Profit from Market Volatility

Profit from Market Volatility

“I am convinced that there is much inefficiency in the market. When a stock can be influenced by a ‘herd’ on Wall Street with prices set by the most depressed person, emotional person or greediest person, it is difficult to conclude that the market is always rational. In fact, market prices are frequently nonsensical.” – Warren Buffett

The majority of academics and professionals apply Modern Portfolio Theory (MPT) to their stock investments. MPT states that markets are efficient and that a company’s stock price continuously reflects all known information. MPT also states that risk is defined by the volatility of a stock. Therefore, investors should decrease risk by diversifying their portfolios with index funds. Index funds are designed to mirror the average return of the broad market (e.g., S&P 500). Consequently, they are appropriate for the vast majority of the public who are passive investors.

In contrast, value investors believe the market is inefficient 20% of the time largely due to business, economic and political factors. When the market decreases by a significant amount, investors often oversell their stock positions for the safety of cash. Selloffs provide value investors with the opportunity to acquire high-quality companies for less than their intrinsic value. History has shown that high-quality companies with strong balance sheets and earnings generally exceed their previous positions.

Value investors also define risk as the “possibility of harm” to a company’s intrinsic worth. Harm is caused by miscalculating a company’s future earnings. Harm is also linked to holding period. The odds of determining if a company’s stock price will be higher in the short-term are low. However, the odds increase over time. Benjamin Graham said: “In the short-term, the stock market is a voting machine, but in the long-term it is a weighing machine.” In the short-term, stock prices increase based on popularity, but in the long-term, they increase based on earnings.

To further reduce risk, value investors “focus” their portfolios as well. A focused portfolio is considered three to ten stock positions. Buffett has said, a focused portfolio will “decrease risk if it raises the intensity by which an investor thinks about a business.” However, one of the by-products of a focused portfolio is increased volatility over the short-term. When a portfolio is focused, the stock price of one company will have a greater impact on the overall return. The ability to withstand this volatility without second-guessing an investment decision is the key to success.

Because of volatility, value investors do not monitor the company’s stock price every day. They let the fundamentals of the company tell them how it is doing. They know that over the long-term, the market will recognize the earnings of a high-quality company and its intrinsic value and market value will converge. Being right about a company’s valuation before it is purchased is most important. However, because valuation is subjective, an adequate margin of safety must be applied. Note even a high-quality company can be an inferior investment if the purchase price was too high.

Studies show that 90% of portfolio managers under-perform the market.  However, the same studies show that value investors consistently outperform the market over the long-term.  To illustrate: Between 1999-2003, the five-year average of ten major value funds was 10.8% versus the S&P 500 at -.6%.  The ten funds included: Clipper Fund, First Eagle Global, FPA Capital, Legg Mason Value, Longleaf Partners, Mutual Beacon, Oak Value, Oakmark Select, Source Capital and Tweedy Browne American Value.

Over the long-term, value investing produces superior returns over MPT.

All contents copyright © 2008, Josh Lowry. All rights reserved.

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