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.
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 include:
- Strong underlying franchise
- Moat around the business
- Conservative marks on assets/liabilities
- Strong FCF yield generation/less reliance of the capital markets for growth
In summary, the Prospector team spends just as much time considering what could go wrong with a stock as they do determining what could go right. Striving to avoid large losses is part of the Prospector DNA, as the team knows it is a critical component to compounding money.
If you are interested in learning more about our investment process, we encourage you to schedule some time to speak with one of our Portfolio Managers.