Mitigate risk when value investing

If clients are buying stocks that have dipped below their true values, they should expect volatility.

That’s because stock prices often drop when companies are facing hard times, says Peter Hardy, vice president and client portfolio manager at American Century Investments in Kansas City, Missouri. His firm manages the Renaissance U.S. Equity Income Fund.

The best way to mitigate risk, he adds, is to focus on high-quality businesses that have:

• high returns on capital;
• low leverage, which helps cut balance-sheet risk; and
• competitive advantages through the development of iconic brands, market share leadership or low costs.

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If a business scores high in all three categories, its stock will likely be less volatile.

It also helps if your “evaluation of business models [is] dynamic at all times,” says Hardy. While many people focus on a firm’s track record to assess its historic profile and performance, he finds a forward-looking, prospective approach can be more useful.

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But you won’t always be right about a stock, he adds. “[In 2008], there were certain companies that we thought were higher quality that exhibited more risk than we presupposed…We eliminated them from our universe.”

Further, the valuation process involves determining both fair and worst-case values for potential stocks. “[W]e’re looking at the range of outcomes from a business perspective and…from a stock perspective,” says Hardy.

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Fair value, he stresses, isn’t based on when a company is outperforming. Instead, the term refers to what a business can realistically achieve in normal environments.

To properly measure performance, it’s best to set a five-year time horizon for that particular metric, says Hardy, who adds, “Companies over-earn and under-earn their normal return level. We’re looking at that long-run, stable normalized return on tangible asset level [when]…determining [a company’s] fair value.”

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Next, it’s important to determine how much a business is expected to dip below its fair value when under pressure.

Hardy and his colleagues often battle volatility with convertibles. “By investing in convertibles, we can lower the range of outcomes of [investing in riskier] businesses. [The bonds] give our investors more stable…return sources.”

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