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Cardinal Rule #2

Cardinal Rule #2

Peeling the Onion of Investment Performance

A good friend and client recently asked for Cardinal Capital’s help in analyzing investment performance and what he should understand about the returns we report, compared to market indices. He used the phrase "peeling back the onion" and I have purloined the phrase to describe my response herein.

Investment performance is straightforward, isn’t it? Either you beat the index or not, right? If we beat the index, that is good and if we didn’t, that’s bad? Right again?

Well, yes and no to both questions. The "weasel words" can obscure several factors; what is the investment objective, how much risk is being taken and what is the investment time horizon. Let’s look at each of these.

If the investment objective is to earn a market-plus return, there are several options. One can choose to index and add a few non-market bets to the brew. This is an approach that reduces the manager’s business risk but doesn’t do much for the client. Or one can adopt an active investment management strategy that is rooted in academic research and has a good track record. As I hope you guessed, Cardinal Capital follows the latter approach.

Our approach is to invest in financially strong, growing companies when their stocks are selling at significant discounts to normal valuation standards. And we sell them when their valuations are significantly rich compared to these same benchmarks.

The result has been superior returns compared to the market over a full market cycle, while taking less than market risk as measured by volatility. However, there is nothing in this process that makes it work in the short run, or every quarter or every year. Indeed, under-performance in some intervals is almost certain, given the multi-period fads that sweep the market.

Risk is another concept to consider. Remember the wild valuations of dot.com stocks a few years ago? And how they became even more absurdly valued…for a while? Technology/telecom/dot.com stocks made up more than 30% of broad market indexes near the top and subsequently lost over half their value.

So index funds may add considerable unintended risk to a portfolio, when at least part of the idea is to reduce risk.

Investment time horizon is also a crucial part of the calculus. In general, the longer the investment time horizon, the more likely that pricing and returns will revert to the norm. For us, that simply supports our confidence that investing in financially strong, growing companies at modest valuations will produce superior returns over time.

This brings us back to the key topic, that of investment objective. For most individuals, it is building and preserving capital for some future need like education, retirement and other family-specific needs. Thus the goal is not to beat a market index every quarter or year, but to follow an approach that has a high probability of achieving the objective over time.

Therefore, focusing too strongly on short-term results may be detrimental to achieving long-term goals if that leads to chasing long shots or whatever is "hot" at the moment.

To learn more, read the CFA Institute’s "What Every Investor Should Know" series that can be accessed through our link at www.cardinalcapitalmanagement.com. We welcome your own questions and comments.

Joel A. Millikan, CFA

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	Cardinal Rules Archive Cardinal Rule #2 Cardinal Rule #2 Peeling the Onion of Investment Performance A good friend and client recently asked for Cardinal Capital’s help in analyzing investment performance and what he should understand about the returns we report, compared to market indices. He used the phrase "peeling back the onion" and I have purloined the phrase to describe my response herein. Investment performance is straightforward, isn’t it? Either you beat the index or not, right? If we beat the index, that is good and if we didn’t, that’s bad? Right again? Well, yes and no to both questions. The "weasel words" can obscure several factors; what is the investment objective, how much risk is being taken and what is the investment time horizon. Let’s look at each of these. If the investment objective is to earn a market-plus return, there are several options. One can choose to index and add a few non-market bets to the brew. This is an approach that reduces the manager’s business risk but doesn’t do much for the client. Or one can adopt an active investment management strategy that is rooted in academic research and has a good track record. As I hope you guessed, Cardinal Capital follows the latter approach. Our approach is to invest in financially strong, growing companies when their stocks are selling at significant discounts to normal valuation standards. And we sell them when their valuations are significantly rich compared to these same benchmarks. The result has been superior returns compared to the market over a full market cycle, while taking less than market risk as measured by volatility. However, there is nothing in this process that makes it work in the short run, or every quarter or every year. Indeed, under-performance in some intervals is almost certain, given the multi-period fads that sweep the market. Risk is another concept to consider. Remember the wild valuations of dot.com stocks a few years ago? And how they became even more absurdly valued…for a while? Technology/telecom/dot.com stocks made up more than 30% of broad market indexes near the top and subsequently lost over half their value. So index funds may add considerable unintended risk to a portfolio, when at least part of the idea is to reduce risk. Investment time horizon is also a crucial part of the calculus. In general, the longer the investment time horizon, the more likely that pricing and returns will revert to the norm. For us, that simply supports our confidence that investing in financially strong, growing companies at modest valuations will produce superior returns over time. This brings us back to the key topic, that of investment objective. For most individuals, it is building and preserving capital for some future need like education, retirement and other family-specific needs. Thus the goal is not to beat a market index every quarter or year, but to follow an approach that has a high probability of achieving the objective over time. Therefore, focusing too strongly on short-term results may be detrimental to achieving long-term goals if that leads to chasing long shots or whatever is "hot" at the moment. To learn more, read the CFA Institute’s "What Every Investor Should Know" series that can be accessed through our link at www.cardinalcapitalmanagement.com. We welcome your own questions and comments. Joel A. Millikan, CFA