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Investing for the downside can have upside results

When choosing quality companies for Fidelity funds, portfolio manager Dan Dupont follows four principles ‘to the letter’ to mitigate downside risk


Date: June 25,2014

Making money when the market is booming would seem to be a pretty straightforward goal, a sweet spot where rising numbers bring healthy returns for most investors.

Yet holding your ground when things turn sour is also important. For Dan Dupont, a portfolio manager at Fidelity Investments, protecting capital and mitigating downside risk is critical to investing.

It’s the cornerstone of a process that Mr. Dupont follows “to the letter” in making investment decisions for several funds at Fidelity, with total assets of more than $10-billion. He co-manages the Fidelity NorthStar Fund, along with Joel Tillinghast, as well as managing the Fidelity Canadian Large Cap Fund, the Fidelity Concentrated Value Private Pool and equity portions of the Fidelity Monthly Income Fund and Fidelity Income Allocation Fund. Also, Mr. Dupont is now managing the equity portion of the newly launched Fidelity NorthStar Balanced Fund.

Mr. Dupont’s investment process is based on four principles: protecting capital and mitigating downside risk; buying quality companies; being “infinitely patient” on price; and trying not to predict the unpredictable.

“You have to think about downside first, try to protect capital first and foremost, and don’t even think about the upside until you have ascertained that the downside on every single security is limited,” he says, noting that Mr. Tillinghast calls this “dropping out of a basement window,” which means it’s hard to get hurt.

“The real promise I make to investors is that if we have a down market, I will try to minimize the amount of their capital that we lose.”

NorthStar is a value-oriented global “best-ideas” fund, says Mr. Dupont, who is primarily a large-cap investor. He says that it’s done “surprisingly well” in the bull market, with one-year returns at about 35 per cent. “Typically we really shine in the down market.”

Why invest for the downside? Mr. Dupont says stocks that are less volatile than average but that have good returns on capital, and that are good businesses generally, tend to outperform the market, “which goes against what you are taught in business school.” Then there’s investor behaviour, the fact that most people are unable to withstand large capital losses and continue to invest when prices are more attractive. “We’re all human.”

Who should focus on the downside? “It goes with your personality, where you are in your investment life,” he suggests. Young investors might be willing to take more risks, “but as people grow older and they get closer to retirement they cannot afford to lose a significant portion of their capital in any given down market.”

The 2008 crash “taught that to a lot of people, unfortunately,” he recalls. “Going forward, a lot of people are looking for investment vehicles that protect better.”

Mr. Dupont says it’s important to minimize the macroeconomic forecasting that goes into investment decisions, which he calls “embracing your ignorance,” while focusing on possible “extreme scenarios” that might be impactful. Variables such as interest-rate movements and commodity prices are important to pricing equities, “but given that they’re unpredictable, it’s a waste of time to try to predict them,” he says. “Even if you spend a significant amount of time on them, your confidence that your prediction is correct cannot be very high.”

Meanwhile, he tries to make sure that “a lot of things that have never happened in the past but may happen in the future … are not significantly detrimental to the capital position of our clients.” These include earthquakes, radical economic changes, nuclear or biological attacks, for instance, even a combination of scenarios.

“We’ll never create a portfolio that doesn’t go down when something bad happens in the world,” he says. “But you need to stress-test your portfolio against things that other investors are not spending their time thinking about … that are significant to the company’s value.”

He typically stays away from cyclical companies, especially those based on commodities, which are difficult to predict in terms of their movement in the cycle, unless their valuation is depressed. “Return on capital can be high, and you can make a significant amount of money over time, if you can withstand the volatility in the margins.”

Mr. Dupont’s portfolio is quite concentrated, with just 30 securities in his part of the NorthStar Fund, for example. “Concentration in investments increases the intensity with which you think about the business. It forces you to make sure that you’re not missing anything,” he explains, adding diversity in terms of industries and risk factors is still vital.

It’s important to invest in quality companies, which means they have good balance sheets and are good businesses. “If you can have both, so much the better; if it can be a lot of one and some of the other, great,” he says. “But you cannot have a bad business with a bad balance sheet. No matter what the price is, even if you pay one times earnings, if it’s too levered and it’s not a good business, we’re not going to touch it.”

Because he owns so few securities, he can be patient and wait for an attractive price that makes it possible to protect against downside. “That means not buying when a lot of other value investors would be attracted, and being just a little bit more patient than pretty much everybody else,” he says, adding that “there are some great businesses out there that you love but that you will never own,” because they never reach the right price.

“That’s all part of the equation,” he says. “It’s very important to just accept that early and just walk away and acknowledge that it is a good business, and explain why you don’t own it, and make sure that your investors also understand that.”

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