Don’t Play in The Street
Volatility Doesn’t Equal Investment Risk, in Fact it Provides Opportunity
Market volatility receives all the headlines, but the focus should instead be on permanent loss of capital.
Academia believes that volatility (usually measured by standard deviation) is equivalent to investment risk. Likely, this is due to it being quantifiable and thus usable for calculations of modern portfolio theory. Volatility is simply a sudden, temporary, price fluctuation, usually due to an emotional overreaction to recent news.
Permanent loss of capital is what investors should truly fear. According to Howard Marks of Oaktree, “Permanent loss is very different from volatility or fluctuation. A downward fluctuation doesn’t present a big problem if the investor is able to hold on and come out the other side. A permanent loss – from which there won’t be a rebound – can occur for either of two reasons: (a) an otherwise-temporary dip is locked in when the investor sells during a downswing – whether because of a loss of conviction; requirements stemming from his timeframe; financial exigency; or emotional pressure, or (b) the investment itself is unable to recover for fundamental reasons.”
Active managers and their devotees should embrace volatility. When used opportunistically, volatility allows active management to capitalize on opportunities that arise out of market inefficiencies. The market at times will be overvalued during periods of euphoria and undervalued when fear grips the public. Successful investors recognize the truth about the market; no one can accurately predict when emotional tides will turn. Former Federal Reserve Chairman, Alan Greenspan, commented in 2007 on his desire but inability to forecast the moods of Wall Street, “If I could figure out a way to determine whether or not people are more fearful or changing to euphoric…I could forecast the economy better than any way I know…The trouble is, we can’t figure that out. I’ve been in the forecasting business for 50 years and I’m no better than I ever was, and nobody else is either.” If investors could predict the ebbs and flows of the market, there would no longer be inefficiencies to take advantage of.
Assuming investors embrace volatility and have a long enough investment horizon to take advantage, how does one protect from true investment risk: the permanent loss of capital?
Because permanent loss of capital is not easily quantifiable, it is important to seek out management teams that have a disciplined, thorough and repeatable research process with a proven historical track record. We try to determine what a rational buyer would pay to own 100% of a company. We forecast a company’s free cash flow using various economic and company-specific scenarios. Since the future isn’t fixed and future events can’t be predicted with any precision, base-, high- and low-case business value estimates are determined. When the stock price is at least 30% lower than our base-case value, we’re interested.
With this purchase discipline embedded into our investments, we have achieved average annual returns, relative to our respective benchmarks, that our investors can appreciate. Like all firms, Weitz is not perfect. Throughout our 30+ year history, we have experienced instances of permanent loss of capital due to the fundamentals of a business changing or buying at the “wrong” price. The important thing is that we have learned from those times and are continually evaluating our research process to find ways to lower this risk going forward.
All investments are subject to risk, including the possible loss of the money you invest. Past performance does not guarantee future results. There is no guarantee that any particular asset allocation, or mix of funds, or any particular mutual fund, will meet your investment objectives or provide you with a given level of income.