In bad times, taking risks can be detrimental to your portfolio
Kyle WalesWe live in turbulent times. Since one of the steepest cycles of interest-rate rises began in 2022, and with a recession on the horizon, the prudent investor’s focus needs to shift from upside potential only towards downside risk too.
The importance of capital preservation is perhaps best captured in a Warren Buffet quote: “Rule number one [of investing]: never lose money. Rule number two: never forget rule number one.” The following are the three key metrics I believe investors should monitor to mitigate downside risk.Most investors would have heard about the price-earnings ratio because it is the most commonly used metric to assess valuation.
Even a good business can be a poor investment at the wrong price, while a poor business can be a good investment at the right price.Overall equity valuations now are not particularly cheap if one considers the weak economic outlook and considerable uncertainty weighing on financial markets. The S&P 500 trades on a forward PE of 17.2 times, versus a historical average of 16.5 times. The forward PE is based on forecast rather than historical earnings.
The characteristics of a high-quality business include a moat, which is the company’s ability to maintain its competitive advantage, high returns on its invested capital and high free cash flow conversion, which is the business’s efficiency in turning sales into cash. Most importantly, it includes pricing power because the company’s capacity to sell its products and services at a profit will determine its revenue growth.Certain types of businesses have very little pricing power.
In good times, investors are almost always rewarded for taking additional risks. In bad times, taking on additional risk can be detrimental to investment performance. Investors need to be aware of the risks they are taking, and protect themselves as far as they can to achieve superior, long-term returns. These three measures give you crucial insight into the potential performance of assets you are considering adding to your portfolio.
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