The capital protection process

The last few weeks have reinforced the importance of portfolio managers and private investors having a solid process to protect capital and prevent themselves from opening position which are, frankly, only ever going to lose them money. For those of you that haven’t seen the headlines, a number of tiny US companies such as Bed, Bath & Beyond and Gamestop were ramped to the moon on an internet forum called Reddit. Shares in Gamestop, for example, shot up from a low of $18 a share on January 8th up to a high of $325 dollars by January 29th (an increase of well over 1500%) before crashing back down to $130 by February 2nd and continuing to slide from there.

Setting aside some of the more socioeconomic commentary on the matter, I have no doubt that retail investors will have cumulatively lost tens of millions in portfolio value chasing this stock. I’ve written before about the importance of having a systematic process for managing your portfolio. If you can’t write your process down then in truth, you probably haven’t actually got one.

In order to establish a process for protecting your capital you need to first have a system for generating ideas for your portfolio; an intellectual framework by which you analyse the markets and identify opportunities to generate profit. Your capital protection system is then in place to ensure that firstly, these ideas are correctly implemented (that you buy low and sell high, rather than the reverse) and that you have a method of ranking these ideas to ensure that you only place the best ones.

For example, when I noticed the stratospheric rise in Gamestop last month, I mentioned to a fellow investor that if I was quick, I could double my money but the risk of mistiming was stratospheric. The company had made no new announcements, was loss-making, and wasn’t doing anything particularly exciting as an aging retail brand. The odds of me buying at £100 and selling at £200 were, at best, equal with me buying at £100 and watching the shares crash to £50 and realistically I was probably far more likely to buy at £300 and watch them crater back down to £3. Compared to the other opportunities I’m tracking, this was, by far, the riskiest and least reliable ‘opportunity’ and over the course of a month I watched the shares skyrocket and then crater.

What kept me out of the realms of gambling in the company was my capital protection process; the system by which I rigorously try to ensure that the positions I open are good ideas that will unfold well rather than good ideas that fail to go in the right direction. As an investor, I accept that a certain number of investments will fail to perform as I expect (generating a profit) but my goal is to minimise these by every possible strategy and ensure that over time, the majority of my positions generate a profit.

As I don’t use active stop losses on my portfolio, I have a larger degree of flexibility to give my investments time to perform. If a share dips 10% in the three months after I buy it and then rises 25% over the next three months, I’ve still generated a profit, even if my initial timing wasn’t perfect. My capital protection process partly focuses on trying to minimise the frequency and size of these ‘initial dips’ as well as trying to protect against them becoming long-term trending declines that grow into significant losses.

For the purposes of this article, I’m going to assume that you have generated a number of investment ideas for your portfolio. When attempting to rank these opportunities, I follow a simple checklist and award a single ‘point’ for each criteria to rank ideas.

  1. Priced in line with my margin of safety. Is the company within my margin of safety estimate based on the Net Asset Value and expected future cashflow?
  2. Positive Addition to the Portfolio. Does company should bring exposure to a high-performance sector or country and avoid being overly speculative?
    1. Are the company’s goods or services essential or discretionary?
    2. Does prevailing sentiment want more or less of them?
    3. Does the company support the ‘future’ of the economy or the past?
  3. Long-Term Price Action. Does the company have a stable or rising share price over one and three year time periods?
  4. Institutional Support. Does the company have significant (over 40%) institutional ownership?
    1. Bonus points for institutional ownership that has grown over the previous 12 months.
  5. Short-Term Price Action. Does the company have a price that is within the bottom 25% of the three-month price range?

At this stage in the process, an idea is simply an idea; it can’t generate any profit for the portfolio but at the same time, it can’t destroy any value either. The capital protection process is designed to try an ensure that the trade idea generates a profit rather than a loss. Without this process in place, an investor risks investing in every idea they have – some of which will always be poorly timed and failed to generate a profit, and others which are simply bad ideas. The first category is often the most irritating to me; when I could have made a profit but due to poor timing ended up making a loss.

When I first began investing, this was the most common source of my losses. Avoiding bad ideas was relatively easy; make sure that the company generates a profit, make sure they don’t have too much debt, make sure they’re doing something useful and that they’ve been successful for many years and so on. By contrast, executing good trade ideas well was much harder; buying a profitable company at the top of a price range of pretty much eliminate your profit. Buying a profitable company in a long-term down trend will result in a loss. Investing in a company where institutions are net sellers will depress the price.

Today, I’m much more careful about the way I open positions and follow my capital protection process to try and time the opening of new trades to maximise the changes of making a profit. I take my time and avoid executing trades which I feel are at sub-optimal positions.

The other thing to highlight with the capital protection process is that it always comes after a fundamental analysis of a company. I do not deviate from my core principles of investing just because a chart is going up or I notice a pattern. Technical analysis is simply a tool to help me time entry and exit of positions; it doesn’t confirm whether an idea is good or not.

As an investor, you absolutely must have a view on the company and its future financial performance. If the only thing you have looked at is historic price action then you are not investing, you are speculating. Your fundamental analysis and research into a company is what gives you confidence during periods of market volatility and weakness. Without this, you risk buying into failing companies facing industry-wide headwinds and holding them as they decline into irrelevance.