What downside protection means to us

Brandon Snow's picture

Over the last five years or so, people have gotten to know the three dimensions of our investment philosophy at Cambridge: 1) active management 2) a focus on understanding downside risks and 3) an ownership mentality.

I want to touch on the second one today because downside protection has become a key focus of many market participants and a key desire of many clients. However, I think in many ways investors are myopically focusing on avoiding short-term share price downside risk, which is hampering their ability to deliver the returns clients need and creating higher levels of market volatility.

Historically, markets have focused on volatility as risk. These days it seems like most risk is simply defined as stock price decline, no matter how short term this focus may be. Talking to head traders across the U.S. and European markets, it is clear that many clients have single stock risk limits, whereby if a stock (or fund) declines beyond a certain percent from where they bought it, or where it entered a performance time period, they are forced to sell. In addition, macro funds, risk parity funds and others are forced to reduce equity exposure when volatility (i.e. “risk”) increases. Therefore, the idea of risk protection for a lot of market participants is selling at a loss before the loss gets bigger. Of course, when everyone is doing this, the outcome is simply exacerbated. We have seen this a half dozen times over the last two years. I think focusing on the goal of avoiding downside risk on stock prices every day, minute or hour has increased downside volatility in the markets and is a constraint on returns for many investors. 

So how does our view of downside risk differentiate us from the rest? At Cambridge, when we talk about downside risk we are talking about fundamental risk: the permanent loss of capital, not temporary share price decline. This could happen in a number ways: value destruction by management teams; a change to an industry structure or competitive environment; or from a portfolio manager overpaying for a business (due to a misunderstanding of market environment, key drivers or simply paying above the intrinsic value of a company.) We know that we won't be able to pick the absolute low price on every business we buy as hard as we might try. This is why our investment philosophy focuses on businesses that can compound over time with management teams who know how to allocate capital well. In fact, I often will ask an analyst to “find me a company that will double over the next three to five years and I don’t care if it goes down 20% at first.” By focusing on companies that compound value, we know we are earning something every day as shareholders. Given enough time; the value creation will be recognized in the market.

While we focus on businesses that compound value, we understand the difference between a good company and a good stock: rarely does the market price represent the true long term fundamental value of a firm. The risk-reward framework we use to value the businesses in our coverage list helps prevent us from overpaying.  Our confidence to act in volatility comes from the deep fundamental research and long term view of value. 

So our focus on downside protection is about avoiding fundamental downside risk. This is a goal for each security we purchase over the long run, but it is not the expectation every day/week/month of the year. The performance we have delivered over the last five years comes from maintaining a long term view of the diverse set of businesses we have under coverage while sticking to our disciplined risk-reward implementation framework. We work hard every day to improve and refine our process, and to think differently about risk and expand our coverage of businesses. Only by getting better can we continue to earn the right to manage our clients’ money.

Comments

Submitted by Francis Martin on

Good morning Brandon, thanks for your article. I respect and agree with your points of view and investment philosophy. Today we are also seeing a growing trend of complex products created with the title "Low Volatility". Do you have an opinion on how this trend is likely to affect equity markets (to your point about most risk being simply defined as stock price decline) and more importantly retail investor sentiment towards investing?

Brandon Snow's picture
Submitted by Brandon Snow on

Yes, we are already seeing it in the markets with little patience for market-to-market losses. For many boring/stable businesses, passive strategies are now among their largest holders and as we know ETFs are not price sensitive. I think people have become complacent owning these instruments because they are deemed stable and low risk, while fundamentally the stock in the products is not very attractive. As always, the risk is retail investors losing confidence in our business as a source of wealth creation which hurts financial markets and all companies' access to capital.  

We have a few more blogs in the works on this topic; keep an eye out for them. And as always, thanks for the interest!

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