Adam Smith observed that “The chance of gain is by every man more or less over-valued, and the chance of loss is by most men under-valued….”
It is for this reason, he continues, that we buy lottery tickets when we know the odds are against us and yet hesitate to insure our homes against disaster (mortgage providers require it nowadays of course). In the Global Emerging Markets team at CCAM, we try to avoid such instincts. We believe that our first task is to preserve our clients’ capital and define risk as the failure to do so. To some, such a focus may appear to contain the makings of dull long-term performance. To the contrary we believe that it is from a protected base of capital that attractive long-term returns may follow.
The power of capital preservation
There are various reasons why we believe emphasising capital preservation is valuable to long-term investors.
First, our clients’ capital is hard-earned and irreplaceable. We aim to treat it like we would our own and are unwilling to take risks that might jeopardise it.
Second, capital losses create steep mountains that are arithmetically challenging to climb. We see the world as replete with painful episodes of economic crises and corporate malfeasance. To avoid or dampen these episodes is therefore valuable. An investment that loses 50% of its value will need to gain 100% to return to its starting point whereas one that loses 25% needs ‘just’ a 33% gain to return to the same starting point, a far less strenuous climb. Emerging markets lost more than 60% of their value in dollar terms in between October 2007 and October 2008, requiring more than a 150% gain to return to their starting point.
Third, as Smith recognised nearly 250 years ago, humans are fallible. We all know that investing is in theory as simple as ‘buy low, sell high’ but in the real world that is a mantra more easily recited than practiced. It is human nature to fall prey to both undue optimism and pessimism. All too often investors can find themselves ‘investing’ in objects of speculation when they are at their most expensive only to sell at trough valuations. There are indications that an average fund investor’s return can fall far short of the funds in which they invest for this precise reason. A focus on capital preservation should result in shallower troughs that make it easier to stay the course; it helps protect us from our ourselves.
Achieving capital preservation
Achieving capital preservation can be challenging. It requires an approach that we believe will at times lead to marked underperformance as it avoids the most fashionable, but ultimately fragile, investments. In our opinion, some fund managers are unable to apply an investment approach that appears to be ‘wrong’ for an extended period: that may be because an intellectually competitive streak leads to the abandonment of investment philosophies in order to keep up with peers; or because they may find themselves labouring within institutions that have little tolerance for short-term underperformance. In our view, incentivisation structures and career risk can weigh heavy on a portfolio manager who refuses to adopt a fluid investment philosophy.
We believe that it is far easier to achieve capital preservation within a small and supportive team that understands there will be challenging periods just as there will be rewarding ones, and this is only possible in an understanding and patient institution. With these rare ingredients in place attention can turn to constructing portfolios that truly align with an investment philosophy.
Ultimately, we see that a portfolio takes on the characteristics of the companies contained within. We focus on three broad and interrelated questions when trying to identify suitable companies:
Who? We seek owners and managers of companies that display integrity, humility and competence. These individuals typically have unusually long-time horizons, with a keen interest in the durability and evolution of their companies.
What? We are looking for companies with demonstrable resilience and hard-earned competency. These companies can consistently generate cash flows from attributes that are difficult to replicate. Examples include consumer companies with top quality brands and industrial companies who sell to businesses who are truly reliant on their products. Such unusual traits provide pricing power.
How? The companies should be run in a way that recognises that enduring success requires partnership and collaboration with various stakeholder groups. They say ‘no’ to many enticing but risky short-term sources of profits. They do not resort to financial gasoline to turbo-charge growth. They consistently invest in their businesses to help ensure long-term evolution and relevance.
No company is perfect but when we find high quality people looking after durable businesses operated for the long-term, we are willing to pay what we appraise to be a reasonable price in order to become part owners. And then we offer them patience. There is little point in identifying companies with an eye on the distant future if we cannot offer similar in return. By seeking these high standards, it is our aim that our portfolios become infused with similar characteristics. This is how we endeavour to achieve capital preservation and attractive long-term returns.