Seeking value in volatile markets

The ongoing news cycle surrounding the spread of the coronavirus and its impact on the financial markets has clearly left investors rattled. While these are uncertain times and it’s difficult to tell when that might change, we believe it’s important to take a step back and remind ourselves of our objectives as long-term investors. Perhaps above all at times like this, we believe it’s essential to stick to established processes that have been proven over time.

As seasoned investors, our approach to building portfolios has remained the same for over 23 years. We’re very focused on the price we pay for each security, and our buy and sell targets allow us to measure the downside risk, while at the same time optimizing the upside opportunity of each investment. We’d argue that risk can often be much more accurately measured by examining the underlying business and its potential for creating—and maintaining—value. As a result, a company’s risk is measured by its operation, management team, and capital structure and not by the volatility of a stock market price.

As we discussed in our recent paper on late-cycle investing, we define risk not as stock price volatility, but rather as permanent loss of capital at the underlying business level. In our view, the key risks investors should be aware of include operating leverage, financial leverage, business risk concentration, and valuation risk. We believe the most effective way of building a portfolio is by assessing the underlying profitability and business risks of companies and then seeking to combine those with different and uncorrelated earnings profiles and business risks.

We call this a conglomerate portfolio. Each stock is treated as a division of the conglomerate and is analysed according to its upside potential and downside risk. Once the buy and sell targets have been established based on the risk/reward, investors are potentially in a position where they’re better able not only to withstand wider stock market volatility (because they have a clear understanding of why they’ve selected the stock they’re invested in) but also are able to focus on finding attractive valuation points at which to buy or sell the stock.

We argue that this approach can give investors the potential to then use market volatility to their advantage—enabling sophisticated stock pickers the chance to invest in high-quality and value stocks that may have been mispriced by indiscriminate stock price fluctuations.

One of the crucial components of stock selection for the construction of the conglomerate portfolio is an intimate, in-depth understanding of the companies we invest in. It’s vital that we understand where profits are coming from in each company and the fundamental drivers that may influence those earning streams. This approach has proven to be invaluable in tumultuous market conditions such as those we find ourselves in today; it’s another reason why we tend to be more cautious on companies whose earnings are significantly influenced by macro events and conditions, which we have no control over and are extremely difficult to predict. Energy stocks, for example, are likely to always be beholden to the price of oil—the movements of which can make it difficult to assess the viability of the underlying profit streams of the individual energy companies.

We believe this approach, coupled with our focus on business risk diversification, can help create a portfolio minimally affected by macro events and conditions, such as a plunge in oil prices, from having a disproportionately negative impact on the overall portfolio.

Furthermore, we believe a portfolio that’s sector agnostic, with companies and industries assessed not on whether they belong to a certain index or region, but on whether they can create business value according to rigorous but adaptable criteria, will result in better performance across all market conditions.

Canadian investors looking for a diversified portfolio might consider putting money into the benchmark index, the S&P/TSX Composite Index. Some two-thirds of the TSX is taken up by just three sectors, however: financials, energy, and materials. As we’ve seen recently, should a major slump take place in one sector (energy, for example), the effects on the overall index can be severe. But by seeking companies with strong longer-term earnings potential, investors can be more confident that whatever the short-term movements in the market, the businesses’ fundamentals will not necessarily deteriorate along with the broader index.

Amid the panic of the news cycle, we believe in the importance of separating noise from signal and assessing company risk on more than stock price alone. In our experience, remaining focused on companies with demonstrable long-term value and looking at underlying business risks can help investors weather volatility, and with buy and sell targets based on company risk/reward, sophisticated investors have the potential to use market volatility to their advantage, exploiting price dislocations in the market to invest in mispriced high-quality and value stocks.