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03 Feb 2017

The First And Foremost Rule Of Investing: Capital Preservation

Benjamin Graham, the father of value investing, defined an investment operation as “one which, upon thorough analysis, promises safety of principal and an adequate return.” Graham’s concept of safety of principal could easily have been expressed as “capital preservation,” one of the first and foremost rules of investing.

The importance of capital preservation in especially uncertain times cannot be overemphasised. This is according to Sihle Lukhele, Institutional Investor Relationship Manager at Foord Asset Management.

“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. In fact, capital preservation is one of the hallmarks of Foord’s investment philosophy.”

“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 R50 after it was purchased for R100 (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 South African economy faces structural headwinds, and political risk remains elevated. Investment risks associated with this uncertainty are high and rising, making the focus on real capital preservation more imperative.

“For now, Foord’s portfolio managers are in capital preservation mode,” says Lukhele.

So what does it mean to be “in capital preservation mode”? Lukhele explains that 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, overall equity (especially SA-equity) allocations are below their long-term averages as portfolio managers mitigate the risk of portfolio loss in the event the market falls dramatically. Within equities, the fund managers prefer quality companies that derive some or all of their earnings outside of South Africa (rand hedge shares), given the risks in this market and to its currency.”

“Thirdly, in the current cycle, holdings of government bonds are low given the risk of rising global and local yields, which work inversely to bond prices,” adds Lukhele.  “Then, portfolio managers will typically have a full weight in foreign assets to diversify the risks of investment in South Africa. 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,” concludes Lukhele.


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