There are really only two rules for successful investment. The first rule is to protect your capital. The second rule is to always remember the first rule. It is surprising how many investors forget or ignore these rules, particularly in a bull phase of the market. Rising share prices (often not supported by the fundamentals) usually leads to fear of being left behind, and investors pile in regardless. This then leads to euphoria, which fuels even higher share prices, and even greater euphoria, and on it goes until the inevitable happens. The aftermath is often very painful, with investors losing substantial amounts of their capital.

As well as the absolute of protecting capital, investment is also a relative game, and no investment can be considered expensive or inexpensive unless it is judged against alternative investments. To make this judgement, all investments should be analysed for the potential returns they can achieve, always remembering the risk undertaken to achieve that return. It seems simple to say, but for a given level of quantified risk, the investment with the highest potential return should be chosen. Equally, the choice between investments with the same potential returns can be made by selecting the investment with the lowest level of risk. Risk and return are, therefore, inextricably linked.

Investment management is often described as a combination of science and art, but this does not fully capture the investment management process. Perhaps a more accurate description of investment management is to say that it is similar to engineering, in that investment managers are in the business of managing and engineering financial investment risk to achieve a desired level of investment return.

It is of note, however, that it can be difficult to protect capital in equity markets, particularly over short time periods. The longer the time horizon, the more likely capital will be protected.

One of the most authoritative statements on the subject of risk (and a good example of where capital was not protected) was issued over 175 years ago by a judge's decision in a lawsuit over the administration of an estate of a Boston man, John McLean. John McLean died in 1823, leaving $50,000 in trust for his wife to receive the 'profits and income thereof' during her lifetime ; on her death, the trustees were to distribute half the remainder, equally, between Harvard College and the Massachusetts General Hospital. When Mrs McLean died five years later, the value of the estate had declined by more than 40%. The College and the Hospital formally brought a suit against the trustees of the estate. In his judgement, the Judge declared that the trustees could not be held accountable for a loss of capital that was not 'owing to their wilful default'. The Judge continued with what came to be known as the Prudent Man Rule : Do what you will, the capital is at hazard………….All that can be required of a trustee to invest, is, that he shall conduct himself faithfully and exercise a sound discretion. He is to observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested. [Against the Gods (Peter L Berstein)]

Investors today would be well advised to remember the two rules of investment and, perhaps, also to incorporate into their thinking the Prudent Man Rule. This may well go some way to protecting investors from over-exuberance in bull markets and prevent them from investing at the top of the market.

Warren Buffett, one of the world’s best known investors, announced this week that he has been buying US equities. Where’s the surprise there, I hear you asking? The surprise is that he is talking about his personal account not Berkshire Hathaway, the investment company he manages. Buffett, for the last couple of years, owned no equities but instead had his personal money tied up in US government bonds but now he believes there is real value in US equities.

If there is value in US equities, is there value elsewhere? I believe the answer is yes, certainly within many areas of the UK stockmarket. It is easy to be downbeat about the prospects for UK equities and the wider economy at large when we are bombarded by the media on a day-to-day basis about the banking crisis, increasing unemployment and a widely expected recession. These facts are known and they cannot be overlooked but, equally, it does not mean that the market has not already priced them in to a large extent. It is our view that the sell-off in UK equities has been overdone and this provides investors with significant opportunities to purchase shares at what we believe to be bargain basement prices. The indiscriminate sell-off has been driven by shareholder anxiety and very little attention is being paid to fundamentals.

The turmoil and volatility is providing wonderful opportunities to make significant amounts of money when the market turns. Eighteen months ago the forward P/E on the FTSE 100 was 13x; now it is on 8x. The difference on the FTSE 250 is even more marked at 16x as opposed to the current 8x. It is difficult to time the bottom of the market, but it is our view, given the low valuations on offer, that we are very near a turning point in the UK stock market. As such, investors who can hold their nerve will be well rewarded in the future. It would be foolish to predict short-term movements in the market, especially during periods of extreme instability and share prices could quite possibly fall from here before rising but what will most probably happen is the stockmarket will increase well before either sentiment or the economy turns.

At Saracen we try to identify well established companies with growing sales, cash flows and profits. Many of the businesses we currently favour have been overlooked by investors recently but that does not mean that, fundamentally, there is anything wrong. Companies which have strong balance sheets, low levels of gearing and powerful positions within their chosen markets will, we believe, perform strongly over the next 5 years. At present oil stocks appear attractive for a number of reasons. BP and Shell currently yield over 7.5% and 7.0% respectively and have dividend covers approaching 3x, leading us to believe it is almost unthinkable that the dividends will be cut. In fact, the last time Shell cut its dividend was at the time of the Second World War!

Other companies we believe provide attractive, long-term growth prospects include GlaxoSmithKline, Vodafone and Imperial Tobacco, each of which offers an above average dividend yield and inexpensive price/earnings ratios. Whilst problems within the financial sector continue and with the best case scenario being vastly reduced dividends from the banks over the next few years, investors will have to look elsewhere to replace lost income. Defensive areas of the market such as Oils, Pharmaceuticals, Tobacco and Utilities will once again come into focus as pension funds and private individuals look for soundly financed, well capitalised companies with above average and growing dividends.

To conclude, I refer again to Warren Buffett (and it is a quote investors both professional and private should keep at the forefront of their minds) - “Be fearful when others are greedy and be greedy when others are fearful.”