THE FIRST RULE OF INVESTING: CAPITAL PRESERVATION
In the article “The Future Is Not What It Is Used To Be”, published on 11 November 2016, Paul Cluer addressed the issue of lower future returns, noting that “for now, Foord’s portfolio managers are in capital preservation mode.” SIHLE LUKHELE takes a closer look at this concept and what it means for investor portfolios.
Benjamin Graham, the father of value investing, defined an investment operation as “one which, upon thorough analysis, promises safety of principal1 and an adequate return.” Graham’s concept of safety of principal could easily have been expressed as “capital preservation,” one of the hallmarks of Foord’s investment philosophy.
The importance of capital preservation in especially uncertain times cannot be overemphasised. At Foord, we define investment risk not as volatility, but as the likelihood of permanent, real capital loss — loss from which recovery is impossible or very highly improbable. Permanent loss of capital is the flipside of capital preservation and is one of the key risks we manage.
We have found that avoiding losers is as important to building a superior, long-term track record as picking winning investments. This is well illustrated by a simple example. Consider an investment whose price declines to $50 after it was purchased for $100 (a 50% loss). The price of that asset must double (a 100% gain) merely to nominally break even. The greater the fall in price, the more significant the required return must be just to reach an overall return of nil.
In addition, the time required to recover nominal losses is often correlated to the capital value decline of the asset — capital recovery in real terms may never occur. It follows that it is far more sensible to embrace the higher probability of preserving capital with a defensive disposition from the outset.
Few people would dispute that the present global economic environment is fraught with uncertainty, with most asset classes at or near historical highs and trillions of dollars of sovereign bonds trading at negative yields. The global economy faces uncertainties following political developments in the US, UK and Europe, with geopolitical risk remaining elevated. Investment risks associated with this uncertainty are high and rising, making the focus on real capital preservation more imperative.
So what does it mean to be “in capital preservation mode”? Firstly, cash levels in equity and multi-asset portfolios are well above their long-term averages. Additional cash in the portfolio serves to provide an income yield when the prospects of return from other asset classes are limited; to buffer the portfolio against potential declines; and to provide liquidity to buy quality investments if asset prices fall significantly.
Secondly, in the current cycle, holdings of government bonds are low given the risk of rising global yields, which work inversely to bond prices. Finally, portfolio managers will often hold a meaningful position in gold bullion (via ETFs) as the metal usually acts as an uncorrelated, safe-haven investment during periods of market dislocation.
Liquidating one’s entire portfolio is an extreme strategy as the very real risks of loss may never eventuate. Therefore, portfolio managers maintain some exposure to growth assets, notably quality companies, to manage the risk of being wrong in their overall risk assessment.