Regardless of market conditions, there is one question we regularly field in client meetings: “What keeps you up at night?” For me, it is a potential misunderstanding between us and our clients.
In the financial world, it is easy to see how misunderstandings happen. There is an enormous amount of interchangeable financial jargon which, not surprisingly, leads to confusion. For instance, stocks, equities and securities can all mean the same thing, but Return on Equity (a common financial metric) has nothing to do with equity market returns. Confused yet?
Sometimes misunderstandings can be cleared up quickly; other times not so much. Taken to an extreme, a misunderstanding can be interpreted as a broken promise. The potential broken promise I fear involves the definition of capital preservation.
At Burgundy, preservation of capital is at the heart of everything we do. So, it can be difficult to step back and approach it as if we were being introduced to the concept for the first time. I’d like to take that step back and clear up any potential misunderstanding.
First, let’s clarify how we do not define capital preservation: a month-to-month or quarter-to-quarter focus on relative returns versus a benchmark. To us, this is not an accurate depiction of capital preservation because short-term movements may be based solely on emotion, which impacts stock prices but not business values. And, as painful as it can be in the moment, without this type of volatility there would be no potential to generate superior long-term returns.
Here is our definition of capital preservation: to avoid permanent loss of capital.
In a 2012 View from Burgundy, David Vanderwood cited James Montier’s three sources of equity risk – the “Trinity of Risk” – to explain how we strive to avoid the risk of permanent loss of capital.
- Business or Earnings Risk: where the level of earnings power estimated for a company turns out to be too high.
- Balance Sheet Risk: where equity owners are dealt losses on part or all of their investment by the investee company’s inability to successfully refinance debt maturities as they come due.
- Valuation Risk: where one pays too much for an investment.
So, this begs the question: how do the Burgundy portfolios stack up today?
- Business or Earnings Risk: We continue to invest in companies with sustainable competitive advantages and we are very conservative in our estimation of their future earnings power. In short, we believe the quality of our portfolio holdings’ business earnings is as high as ever.
- Balance Sheet Risk: We refuse to take on balance sheet risk in the companies we own. In fact, if we rolled up all the companies in the Burgundy Partners’ Global Fund into a holding company, you would see approximately 7% of the value of the companies as debt. This is equivalent to having a $70,000 mortgage on a $1,000,000 house while still being at your peak earning potential.
- Valuation Risk: Valuation risk is the variable that changes daily in the market and in our portfolios. With our margin of safety approach to guide us, we know we are not overpaying for the companies we own. But, the reality is there is not as much room for error lately. While the markets are not close to 1999 or 2007 valuations, we still must recognize that, with the narrowing of our margins of safety, we could see a period of increased volatility.
In times of market volatility, or when an investment is made “too early,” quotational losses can be experienced. But over the long term, these should reverse and turn into profits if we have managed the Trinity of Risk well. While we can’t predict what short-term returns will be, we believe our portfolios are well positioned to avoid permanent losses of capital if the environment were to turn negative.
As always, we do encourage you to have an open dialogue with your Investment Counsellor to compare interpretations of the Burgundy investment principles. This will reduce the chances of a misunderstanding – or worse, a perceived broken promise!