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Avoiding costly mistakes: a culture of minimising downside risk

08 July 2014 Mike Clements, Franklin Equity Group

It’s clear from the way the European stock market has recently been reacting to events such as the crisis in the Ukraine or recent European Central Bank policy actions, that short-term volatility is often as unpredictable as it is unavoidable. As bottom-up equity investors, these are not things we at Franklin Equity Group can hope to control. When selecting our investments from among the 3,000-stock universe available in Europe, we focus in on the risks that we can foresee by scrutinising what could go wrong in the business model of a company we’re evaluating.

We look for businesses with strong market shares and strong brands. We also look for companies that have pricing power that could allow them to generate good returns. Naturally, I try to make fewer mistakes than competitors, but even more importantly, I do everything I possibly can to limit their impact.

We believe that avoiding costly mistakes is at least as important as finding stocks that can potentially beat the market, and our strategy for ensuring we minimise downside risk is three-fold. Firstly, we strive to buy what we perceive to be high quality businesses. By this, I mean we look for businesses with strong, sustainable, competitive advantages that we think can stand the test of time, with a five-year investment horizon in mind. We look for businesses with strong market share and a strong brand. We also look for companies that have pricing power that could allow them to generate good returns.

Next, we focus on valuation by looking for companies that we believe are undervalued or overlooked by the broader market. Valuation matters a lot to us because it’s very easy to turn a good company into a mediocre investment by overpaying for it. The third part and one that I think really distinguishes us, is the culture of our team, which aims to minimise the downside risk of an investment by encouraging intellectual honesty. Our process involves asking a lot of questions about potential downside risks and harnessing the collective wisdom of the team. We believe that having all eight European equity team members involved in discussing each investment idea allows us to collectively research, scrutinise and challenge that idea more thoroughly.

We believe that having as many pairs of eyes on an idea as possible helps us to avoid potential pitfalls and ultimately make fewer mistakes when selecting stocks for the portfolio. We also coordinate closely with our partners in Franklin Templeton’s Performance Analysis and Investment Risk (PAIR) operation to gain their independent perspective on the overall level of risk in our portfolio. Indeed, PAIR is embedded within our team, bringing additional risk management tools, including data analytics and modelling to leverage at each stage of our investment process.

This collective approach is also important in helping determine the most appropriate time to sell a stock that we hold in a portfolio. No portfolio manager should ignore his or her estimate of what a stock is worth and allow themselves to get carried away by momentum when its price is rising. The scrutiny of the rest of the team and our strict focus on valuation allow us to be disciplined about when to sell. The day we buy a stock we also have a sell price in mind, and when the stock approaches that sell price, the team discusses whether anything has fundamentally changed in our original investment case that would justify revising our sell price and continuing to hold the stock. It’s much easier to let go of a stock that’s done very well for you when the other seven people on the team are making a good case for going ahead and taking a profit.

Finally, we recognise that no one has a monopoly on good ideas and that our process works best when everyone contributes. We think this is one of our biggest strengths, and one that sets us up for potential success.

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