One of the guiding principles we advocate in the management of our clients’ investments is “preservation of capital”. This concept is often mistakenly associated with a fear of any and all risk. In fact it is an objective that can be incorporated into even the most aggressive of stock strategies. It requires the simple recognition that large losses and the permanent destruction of capital can do irreparable harm to household savings.
The math is quite cruel. The 51% peak-to-trough drawdown of the S&P 500 in 2008 will require a 104% portfolio gain to return to a net 0% loss. That’s a lot of excitement for no return. The NASDAQ decline of 2002, also known as the dot-com meltdown, destroyed 78% of that index’s value. A 355% gain from the low would be required to complete the recovery of value for that index.
Such observations lead some investors to conclude that you have to time the market in order to make and keep profits. Market timing may actually succeed in taking a challenging task and making it impossible. To effectively time the market you have to be right twice in succession about something that most seldom get
right at all. First you have to know when to get out, and then you have to know when to get back in. Market timing also invites us to view investing through the filter of human emotions which seem best equipped to buy high and sell low.
One of the qualities we seek in an active manager is “downside protection.” We believe that this is an important part of what you pay for in the higher fees associated with active management. After all, when the market is going straight up, the cheapest and easiest way to participate in that rally is with a low-cost index fund. However, when the market turns, that same index will be down in lock-step with the market. This is where an active manager can distinguish himself by playing strong defense. And that typically does not mean going to cash when the going gets tough. It does mean having a process that protects value on the downside. Often this protection has more to do with the manager’s “buy” discipline than the sell side. One manager we use emphasizes quality stocks that pay high dividends. That manager points out that, depending on the period studied, dividends account for anywhere from 20% to over 50% of stocks’ total return.
The percentage tends to be higher in more challenging environments. In a down market, the cash flow from the dividends tends to help protect the value of dividend-paying stocks. Dividend-paying companies tend to have stronger balance sheets and more consistent income streams – protective qualities in a difficult market. Another manager we use protects the downside by only buying stocks when they are priced below the company’s “intrinsic value.” They do the laborious work of arriving at an independent
valuation for a company based on a careful read of its balance sheet and its income statement, and then only buy if the stock is trading for a price meaningfully below that figure. This discipline incorporates a “margin of safety” into every purchase they make. Some of these disciplines will lag when the broad market is going straight up, but they more than make up for it by protecting value when investors are running for the exits.
At Seaside, we seek to incorporate preservation of capital into every portfolio we build. One client put it this way: “I made it – your job is not to lose it.” We can do that.
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Subject to risk and may lose value