What is capital preservation?

On the one-year anniversary of the fastest, most significant sell-off in the history of Australian capital markets, it seems appropriate to discuss one of the most important topics in investing: capital preservation. This also coincides with the 100th month of operation – more than eight years – of the Auscap Long Short Australian Equities Fund.

Capital preservation is an objective, not a strategy. Our two core aims when investing are to both preserve capital and to generate an attractive return on that capital.

While having a capital preservation objective is sensible, almost every investment manager has one. It’s the approach to capital preservation that differentiates investment managers.

Firstly, we focus on owning high quality businesses with:

• sustainable competitive advantages,
• growth prospects,
• aligned management,
• strong balance sheets, and
• clean financials.

These businesses, while not immune to hiccups, tend to emerge from unforeseen economic shocks in even more dominant market positions.

A sustainable competitive advantage might include:

• Scale advantages that result in a consistently lower cost of doing business such as superior buying power, a lower per unit corporate overhead cost and the capacity to spread investments over a larger revenue base;
• An entrenched customer base where the switching costs are considerable and the relationships are of long duration, making it able to withstand short term competitive pressure;
• A resource that has natural cost, product quality and/or transport and logistics advantages over peers; and
• Assets in monopolistic positions, such as major transport infrastructure within and between significant cities or shopping centres in irreplicable positions in major metropolitan precincts.

Businesses with competitive advantages tend to achieve superior returns on capital. This is logical. If a business truly has a competitive advantage, it should make more money for each dollar invested than its peers. This can be determined by analysing the return on capital metrics in the financial accounts of the business.

We’re interested in businesses where we see enduring competitive advantages, a track record of strong returns on invested capital and good prospects these will continue into the future.

Secondly, we like to purchase stakes in these businesses when we think they are trading below our estimation of their worth. The purpose of buying below our valuation is simple, the valuation could be wrong! For example, the factors affecting a company’s worth could change for the worse, rendering the assumptions used in the valuation less meaningful.

Purchasing part of a business for less than we think it is worth provides a “margin of safety” for errors in analysis or worsening conditions. Negative surprises are inevitable, even for high quality businesses, but a focus on valuation aims to mitigate their impact.

Of course, valuations depend on several inputs, with growth in revenue and earnings being critical factors. Due to the significance of compounding, the value of a predictably growing earnings stream from a business with a high return on capital should not be underestimated. We’re willing to, and expect to, pay more for profitable businesses that are growing reasonably quickly, if the measure of “paying more” is based on a multiple of its forecast near-term earnings. This makes logical sense. To us, the objective of buying into companies for less than we think they are conservatively worth makes us a “value” investor.

Making ratios rational

Whether companies are trading at low price-to-book and/or low price-to-earnings ratios, or have high current dividend yields, are not determining factors on their own. A low PB ratio might simply reflect a company with a very poor return on capital, which needs to constantly reinvest profits back into the business just to maintain profitability. In this case, the company deserves its low PB ratio.

And a low PE ratio may reflect a declining business that could still be expensive on further analysis if earnings decline more quickly than the market anticipates. A high dividend yield may reflect an unsustainable payout of cash flow that will diminish over time. An approach defined by buying these sorts of companies could be more typically categorised as deep value, an approach that we tend to avoid.

But we are cautious about forecasting many years of exceptional growth, particularly for businesses that are currently unprofitable – or barely profitable. Only very few companies can grow quickly for many consecutive years. There are often disruptive events, new competition, changing regulations or other adverse events that interrupt rapid growers at one stage or another.

Paying up based on the assumption of continual rapid growth rarely provides us with a sufficient margin of safety to be comfortable.

Emphasising our earlier point about buying companies that we believe will deliver good returns on invested capital over time - the obvious question is over what timeframe? And should such an approach result in reasonably linear performance, or will there be cyclicality, where sometimes it works and other times it doesn’t? Clearly, we have no predictive power over daily share price fluctuations, so expecting performance over a short time horizon is a folly.

Companies can be out of favour for several years for reasons that are entirely outside their control. JB Hi-Fi (ASX: JBH) is one example, a company we’ve held for many years, which has:

• one of the lowest business operating costs in the electronics retailing universe
• a leading brand,
• a powerful market position in Australia within a fast-growing industry.

But from mid-2016 to early 2019 the company’s share price declined from more than $31 to under $21 – frightful performance for anyone with a short-term investment horizon. What had gone drastically wrong? Precisely nothing. It grew earnings per share substantially during this period. 

JB Hi-Fi was responding to the opportunity and threat of e-commerce with vigour, a battle for which they continue to look well positioned. But the challenges it faced included:

• the threat of Amazon and other online players,
• the presumed impact on consumption from a decline in the residential property market,
• the structural decline in DVD sales and
• the perceived integration risk around the acquisition of The Good Guys

The combination of these factors saw pessimism increase to a peak in early 2019. But eventually earnings dictate share prices. The stock moved quickly from $21 to over $41 by early 2020.

Warren Buffet has called the stock market “a device for transferring money from the impatient to the patient.” The suggested time horizon many seasoned professionals have for equities is at least five years. Our intended time horizon for holding businesses is many, many years. Market sentiment can remain negative for substantial periods of time, even as a business continues to develop, invest and grow earnings.

It is our intention to preserve capital through our approach to investing. This is how we preserve capital. We also selectively short businesses that we consider to be considerably overvalued with medium term downside to earnings forecasts. In aggregate we have always run a considerable net long portfolio, so these shorts are not designed to hedge the portfolio because we want long term exposure to great businesses.

We do not try to supplement this approach with any fancy short-term “trading” strategies. We have no advantage in guessing where the market might head on any given day, week or month, so trying to guess our way to short term profits in our view is not only impossible but more likely to lead to short term losses than gains, consuming important mental capital in the process.

Importantly, our approach to preservation of capital has not mentioned volatility.

• We do not specifically aim to minimise volatility.
• We do not aim to keep the Fund’s volatility at a particular level or in line with a basket of stocks such as an index.
• We are generally sceptical of the merits of using historical share price volatility as a proxy for risk.

Investors want a measure of riskiness and, in the absence of anything better, often measure volatility because it is measurable. It reminds us of Albert Einstein’s quote, “not everything that can be counted counts and not everything that counts can be counted.”

The problem is, while some extremely volatile instruments are definitely risky, volatility is not a sufficient condition for something to be risky. At moments of extreme value, investments often exhibit extreme volatility.

Equities in March 2020 were the least risky they had been for some time and were offering incredible value, despite the extreme volatility that they were exhibiting. In such an instance, high levels of volatility do not equal high levels of risk. The same could be said for investing in high quality businesses after every major market fall. 

Yet if volatility was used as a benchmark, such stocks would be considered extremely risky at these points in time. By this reasoning, targeting volatility is very likely to differ from minimising or even managing risk, since volatility is an outcome, and one that does not necessarily correlate with risk.

One easy way to minimise volatility is to reduce exposure. While investing in cash carries minimal volatility, it carries little or, in the current environment, no reward. But this defeats the purpose of investing in equities. If you’re trying to keep volatility constant over time, you would be inclined to have the smallest exposure when stock price volatility is highest, after large market falls, when the most compelling value is on offer. Similarly, one would often have the highest exposure to equities when markets are sanguine and complacent about risk, typically after strong upward moves when value is least compelling. Targeting a level of volatility can also be counter-instructive to delivering capital preservation.

Another alternative is to seek volatility that is similar to an index. The inevitable result of such targeting is fairly logical: to have the volatility of an index, a fund must look similar to that index. This leads to managers seeking to resemble the index in at least the sectoral composition of their portfolio, and often in relation to the biggest weights in the index in particular, irrespective of whether value is on offer in these names. This is perhaps not surprising, given the asymmetric risk for managers in delivering returns that are differentiated from the market.

The reluctance to deviate too far from the mean in terms of performance or volatility results in “index hugging”, where the manager largely replicates the index while hoping that a small number of stock picks will generate enough alpha to drive outperformance. This is a difficult feat to achieve after fees, and the majority of managers taking this approach will struggle to achieve this delicate balance. It also throws up an obvious problem: that a stock with a large index weighting is dangerous to such a manager if it performs particularly well and the manager does not own it. This can lead to ownership for reasons that have nothing to do with fundamentals. And the entire exercise often leads to justifiable criticism that this sort of investment management is not genuine active investing.

We ignore the composition of the market in deciding what our best risk-adjusted portfolio might be, or which sectors we should be overweight.

We do not have any perceived view that the fund’s volatility should be greatly above or below the market. But over time, we expect our returns to beat the market, since we are focused on finding the best risk-adjusted returns through a superior quality portfolio purchased at attractive prices. To date, the fund has delivered 15.9% per annum post fees for more than eight years, versus 9.6% from the All Ordinaries Accumulation Index over the same timeframe.

This concentrated and active investment approach means there will be periods when the fund is both more volatile and less volatile than benchmark. But volatility is only a risk to the investor to the extent it is acted upon. We continue to believe we own market leading businesses that will survive and thrive through crises. So, the risk of us liquidating investments when great value is on offer is extremely low, unless done to optimise the portfolio and facilitate buying in even more compelling opportunities.

Investing is always a relative proposition. Better opportunities should be prioritised.

Conclusion

Our objective is to focus on value and quality stocks, not to buy the cheapest stocks on offer. On that front, from this month we will disclose the top 20 positions in the portfolio. This is to continue the journey of improving transparency so that investors are increasingly familiar with the sorts of companies we are invested in.

We also intend to introduce a more comprehensive quarterly newsletter that will generally be more focused on stock investments than the monthly newsletter, and reduce the detail in the monthly newsletter to a performance fact sheet. Our investment timeframe is long term, and we hope that our investors will benefit from more detailed analysis delivered slightly less frequently. All past newsletters will continue to be available on the website. As always, we encourage any feedback on these developments. 

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