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The importance of protecting capital

28 November 2012 Gareth Stokes
Gareth Stokes, FAnews Online Editor

Gareth Stokes, FAnews Online Editor

Investors tend to favour unit trust funds that top the one, three, and five-year performance tables. But backing this year’s star performer is not the fool-proof investment strategy that many believe it to be. Their mistake is illustrated by considering t

Although this is a simple example it demonstrates the importance of protecting capital versus chasing outperformance of a benchmark. The capital protection concept featured strongly at the RE: CM 2012 & Beyond: A Contrarian Perspective presentation hosted in Johannesburg recently. “We are trying to generate real returns for our investors,” says Linda Eedes, a portfolio manager at the asset manager. “Protecting capital is like driving within a speed limit… The journey is less exciting, but you arrive at your ‘superior real returns over time’ destination without suffering a car wreck along the way”. She observes that RE: CM’s job as asset manager is to generate real returns for its clients while protecting them against the risk of capital loss.

Benchmark investing throws some frightening curve balls

The JSE is dominated by a handful of heavyweight firms. An asset manager benchmarking its fund performance against the JSE All Share or JSE Top 40 index would have to take massive positions in certain shares whether they like them or not… So, for example, at the height of the recent resources boom in mid-2008 these managers would have held almost 15% of their portfolios in Anglo American. RE: CM points out that many funds were ‘at weight’ Anglo American despite the share being considered expensive on just about every traditional valuation technique. “These asset managers could not afford to be ‘wrong’ by not investing in the share according to its index weighting,” says Eedes.

RE: CM, which ascribes to the value investing methodology, held zero Anglo American at the time… This turned out to be a good move because Anglo American slipped 75% top to bottom from mid-2008 to March 2009… An investor with 15% portfolio exposure to the share would have lost 11% of his or her entire portfolio over the period. The asset manager protected its investors by making sensible investment decisions based on capital preservation rather than return maximisation.

How absolute return managers protect against permanent capital loss

What should an asset manager or investor do to protect against capital loss? The first step is to approach portfolio construction with a blank piece of paper rather than a list of pre-selected (based on their index weightings) shares. “RE: CM is an absolute return manager,” says Eedes. “We do not obsess over outperforming an index or our peers, but rather on delivering real returns to our investors”.

The second step is to focus on high quality businesses that generate a return on capital over and above the cost of capital over time. These businesses typically possess high barriers to entry / economic moats that ensure they will deliver similar results going forward. “If, in the worst case scenario, the value you placed on a business is wrong, then a high quality business that grows its intrinsic value over time will ultimately grow into that price,” she says. A third capital protection is to only invest when there is a significant margin of safety. A value-based investor such as RE: CM likes to invest in companies where the discount between the price and the value is upwards of 30%. This ensures enough of a buffer if the market view on a particular investment remains negative for longer than anticipated.

The fourth and final ‘step’ in the capital preservation strategy is to defer to cash in the absence of sufficient absolute value ideas. “The best way to protect against capital loss is to not buy businesses when they are trading at well above what they are worth,” says Eedes. It makes more sense to hold cash until true value opportunities present. As an example of this strategy in action the RE: CM Flexible Equity Fund held 15.6% in cash at 31 October 2012.

Does absolute return make sense?

It is difficult to present the case for one investment strategy over another, and each investor must eventually make decisions based on his or her unique financial position and risk appetite. An absolute return strategy works best if you wish to achieve absolute real returns without placing your capital at undue risk. RE: CM illustrates its strategy in action by comparing the RE: CM SA Equity composite (an index of its domestic equity holdings) against the JSE All Share index. Between August 2003 and May 2008 their basket of shares underperformed the JSE, achieving 29% per annum versus 33.4%... But when the market plunged, between May 2008 and March 2009, investors in the JSE lost 40.4% versus just 9% in the RE: CM composite.

Despite their efforts in selecting deep value shares the team at RE: CM has made some mistakes. Telkom is held up as a major disappointment, while the likes of Old Mutual (bought for R8/share) and Discovery (bought for R27) stand out as fantastic performers. “As a smaller asset manager in South African equities we have a great opportunity set to find absolute value,” says Eedes. She says that the asset manager will focus on real rather than relative returns and protect against capital loss over volatility going forward. “There is not a shadow of a doubt that the value philosophy implemented and stuck with produces the best returns over time,” she concludes.

Editor’s thoughts: The RE: CM presentation once again highlights how important it is to take a long term view when investing in equities. It also shows that choosing a fund based on performance alone can be costly, especially in markets like ours, where single shares contribute massively to just about every index. A value based strategy is one way to mitigate the risk in poorly diversified benchmarks... Would you agree that your clients are more concerned with capital preservation than market volatility? Please add your comment or send it to

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