Uncertainty isn’t always bad for investors. Experts weigh in on when to wet your feet in rough waters

Tye Bousada, founding partner, EdgePoint Wealth Management

STANCE: Volatility is your Friend

Volatility isn’t risk

It’s common to equate volatility with risk, but there’s an important distinction between the two. Risk is the opportunity for permanent capital loss. Say you’re 65 years old and had invested in the NASDAQ index at its peak. The way things stand, you’ve experienced permanent loss of capital because you won’t make that money back before you die.

Volatility, on the other hand, can be your friend if you know the true value of a company. The reason people often can’t handle volatility is they don’t know their investments’ true worth.

When people define risk as volatility, they flock toward something they believe will be less volatile in the future. During extremely volatile times, the consensus is to rush to safe havens. That’s the time to leverage volatility. To add value, you can’t be doing the same thing everyone else does.

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.

Picking the winners

• look at historical performance: how has the company done over various cycles?
• Interview management: do they see evidence the company will continue to grow?
• Constantly gather facts and apply reasoning to those facts: If the entire sector is slowing down, how will this company look in a flat-type environment?

When determining real risk, we look for risk to revenue growth, margin contraction, discernible barriers that could bring a business down, poor succession planning, and risk of management’s incompetency.

In for the long haul

Volatility is best leveraged when you take a long-term view of investments.When share prices fluctuate wildly, investors feel uncomfortable because they don’t [understand] the stocks’ true worth. It’s our job to have a sense for the underlying value of a business and capitalize on the volatility of the market prices. But we never try to capitalize for a month or two—no one can really do that. We invest for the next five years. When you invest for a week, a month or a quarter, volatility might very well be defined as risk.

We try and come at each business as if it’s going to feed our family and put a roof over their head. So we’re forced to eat our own cooking. In my case, a vast majority of my wealth, outside of my home, is tied into my company’s portfolios.

Unearthing gems

When we started the company in November 2008, the general sentiment in the market was of absolute fear and extreme volatility. But we didn’t buy the safe-haven pharmaceutical companies, utilities or grocery stores like everyone else. Instead, we invested in a company that makes modular carpet tiles, for example.

Businesses that are perceived as being subject to recession sometimes over-correct.We believed the carpet manufacturer was going to grow, while a lot of people conjectured it wouldn’t even survive. Business continued even during recession, [yet] it was priced as if it had gone out of business.Turned out the business was worth more than 80% of the price we were paying for it.

The scale or market cap of the company doesn’t matter. It’s about finding that unique idea.We look for something the rest of the market hasn’t yet noticed.Then we ask, “Can the business be larger than it is today?” If yes, we try and figure out why we’re not being asked to pay the bill now.

Obvious red flags

• Companies that don’t spend any free cash flow (enron is an example)
• Over-leveraged balance sheets
• Too many balance-sheet liabilities

The evaluation process involves a lot of common sense. We tear apart the company’s balance sheet and cash flow. We try our best to disprove the thesis that the company is going to be twice its size in the next five years. If we can’t find much to disprove we consider it a good investment. That’s the exact opposite of looking at crummy companies and trying to find what’s good about them. We’ve avoided a lot of risky situations by steering clear of marquee brands that later blew up. We’ve never owned the likes of Lehman Brothers, Bear Sterns, Merrill Lynch, AIG, Countrywide, Fannie Mae or Freddie Mac. We did look at AIG when its share prices got cut in half. But all we needed to do was read the annual report to understand they didn’t have a clue what was going on inside the company.

Crafty contrarians

Sometimes it takes us a while to realize we’ve made a mistake, but as soon as we determine our thesis is no longer valid, we exit the business. We sell for only one or two reasons. First, our original thesis was incorrect. Secondly, we make sure the worst idea in the portfolio is constantly considered for replacement by the best idea that’s not in the portfolio.

The most value we’ve added is at points of volatility. Non-stop volatility isn’t good for anyone, but when people are optimistic about the future and share prices go up, it becomes incrementally more difficult to find opportunities to buy growth and not pay for it.

Patti Shannon, VP, Portfolio Manager, Leith Wheeler Investment Counsel

STANCE: Volatility’s good for investors if they have strong emotional control

Watch your heart

Volatility is good for people who have emotional control and can look beyond the noise. If you’re prone to saying, “I can’t take this anymore,” and then sell out after the market has pulled back, then volatility is bad for you. Personally, I like volatility because it shakes weak investors out of the market.

Put volatility to work

All serious investors should be looking at the VIX (Chicago Board Options ExchangeMarket Volatility Index), a popular measure of the implied volatility of S&P 500 index options (see sidebar, “Spotlight on VIX”). You can see the movement in VIX in any publicly available charting package.

Spotlight on VIX

The VIX represents an expected annualized change over the next 30 days. If VIX = 15, that means over the next 30 days, the index option markets expect the S&P 500 to move up or down VIX% ÷ √12=15% ÷ √12=4.33%.

The S&P 500 index doesn’t change on a daily,weekly ormonthly basis. If you buy an option, some days, weeks or months you might have to paymore for it.That higher price of put and call options points to higher implied volatility.

VIX is a measure for fear, and usually has an inverse relationship with the stock market. It actually behaved abnormally in 2007, and could have proved a valuable indicator of what was to follow. From April to October 2007, the stock market veered up and the VIX trended higher too. Investors could have spotted the oddity—some big players and money managers were beginning to get nervous about the market.

VIX isn’t, however, a leading indicator; it’s more a coincident indicator. Here’s how investors can leverage it: If the VIX is trading around 15 to 20, that’s pretty bullish. It means investor confidence is strong, and everyone thinks the economy’s doing great.

If the VIX is above 30, it’s indicative of a panicky market. This is the time to not panic and sell out of your investments. Historically, it has proven a good entry point for people with a longer time horizon, and cash to invest.

When to buy

During mass hysteria in the market, you want to avoid becoming part of the herd. [Don’t] capitulate and sell. Often when it reaches extremes and then the trend changes—in April 2009 it started to trend lower—it’s a good time to buy.

If you receive an inheritance or have sold your company and the VIX has been trading at 15 for some time, wait until the market has a bit of a panic attack [to invest the cash].

How to buy

Be mindful of the triple E of earnings, emotions and expectations. The best time to buy a company might be when emotions or expectations are really low. When Nortel was at its highest valuations, it was trading as if it would grow its earnings substantially for years to come. Expectations were sky-high.

But when expectations are too high, and the company falters a bit, share prices can fall.That’s a prime example of how the true intrinsic value of a company isn’t always reflected in its stock price.

Ideally, you should look for companies that have:

• good business models
• good earnings outlook
• reasonable valuation
• experienced managers
• management invested in the company

We always like it when people managing the company have more skin in the game. Likewise, when choosing a portfolio manager, it is nice for investors to know they are investing alongside their manager. There is nothing worse than investing with a portfolio manager who doesn’t have any of his or her own personal money invested.

Some questions you should be asking yourself include:

• What’s the track record of building shareholder equity? Has shareholder equity gone up over time?
• Have earnings-per-share gone up over time?
• Is the company disciplined with its cash flow?

If a company has excess cash flow, you need to research what it does with it. Does the company return it to shareholders or go out and make an overly expensive purchase?

If the company acquires another business, you need to ask if they paid too much for it—could it lead to too much goodwill on their balance sheet that has to be written down over time.

Also be wary of companies or sectors with too much emotional exuberance attached to them. Take silver, for example—on a wild uptrend in April this year, silver was emotionally overbought, and then fell hard. Doesn’t mean it can’t be a good long-term investment, but if you see something that’s trading two standard deviations above a rising 50-day moving average, don’t buy it now.