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"Rule #1: Never lose money"

(Warren Buffett)

To my mind, the stranglehold of this academic approach to portfolio management deflects the investor's attention from the main risk of any investment, the risk of losing money.

It would therefore seem to be more appropriate to view the risk of an investment as the possibility of suffering permanent losses of capital. This is the definition we use at BLI. It is central to our portfolio management methodology. We therefore define ourselves more by aversion to losses than by aversion to risk.

 

 

Risk becomes a differentiating parameter which guides our individual investment choices ex-ante. It is a multidimensional risk that cannot be modelled or quantified prospectively or retrospectively. As Howard Marks from Oaktree Capital Management puts it: there is no standard by which you can measure the probability of capital losses that is based on reasoning which differs from one person to another, according to his or her objective or investment horizon, for example.

Assessing this risk is a judgment based on a set of incomplete pieces of information. Faced with tomorrow's uncertainty, risk must be appraised circumspectly, with the aim of reducing the probabilities of the occurrence of unfavourable events.

Circle of Competence

The quality of this judgment is heavily influenced by the investor's profile, depending on his or her training, expertise and experience, and by knowledge of the company, its products, markets and prospects.

The best strategy to adopt is therefore to stick within what Warren Buffet calls the "circle of competence", which is specific to each individual. It means being selective when choosing companies in which we might invest, based on our capacity to understand them in order to be in a better position to gauge the risk parameters. Warren Buffett says: "Knowing what to leave out is just as important as knowing what to focus on"; so it isn't the size of the circle that counts, it is really about setting its limits. As Awath Damodaran, Professor of Finance at New York University Stern School of Business puts it: "Investors who are selective about the risks they take can exploit those risks to advantage, but investors who take risks without sufficiently preparing for their consequences can be hurt badly."

Endorsing this approach has the advantage of focusing on the investment process rather than on its end goal, the expected profitability. An investment process developed along these lines provides a certain serenity and helps reduce the number of errors committed, a critical factor in diluting a portfolio's profitability.

Sources of risks

As part of our methodology, in addition to our understanding of the company, and in order to reduce the probability of suffering permanent capital losses, we use fundamental analysis structured on three sources of major risks:

  • the fundamental risk which focuses on a company's capacity to maintain its profitability. The company's differentiating factors through its competitive advantage, good positioning on its markets, appropriate capital allocation directed towards its area of know-how, and its capacity to dictate selling prices are all ways of discerning whether the company has control over the majority of aspects that will enable it to prevent a structural decline in its profitability;

  • the financial risk which is intended to check that the value of the company will not be compromised by inadequate financing of its operating cycle or capital assets;

  • the valuation risk which primarily helps us limit our investments to companies whose valuation we can understand on the basis of transparent and objective criteria. Once the valuation has been calculated, we keep monitoring that the share price offers us 

    a margin of safety against the company's intrinsic value in order to protect us from an unexpected event or erroneous judgment, as well as to help increase the investment's return.

    Less conventional portfolios

    In contrast to certain more traditional management models, which are based on notions such as volatility, our management tries to define a selection of companies based on transparency and our own knowledge or understanding, specifically by applying the following criteria:

  • our investment universe is more restricted than that of a market index since

    (i) our circle of competence does not extend to all companies and sectors of the index and (ii) our search for companies with a sustainable competitive advantage eliminates many potential candidates and even sectors from our universe;

  • this is conviction management. It results in concentrated portfolios, without increasing the risk compared to a more conventional investment approach. As Buffet says: "We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it”;

  • the portfolio's sector and geographic allocations are structurally different from those of a market index. They result from choices dictated by the search for safety margins and by an approach based on an investment's opportunity cost;

  • our investment horizon looks to the long term. "Time is the friend of the wonderful business" (Warren Buffet), as the company has the capacity to capitalise on its strengths and the investor will be able to benefit from the fruits of a compound return.

This structure departs substantially from Modern Portfolio Theory in two respects. Firstly, volatility is no longer considered as a source of risk. It is inherent in any liquid market where the costs of transactions are low, and all the more marked because the choices and decisions made are influenced by psychology, fear, conformity and capitulation, as is the case on the financial markets. Volatility can be turned to profit as a source of opportunities to make investments at good prices in companies that we understand. Secondly, aversion to losses, which identifies risk as the probability of suffering permanent capital losses, has the edge over aversion to risk. This makes a negative correlation possible between risk and return, as has been partly corroborated by the very good stock market performance of low-risk high-quality companies.

Through our portfolio management, it is this correlation that we aim to apply in our choice of investments.

Ivan Bouillot, Equity Fund Manager

Following two years as portfolio manager and investment advisor at Banque Degroof Luxembourg, Ivan joined Banque de Luxembourg in 2000 as a financial analyst. Since 2004, he has been in charge of European equity investments for the Bank's funds range. Ivan has a degree in Business and Finance from the ICHEC University in Brussels. In 2000, he obtained his CEFA (Certified EFFAS Financial Analyst) diploma and he has been a CFA (chartered financial analyst) charter holder since 2006.

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