts discussed previously to be worthy of re-sharing.

Investors are suddenly faced with the reappearance of large daily drops in major U.S. equity indices, which have a tendency to emotionally rattle even experienced advisors and money managers. These types of dramatic downward moves have largely been absent since the fourth quarter of 2018.

While the initial spreading of the coronavirus has not been catastrophic and has been deemed less serious than the SARS virus that infected over 8,000 people in 2002 to 2003, it is occurring at a time when investors already have myriad economic and political concerns on their radar. The S&P 500 Index had made a habit of hitting new all-time highs throughout the 2019 calendar year, and traditional valuations such as trailing- and forward-looking P/E ratios have begun to look stretched relative to historic averages. The S&P 500 currently trades at a trailing P/E ratio of 21.7x compared to its long-term average of 15.6x.

Negative interest rates on sovereign debt across much of the developed world, ballooning U.S. corporate and government debt as well as slowing global economic growth have been on investors’ minds for some time, but it appears that fears over the coronavirus have tipped the scale of investor sentiment. No matter which course you choose in navigating this environment, keep in mind the arithmetic of large losses, which the below writing reflects upon.

Original blog post below. 

Successful investing doesn’t have to mimic rocket science. Warren Buffet breaks it down well in his first two rules of investing:

Rule #1 – Don’t lose money; Rule #2- Don’t forget Rule #1!

We adhere to this principle, and our entire investment process revolves around the idea of limiting downside risk in order to maximize compounding over full market cycles. We believe the secret to accomplishing this, and creating wealth in general, is to avoid large losses. After all, if you lose 20%, you have to be up 25% just to get back to where you started, and the larger the loss, the more this arithmetic works against you. Therefore, one of the first questions we ask ourselves when looking at an investment is: what can go wrong?

Using baseball terminology, this approach is similar to striving for singles and doubles, rather than going for home runs and facing a higher strikeout rate. Many of our competitors go the home run route and look to have their winners offset their losers, but this doesn’t sync with our goal of generating strong risk-adjusted returns, and it’s not what our clients expect of us.

swing and a miss

Image source:

With this more conservative mindset, we seek-out less financially-leveraged companies, since leverage is often the root cause of permanent losses. We strive to be aware of both financial and business leverage (low asset-leveraged financials vs high asset-leveraged financials). This analysis takes place from a credit perspective, which we believe we have an edge in due to our team’s robust combination of CPA and CFA designations as well as backgrounds in both accounting and financial analysis. Other qualities our team looks for while attempting to limit downside risk is:

  • Strong underlying franchise
  • Moat around the business
  • Conservative marks on assets/liabilities
  • Strong FCF yield generation/less reliance of the capital markets for growth

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The views described herein do not constitute investment advice, are not a guarantee of future performance, and are not intended as an offer or solicitation with respect to the purchase or sale of any security. Investing involves risk, including loss of principal. Investors should consider the investment objective, risks, charges and expenses of a Fund carefully before investing. Please review the offering memorandum or prospectus of a Fund for a complete discussion of the Fund’s risks which include, but are not limited to: possible loss of principal amount invested; stock market risk; value risk; interest rate risk; income risk; credit risk; foreign securities risk; currency risk and derivatives risk.

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