May 2006
Great football coaches know that defense wins games. Granted, they realize that the offense usually gets the glory and helps sell tickets, but deep down they know that a solid defense is the difference between winning and losing over a long season. The same holds true when it comes to investments. Investors tend to get caught up in the excitement of a bull market and focus on offense, always looking for the next big score. Like coaches, we think a defensive investment style provides winning returns over the long-term and especially in a market environment that we envision in the year ahead.
Having an effective defensive strategy that works to minimize setbacks makes it easier to win. Time isn't wasted making up for past portfolio declines and after all, time, is what fuels the power of compounding.
For example, if a portfolio is able to earn just 7% per year it will double in size in about 10 years. However, if in, let's say, the sixth year the portfolio suffers a 25% decline it would end up taking about 16 years to reach that goal. That could be enough to alter someone's retirement plans.
Many investors who got caught up in the .com game in the late 1990's and concentrated on aggressive offensive investment strategies are still struggling to get their portfolios back to where they stood back in early 2000. They have learned the hard way that a 50% loss means they need to pull off a 100% gain just to get back to even.
Although our disciplined value approach to investing helped us avoid the damage from the bursting of the technology bubble, we have learned from that experience as well as others (like the 1987 crash) the importance of incorporating defensive investment strategies into our game plan. In fact, our firm's investment philosophy and style are based on defensive principles.
Our number one responsibility as investment managers is to protect our clients' money. Why? Because it helps us achieve the obvious goal of earning above-average returns over time. Scrambling to overcome past losses is just not the best way to get the job done. In other words, losing money is the enemy of making money. (We aren't sure if Yogi Berra said that first, but it sounds like one of his more obscure quotes.)
We try to get above average returns by designing our investment game plan around defensive techniques like tactical asset allocation and insisting on buying assets at bargain prices to control risk. We then focus on offensive strategies of finding the right set of investments to achieve the returns we need to make the portfolio grow.
People often label an investment approach like this as being "conservative". Like football fans, they want to see more offense, more action and more points (returns) on the scoreboard. They do not fully appreciate the contribution to the game (a well-reasoned investment process) that the defense makes. Most ignored defensive players will attest to that observation. A good defense prevents the team (portfolio) from getting far behind (losing value) and not forcing the offense to have to use riskier plays (aggressive investment strategies) late in the game to win.
To label this defensive investment style as conservative may be appropriate but I think it misses the essence of what we are trying to accomplish for our clients over the long-term. We do admit that we are careful to design portfolios that are appropriate for the particular needs of our clients. We do not want a significant stock market decline to alter their established lifestyle, especially if they are retired.
On the other hand, like Chef Emeril Lagasse, we have also been known to "kick it up a notch" (BAM!) and be more aggressive with our investment selections when we think the time is right and opportunities are apparent. We have not been shy about venturing into more obscure stock ideas if the potential returns warrant the risks and our clients have been well rewarded.
The economy and the stock market have worried us for a while now and as the market has hit five or six year highs you would think we should feel a bit like Chicken Little. We don't. In our opinion, the American consumer cannot continue to support the global economy with a seemingly insatiable appetite to spend money. The job market is better and wages are rising but gasoline prices and interest rates are climbing even faster. I recently paid over $100 to fill up our two cars! OUCH!
We have also been concerned by the fact that the lower quality, higher risk securities have been providing the biggest returns. This suggests that investors are feeling fearless and seeking risk.
As an example, the stocks with the lowest quality ratings by Standard and Poor's are up an average of 17% so far this year. The best quality companies have earned a pitiful 1.2%. The Russell 2000 Index of small-cap stocks is up about 15% this year versus about 5 - 6% for the S&P 500 Index and the Dow Jones Industrial Average. The valuations of these smaller stocks are now stretched, in our opinion, and vulnerable to a serious decline.
Like now, when we see some dark clouds on the near-term investment horizon, we think it is only prudent to bring in more of the defense to protect the portfolios. Our defense roster is made up of money market funds and securities, bonds, and a special weapon we use sparingly - index put options. Money market funds and bonds have been bulking up on higher interest rates and can better defend portfolios with their higher income. Their yields are getting competitive with expected stock returns.
We also review the stocks that we hold in the portfolios to ensure that we have confidence in their abilities to outperform in a difficult environment. If they don't measure up in our analysis, they get cut from the squad (portfolio). All of these tactics and tools have proven to be very effective in reducing volatility in portfolios during turbulent times.
Having a defensive investment philosophy as a basis for our investment strategies means we are always conscious about the risks that we are taking on behalf of our clients. It doesn't mean that we are giving up the ability to become more aggressive on offense to try to make good returns when the time is right. For now, however, we think it's time to send in the defense.
John W. Gudritz, CFA
john@frontstreet.com