Know the downside of your stock picks

Iain Power, portfolio manager at boutique investment management firm Truffle Asset Management. (Supplied)
Iain Power, portfolio manager at boutique investment management firm Truffle Asset Management. (Supplied)

Cape Town - The layperson is often surprised to find out that when a large conglomerate purchases a small, bolt-on acquisition they don’t typically buy the slickest, most well-run and efficient operations. Instead, they typically buy businesses that aren’t all that well run, which they think they can improve by seeking greater efficiencies. The reason is that these businesses are typically cheaper than their more well-run counterparts.

Value investors like Warren Buffet operate in a somewhat similar way. Instead of buying the most highly-rated blue chip stocks, value investors tend to look for equities that they believe the market is undervaluing or that are trading at less than their intrinsic value.

The underlying sentiment is that the market tends to over-price companies that have delivered good results or that have benefited from a lot of good news, while under-pricing companies that have not delivered the best results or have experienced turmoil in their industry.

Where value investors differ though is that they still place a big premium on good management. A large conglomerate has the luxury of being able to replace the management team of a small bolt-on acquisition whereas a value investor still needs to have faith in the management of the company, even though the market may be under-pricing the counter due to the headwinds being faced in its sector. Their similarity is that both investors in this case, prefer targets that appear to be trading at a discount.

However, Iain Power, a portfolio manager at leading boutique investment management company, Truffle Asset Management says it is not good enough to simply identify and purchase discounted shares. Investors need to take the process one step further and conduct a thorough analysis into a share’s potential downside risk in the event that their assessment of intrinsic value is off the mark.

The idea is to invest in quality, well-run companies that are facing temporary setbacks, but are likely to recover to normalised profitability over the longer term. A related strategy is to invest in companies that are not yet on everybody’s investment radar.

“One of Truffle’s strengths has been our ability to identify under-priced companies that are being ‘ignored’ by the market and, hence, can be bought for a reasonable price,” says Power.

However, Power warns that anyone seeking to embark on a long-term strategy of value investing needs to be careful to distinguish between a true mispriced value opportunity and what he calls a superficial value trap. Power says this often happens when investors focus too much on an investment’s upside potential and gloss over the possible downside risks.

“During the past few years shares in the construction, platinum and sugar industries appeared superficially cheap,” says Power. “However, further detailed analysis revealed an asymmetry of returns which were skewed to the downside and consequently did not justify an investment into these sectors.”

A failure to adequately assess a share’s downside risks can have devastating consequences. In fact, Power believes that understanding the downside of any investment opportunity is arguably more important than understanding its upside potential.

The last few years have seen huge tailwinds for equities, resulting in great returns for customers well ahead of what they could reasonably have expected given underlying economic fundamentals. As many of the tailwinds experienced during the last five years are now turning into headwinds, there is a distinct possibility that the returns enjoyed by investors in recent years could begin to evaporate.

“Investors should prepare themselves for significantly higher levels of volatility and lower returns going forward,” he says.

In an environment of heightened economic and market uncertainty, the ability to adequately assess the downside potential of one’s stock pick becomes even more crucial.

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