Clark Stamper’s Investment Philosophy
Seeking to Maximize Risk-Adjusted Performance…
…is the professional, responsible, long-term investment goal that we focus on at Stamper Capital & Investments Inc.
Why Risk-Adjusted Performance?
Concentrating on risk-adjusted performance prudently maximizes long-term wealth. Risk-adjusted performance means that you are striving to achieve the highest total return for the amount of risk that you are taking on – we believe this is a realistic and reasonable goal. Often, market participants focus on upside potential and the total return expected, without regard to the risk of loss of principal and the downside protection given up. We believe limited focus is unprofessional, irresponsible, and unrealistic. Not focusing on the risk aspect of investing is, in effect, a denial of its existence. Denying the existence of risk proves foolhardy over the long run and is often a recipe for disaster.
What is risk?
Risk is the chance that some unfavorable and unexpected event will occur.
Common Risks in investing include:
Market Risk, Credit Risk, Risk of Inflation, Risk of Deflation and Interest Rate Risk. All investments are vulnerable to these types of risks and investors must have a firm understanding of these risks to build an enduring portfolio.
- Market Risk – The risk of the market in general is the risk that still exists after a portfolio is properly diversified. Academic theory holds that you cannot get rid of this risk. However, there are some non-market-sensitive investments. Non-market-sensitive investments perform independently of the market and have their own risks and rewards.
- Credit Risk – More easily understood in terms of a bond. In that case, it is the risk that a creditor will not make the interest or principal payments as agreed to in the indenture. In terms of equities, it is the improvement or deterioration of a company’s prospects due to improving or deteriorating financial results and expectations.
- Interest Rate Risk – Primarily the risk that affects most fixed income portfolios. It is the danger that interest rates will rise causing a bond’s principal value to drop. There is an inverse relationship between the level of interest rates and bond prices. The prices of long-term bonds are much more sensitive to changes in interest rates than are the prices of short-term bonds. Therefore, in general, long-term bonds have more interest rate risk than short-term bonds. Specific security characteristics of bonds can mitigate or change the normal interest rate risk of a particular long-term bond.
- Risk of Inflation – The risk that the value of one’s investment will drop due to a rise in the prices of most goods and services in general. There is normally an expected level of inflation. The real risk here is that actual inflation will exceed the expected level. This is due to the fact that the yield on a security reflects the average inflation rate expected over the security’s life. If a high inflation rate is expected in the future, that expectation is built into the interest rate of the security (along with other factors).
- Risk of Deflation – The opposite of inflation is a risk that is rarely talked about today. That risk is deflation, which is a drop in the general price level of all goods and services. When deflation occurs, the economy slips into a depression, which is deeper than a recession or a normal business cycle low. When deflation occurs, almost all assets drop in value.
Risks are special characteristics that bonds have (like calls and sinkers) which can determine the upside potential and downside protection of an investment.
- Call Risk – This is the risk that a bond will be called away from the owner and the funds from the call will have to be reinvested in lower yielding securities. Call risk is of primary concern when interest rates drop. It is at this time that the issuer would like to call the high coupon (high income to the holder) bonds and refinance them with lower coupon bonds. One type of call risk associated with mortgaged-backed securities is prepayment risk. This is the risk that the underlying borrower will pay off their mortgage and the issuer will take the proceeds and call the mortgaged-backed security at par. We have found that sometimes it is appropriate to take on call risk and give up other types of risk.
– put simply, are what we invest for!
- Potential Rewards – The dividend or coupon and the upside potential of an investment. In terms of equities, in addition to dividends, it is the potential for a company’s sales, earnings, and cash flow to come in better than expected which would, theoretically, move up the price of its stock. For bonds, it is the coupon income and capital appreciation either from improving credit quality or from dropping interest rates in general, which causes bond prices in general to rise. These are the general rewards; however, there are numerous other rewards, such as a large coupon bond passing a call (thus, being outstanding longer than most expected, so the owner gets that large coupon longer than anticipated) that would take a huge volume of space to explain.
By Focusing on the Upside Potential & Downside Protection…
…of each investment, we build portfolios that earn the most for the money in terms of potential reward per risk taken.
- Downside Protection – Along with looking at an investment on a worst-case basis, you need to understand the amount of downside protection that the investment offers – how much can the price drop and what will support it. For example, downside protection is often, in part, determined by a bonds priority in the issuers’ capital structure. If bonds are senior and secured, they usually have a first claim on the assets backing them. In that case you can determine by how much the market value of the asset backing that particular bond covers the bond. If bonds are unsecured (and are below other bonds in priority), you can use historical rules of thumb based on recent or past events and relative valuation levels (for example, relative to cash flow generated) to get an idea of what an unsecured debt position is worth in bankruptcy or a restructuring. These rules of thumb often depend upon what industry the issuer is in and on other factors.
- Upside Potential – You also need to understand the amount of an investment’s expected return, and its upside potential or the amount of return you would receive under varying scenarios such as “expected” and “best case.” The upside on a bond is usually limited by its security characteristics such as its call schedule or sinking fund schedule. There are some cases where the downside protection is weak but the upside potential of a business is very strong. In this case, since a bond’s upside is usually limited by a call of some sort, a much smarter way to get involved is to own equity where you have essentially unlimited upside but even greater downside.