Value investing in volatile times

Several MacroBusiness bloggers have talked about the possibility of share markets entering a period dubbed the “Great Volatility”.  This is essentially a secular bear market where prices rise and fall 20‑50% within a year but give low growth (1-2%) on average over the long term.  This would be in contrast to the “Great Moderation” – a period of low inflation and low interest rates that occurred in the developed world over the last 20 years. For more information on the Great Volatility, see The Prince’s excellent article on share market valuation.

Invariably, predictions of increased volatility come with warnings about “traders markets” and that long term value investors should stay on the sidelines due to wild price swings.  I couldn’t disagree more because volatility creates opportunity for investors and speculators alike; opportunities to buy when the market is depressed and opportunities to sell when the market is irrationally exuberant.

If you decide that you want to be an investor instead of a trader (check out another great article by the Prince on investor psychology here), then to navigate and profit from the “Great Volatility” I believe you will need four things:

  • A method of identifying great companies (grading)
  • A method of calculating the value of a security (valuing)
  • A method of calculating when a security should be sold (selling)
  • Courage (discipline)

Grading

Before any thought is given to quantitative valuation of a company’s share price, the value investor has to ask if it’s worth owning at all.  Great companies will enter financial crises and emerge lean and meaner on the other side.  Poor companies will fold or undergo major restructuring to weather the crisis, possibly emerging as quite different businesses.  Bluescope (BSL) is an example of the latter.  Despite trading at very low prices recently, a value investor would never invest in Bluescope because their return on equity (ROE) was marginal even during the good times.  BSL now faces large headwinds from the high AUD and has recently axed hundreds of jobs – further confirmation that it is not investment-grade.

The ASX is full of companies that Empire Investing consider non-investment grade.  In fact, we would stay clear of most of the ASX200 – there’s far more dogs out there than diamonds, with approximately 60 companies making investment grade (the Empire Index).

Valuing

Once a good company is indentified, the valuation tells the investor when to purchase the share.  As the market swings wildly, share prices of good companies will fall below what the investor believes they are worth.   At this point, the investor has the opportunity to purchase the shares from a depressed market at a significant discount to value.

One famous historical example of this practice is Warren Buffet’s purchase of American Express securities in 1964 after a fraud scandal.  Buffet believed the market over-reacted to the scandal and that earnings would not be as affected as the share price indicated.  He turned out to be correct – Amex traded well above its 1964 lows only 12 months later.  This is a key message with regard to quality and robustness of the underlying business  – a sound valuation technique is effectively an indirect hedging strategy against market and economic volatility.

Selling

The determination of a sell price is as equally important as the buy price – especially during times of high volatility.  As the market’s mood becomes manic, the astute value investor will sell him the shares of his securities at prices above their value.  Whilst the value investor may think highly of the company they have invested in, it’d be a mistake to hang on to any share when it trades well above value.  Firstly, prices will tend to reflect fundamental value in the long run- so the share price may stagnate until value catches up or drop to meet the value.  Secondly, it’s better to have $X cash in the hand than hold a share that is worth $Y when Y is a lot less than X.

Courage

To combine the above strategies when the market is volatile requires courage and discipline.  Most investors get nervous when their portfolios are splashed with red (this one included).  However by grading, valuing and determining a sell price the value investor will go a long way towards mitigating losses and realising profits.  They just need to have faith in their valuation skills and ensure they take a conservative approach when forecasting future earnings.

A case study – Reece Australia Ltd

In order to show how this approach could have been applied in the past, I’ve done a little back-testing on one of Empire’s favourite stocks – Reece Australia Ltd (REH).  We believe REH is a wonderful company based on its high and stable ROE (see graph), low to no debt, no intangibles assets and dominant market position/brand name.

I have calculated the key financial metrics (ROE, equity per share etc) from the last 10 years of annual reports.  To determine historical value, I have put myself in the shoes of an investor at the end of each of the year and tried to calculate the value of REH based on only past information.  The valuations of Reece versus the historical share price are shown below.

Note: The early 2000’s valuations will be the sketchiest as we often look at 5 years worth of data in an attempt to discern the volatility of earnings.  The valuation for years 2001 – 2004 didn’t use data from the mid 90’s onwards, but relied on the figures from 2001 onwards.  I also recognise the bias involved in backward-looking valuations, but in lieu of a time machine it’s a valid exercise.

It is clear that the share price of REH shot well ahead of our valuation results in the lead up to the GFC.  This confirms the selling strategy – when the market is over exuberant it’s time to offload your shares.  At the height of the boom, REH was trading at $30 – which is well any value we would have calculated based on the previous 5 years worth of data.   Better to have $30 cash in the hand than own a share you think is worth $20.

Conversely, at the depths of the GFC Reece was trading below our valuation – $15.70 versus a value of about $19.  No doubt investing in that climate would have been stressful as share prices plunged, however that’s where courage comes in.  It’s easier to sell when you’ve made a fat profit, but very difficult to buy when the rest of the world is selling all shares in sight.  A sound investment plan – constructed before having to deal with these real-time events – can assist in developing the required discipline and courage.

Conclusion

The Great Volatility can potentially mean great profits for value investors as long as they have a rigorous approach to grading, valuing and selling shares.

When you hear the phrase “buy and hold is dead”, it’s not a slight on value investors.  It’s a slight on blindly buying ASX200 companies with a view to holding them for 10+ years, believing they’ll always go up in the long run.  Not everything is worth buying and even the best companies are worth selling if the price is high enough.  The value investor needs to understand and implement these principles if they are to make a decent profit – volatility or not.

Disclosure: The author is a Director of a private investment company (Empire Investing Pty Ltd), which has no current interest in the business mentioned in this article.  The article is not to be taken as investment advice and the views expressed are opinions only.  Readers should seek advice from someone who claims to be qualified before considering allocating capital in any investment.

Comments

  1. A timely article. Even though I am swimming in a sea of red, just missing the last selling boat by a few hours and then got price anchor fever, I am more bullish now than ever.
    Another 20% drop in the market will really cement that for me.

    • Another 20% drop and I’ll be salivating Johno, but I’ll still have an eye on the macro environment. The Euro zone is the biggest flashpoint right now, with markets swinging on the sentiments and utterances of Euro bureaucrats and politicians. Until Greece defaults or a Eurobond is issued, I’ll be looking for massive discounts to value.

  2. Hi Q,

    By and large I agree, however, I slightly disagree around 2 minor points – the “when to buy” point and the “when to sell” point. 🙂

    The danger with your “when to sell” point above is that to remain an “investor” rather than a “trader”, you need to be “long equities”. That is, you need to make your money from owning the companies, rather than trading them. In the example you have above, it is possible that the second “hump” represents a good time to sell, and that a good time to buy will never be presented again. In this case, it would have been better not to sell during the first hump, and be the long term owner of a great company.

    You don’t actually identify “when to buy”, however one must be careful of rushing in at the moment, given currently high P/Es against their long term averages. I would definitely favour valuation models from previous generations, rather than look to the last 20 years for valuation norms.

      • delusionalinvesting

        Thanks Prince. That reminds me. The MB mobile site is very broken. Doesn’t disable, doesn’t go past page one, and doesn’t let you login to see premium content… I really wish you guys with either completely disable it, fix it so that it can be disabled by the user, or fix all the issues with it.

        But, now that you’ve reminded me, and I’m in front of PC, I’ll log in and have a look…

    • Hi David
      I agree on the valuation models using recent data. We’ve certainly adjusted our metrics in anticipation of a secular bear market.
      With regards to selling, I’ll have to disagree. Going by your logic, an investor would never sell a company no matter how crazily priced it was. If I offered you $1 million per share for company XYZ, even though they are trading at $10, you would still keep them in order to call yourself an investor? I wager not.
      In practice, great companies will increase in value over time anyway, so if the market is rational then the price would follow value. So the investor should still have a far, far lower frequency of buy/sell than a “trader”. However, history has shown markets are anything but consistently rational. To forego selling (and profit making) opportunities when the market is over-exuberant, just to maintain the mantle of an ‘investor”, is choosing purity over profits. I’ll take the latter thanks 🙂
      Besides – no one lives forever and shares can’t be utilised post mortem. You’ll be selling at some point no matter what!

      • delusionalinvesting

        Hi Q,

        I didn’t say “never sell”, but I’m sure that as a value investor we can find better reasons to sell than chart/price volatility. As an investor, you’ll still certainly sell, but I think that more consideration needs to be given to it.

        For example, I’d be less likely to un-deploy capital if I already had cash reserves – particularly if I deployed the capital as a really great price.

        As a value investor, I would have also thought the primary reason to be to sell a share would be based on the underlying business, rather than the price, even in “volatile” times.

        Dave.

      • Sorry Dave – my reply was a little harsh on second reading. Not my intention. 🙂

        Our approach is that the business fundamentals tell you what it’s worth to you, whilst the market provides the opportunities to buy and sell/make a profit. We always invest with a minimum 5 year time frame. But if we bought a share 6 months ago and its price goes way above value, we’ll sell. That’s because the cash in our hand is worth more than the share (based on our valuation). Even if it was the only share we held (and everything else was in cash) it doesn’t make sense to hold onto something you think is worth x when you can sell it and obtain (x + 30%) cash. Even in a cash account, getting 3-4% on (x + 30%) is better than holding onto a share that will probably fall back to value x in the long run. And just because we may have bought it for a steal doesn’t mean we’ll never sell it – we’ll just sell it when it makes sense from a fundamental value point of view.
        As value investors, our primary purpose is to make a profit by buying shares below their value and realising good returns via dividends or, where the market allows it, capital gains.

      • Hi Q,

        It just seems to me that the approach outlined in the post is not consistent (perhaps orthogonal) with the need find companies with high ROE, nor is “We always invest with a minimum 5 year time frame” consistent with selling in 6 months. It seems that companies with high volatility would be preferable rather than a high ROE.

        OMG – Has The Prince finally gotten to you, hasn’t he? Have we lost another to the dark side? 🙂

      • Note that during the positive volatility in 2009 (where markets experienced crack up booms from QE 1 and 1.5 and $900 cheques etc), that it was mainly the high ROE, oversold companies that bounced back and made very large returns.

        MMS, ARP, FWD, COH, etc

        Some of which were subsequently overvalued…and have now only come back to or slightly overvalued.

        Ben Graham (who Australian investors should identify with more than Buffett) originally had a 2 year timeframe – he made most of his money during the secular bear market of the 1930’s…

        Buffett, contrary to populist (Motley Fool etc) opinion started as a hedge fund partnership – he rarely kept his positions long term and made most of his initial money during a secular bull market. It was only after this, when he went for the jugular (i.e 0.1% club membership) did he switch to a brand of investing closed to approx. 95% of all investors. It’s a good mythology to explore, Marcus Padley has done some good stuff on this..

        There has to be a realisation that we live in an ever increasing financialised world – not one full of rational investors all co-operating to maximise gains and allocate capital effiecently and with Vulcan like prescience regarding super long timeframes.

        But driven by Minskian dynamics and extreme capitalism/financial engineering. In some ways, it hasn’t changed, in others it has accelerated.

        As for the Dark Side, well, let’s just say my annual ROE is a bit higher than all the companies above, although it has been, ahem, volatile….I think he’s waiting for a longer term set of financials before he considers my style of trading “investment grade”.

      • I’ll never join the dark side David! 🙂 We always invest in companies with high and stable ROE (one of the first filters). We’ll never invest in a share based on its “volatility” or “price action”, or whatever terms the tea leave readers use. We also invest with a 5 year time frame minimum – we don’t expect 20% returns in 6 months. However, when the market provides an opportunity to sell your share way above value – and it happens within 6 months of purchase – I will take the profit every time and then wait for the price to come back below value (or value to catch up with price, however long that may take). I don’t expect it to happen very often, but when it does I won’t forego a profit just for the sake of value-investing purity. After all – we’re all in it to make a buck.
        What I am trying to say is that the value investor needs to be aware of the opportunities that can be provided by a volatile market (as opposed to trading volatility as a speculator). Obviously my article muddled this point – I’ll do better next time.

      • Dave From Pakenham

        Hi Q,

        I think it difficult that any market remain volatile for a protracted period. Any market realising volatility greater than 20% for longer than 6 months is extremely rare. Admittedly in the past 6 months we have seen 3 brief periods of 20%+ vol.

        I think by definition, volatility is a proxy for uncertainty. And markets cannot remain uncertain for a protracted period, otherwise they collapse, if so volatility collapses.

        So while a market can realise volatility of 50% in 12 months, its unlikely that volatility itself remains at these levels for any period greater than several weeks, within such a drawdown which would mean trading supposed peaks and troughs difficult if not impossible.

        Volatility is a fear gauge so there is no ability to trade volatility in an exuberant market.

        I my opinion your trading thesis here requires volatility to subside for a protracted period to realise any merit from ‘investing’.

        In short an investor cannot make money in a volatile market.

      • Howdy Dave

        I’m not expecting 20-50% volatility repeatedly within a 6 month time frame nor that value investors should try and trade the ups and downs on such a short time frame. That’s what speculators do. The REH chart above shows one buy and one sell period over the course of ten years – I’d expect similar sorts of outcomes for most high-quality stocks.

        My point is that volatility in markets provides opportunities – either to buy below value or sell way above it. For value investors to shy away because they don’t foresee an orderly 5-10% increase in assets prices, year in year out, is to risk incurring large opportunity costs through inaction.

        I’d counter your last statement by pointing to Buffet’s record through the 60s and 70s. Just because a share price is volatile doesn’t necessarily mean the underlying earnings or book value growth is. Look at REH’s ROE over the last 10 years and compare it with the volatility of the share price during the last 5.

  3. that signal to buy REH shares in Nov 2008 -at a 30% discount to perceived value falls way outside my criteria.
    It has to be at least 50% discount before I could be tempted to buy and hold ..and then the question has to be addressed : ” who will buy them from me and why?”
    REH analysis is good ..and thanks.

  4. One small point re when to sell – investors should take account of the tax implications of selling. If you sell for $X, but $Y of that is capital gain, you only have $X-Y/2 in your hand at the end of the day. It is that amount that you should be comparing to your estimate of value when determining whether to sell.

      • Thanks for the response, QC. Of course, this can make it difficult to sell if you have held a share long enough. CBA shareholders who bought in the float, for example. When you get to the point that the annual dividend is almost half what you paid for the shares, it is hard to imagine the circumstances where you would pull out.

      • Don’t forget inflation Alex. Five bucks 20 years ago is about %12 to $15 today and it works the same way in reverse when comparing a dividend today with the purhcase 20 years ago.

      • Just for interest, I plugged CBA figures into your formula from that post. Assuming you were in the top tax bracket, you would need to value CBA shares at under $27 for it to be worthwhile selling now (current price $43.74).

        BTW, I don’t have CBA, nor am I in the top tax bracket!

      • Ah. No. When I redid taking account of halving, you would need to value CBA at under around $35 to sell. The figure gets closer to current prices if you are in a lower tax bracket.