By Montag & Caldwell

With the increase in market volatility this year, it may be an opportune time to review your portfolio’s capacity to manage risk and, in particular, the quality profile of your portfolio. One of the best portfolio hedges to increased market volatility is high-quality fixed income and equity investments, given their strong capital preservation characteristics, which may lead to significant reductions in portfolio risk.

In the investment arena, market volatility translates to dispersion around the average return of a security or market index. It is typically associated with investment risk, or declining market environments, which naturally increase investor anxiety. Although volatility is a natural and normal phenomenon in investment markets, investors should nevertheless aim to minimize exposure to increased volatility with a bias towards high-quality investments.

What is a high-quality security?

While no single, concrete set of standards defines a company as high quality, investors can focus on characteristics such as balance sheet strength, earnings quality and visibility, and profitability. These attributes tend to help preserve asset values during periods of negative returns, and often lead to outperformance over full market cycles (the combination of a bull and bear market). In both rational and volatile market environments, investors tend to pay more for quality because of the premium they put on safety, as investors often demand more compensation for taking on more fundamental risk from lower-quality companies.

Balance sheet emphasis

While quality characteristics such as profitability and cash flow generation are significant drivers of a company’s value over time, a strong (cash-rich) balance sheet is what allows a company to survive — and potentially thrive — during periods of economic stress.  These companies are often able to improve their competitive positions through economic downturns. In challenging environments, the resiliency of strong balance sheets may allow them to emerge stronger by taking market share and improving profitability as weaker competitors fail or are too cash-strapped to innovate.

Margin of safety

Many high-quality investors use valuation approaches that emphasize a margin of safety, which may be defined as purchasing a security when the current market price is below an estimation of intrinsic value. Using this approach may decrease the downside risk when investing in securities — providing a built-in cushion during market declines. Investing with a margin of safety helps to ensure investors are compensated for any company-specific investment risk.

The importance of capital preservation

Over long periods of time, and in particular, against a backdrop of higher potential market volatility, capital preservation might be better achieved with a high-quality portfolio — and is often more important than absolute asset growth. Downside protection matters because losing less of your investment requires less of a rebound. For example, asset losses of 20% require an increase of 25% to get back to even; a loss of 30% needs a rebound of 43% to get even; and a loss of 50% would require a 100% increase to get back to even. These examples demonstrate that avoiding large losses in down markets could be more valuable than excess returns in up markets.

Investors are taught to believe that higher risk generates higher returns, but over long periods of time, and certainly through volatile market environments, a bias towards high-quality investments may in fact generate higher returns with less risk. Investors should consider a bias towards high quality as their core portfolio allocation. Emphasizing characteristics such as strong balance sheets with a valuation discipline (margin of safety) will help preserve capital and potentially generate higher and more consistent portfolio returns over time.

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Montag & Caldwell, LLC was founded in Atlanta, Georgia in 1945 and has served both private clients and institutional investors for 75 years. While primarily known for managing equity securities, our firm’s experience also includes fixed income and asset allocation strategies – with an emphasis on managing risk.