Contrary to what you might think, volatility isn’t necessarily a bad thing. And watching out for truly risky investments doesn’t mean running from volatile ones.
Volatile or not, choosing good investments means betting on good companies, especially when most others aren’t.
Volatility isn’t risk
“It’s common to equate volatility with risk, but there’s an important distinction between the two,” says Tye Bousada, founding partner of EdgePoint Management. “Risk is the opportunity for permanent capital loss. Volatility, on the other hand, can be your friend if you know the true value of a company.”
If you view volatility as risk, you’ll naturally retreat toward investments you believe will be less volatile in the future. In times of extreme volatility, that translates into a rush to safe havens that often don’t produce good long-term returns. And, in fact, you’ll miss the opportunity to leverage volatility.
“During mass hysteria in the market, you want avoid becoming part of the herd,” says Patti Shannon, VP and portfolio manager at Leith Wheeler Investment Counsel. The market will often hit extremes and then trend in the other direction.
“To add value, you can’t be doing the same thing everyone else does,” Bousada says. “Our job is to find the minority of businesses that can grow irrespective of what happens in the economy, and not pay for that growth today.
“Volatility shouldn’t be a factor in determining the value of a business, unless you’re talking about volatility in the underlying fundamentals of the business.”
To determine real risk, portfolio managers look for specific red flags such as risk to revenue growth, margin contraction, and poor succession planning.
Shannon adds you should instead look for companies with good business models and earnings outlook, reasonable valuation, and experienced managers with a stake in a company’s success.
“We always like it when people managing the company have more skin in the game,” she says. You should expect that a portfolio manager is investing their own money along with you.
To best leverage volatility, take a long-term view of your investments. Wildly fluctuating share prices can be alarming, but they shouldn’t be a deal-breaker if you’ve done due diligence by judging an investment on its real risk factors. For long-term investments – five years or more – the underlying value of a business will shine through.
When Bousada started his company in 2008, the market atmosphere was fraught with fear and extreme volatility. But instead of jumping into safe-haven investments such as pharmaceutical companies or utilities, the firm invested in companies like one that makes modular carpet tiles.
“Businesses that are perceived as being subject to recession sometimes over-correct,” he says. “We believed the carpet manufacturer was going to grow, while a lot of people conjectured it wouldn’t even survive.”
The business carried on, yet its stock was severely underpriced because of the recession.
Evaluating a company boils down to common sense: looking deeply into a company’s balance sheet and cash flow. Bousada starts with the thesis that a company is going to double in size over the next five years, and then tries to disprove that claim. If the claim stands, it’s a good investment.
“That’s the exact opposite of looking at crummy companies and trying to find what’s good about them,” he says. “We’ve avoided a lot of risky situations by steering clear of marquee brands that later blew up.”
While Bousada concedes constant volatility isn’t good for anyone in the market, he says times of market volatility are the best for buying growth without having to pay for it.