Anxious stock investors were reassured to see volatility subside in the immediate aftermath of the U.S. presidential election. But in a bull market that's already more than seven years old, worries about volatility can quickly resurface. Volatility is widely feared as a major investment risk, and when it spikes, some investors can be expected to panic.
Disciplined value investors generally don't share in this reaction because they don't equate volatility with risk. Some value investors believe that the real risk of investing is not short-term variation in share prices — volatility — but permanent impairment of capital. To help mitigate this serious risk, they buy stocks that are trading at what they consider a discount to their intrinsic value. (The difference between the purchase price and the intrinsic value is known as a "margin of safety.") When volatility drives other investors out of the market, prices of attractive stocks may fall below their intrinsic value. For value investors, these windows of distress may create buying opportunities. But to take advantage, investors need to have cash (or cash equivalents) on hand.
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CASH AS A BRIDGE
Some value investors are prepared for these buying opportunities. That's because of the way they invest in periods of market exuberance. When share prices climb steeply and stocks in the portfolio approach their intrinsic value, some positions will be sold. The question, then, is what to do with the proceeds. In a very frothy market, there may be few stocks selling at prices that offer a margin of safety.
Some value managers believe it's more important to stay true to their convictions than to stay fully invested. When discounted stocks are scarce, these managers hold their residual cash and wait patiently for volatility to return and what they believe are better prices to reappear. Used in this way — as deferred purchasing power — cash can serve as a bridge between buying low in volatile markets and selling high in buoyant ones.
The period surrounding the global financial crisis illustrates this use of cash. As market valuations rose in the spring and summer of 2007, some value managers could not find quality businesses that were trading at what they considered appropriate discounts to intrinsic value. Cash built up to as much as a fifth of their portfolios. When the global financial crisis struck, these managers were able to deploy their cash into windows of distress without having to sell shares that, at the time, they considered undervalued. By early 2009, as the financial crisis unlocked value opportunities, the proportion of cash in their portfolios fell to the mid-single digits.
This kind of rising and falling cash position should not be confused with market timing, which is a strategy based on entering and leaving a market in order to take advantage of anticipated future prices. Disciplined value managers tend to view the future as unknowable. Variations in their cash holdings are a by-product of a disciplined, bottom-up investment process rather than an effort to capitalize on predictions of asset prices.
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FOCUSING ON THE FULL CYCLE
Disciplined value investors generally have a through-the-cycle perspective. They know that if they have an allocation to cash, they are likely to lag in runaway bull markets. But they also know that their potential outperformance in volatile markets may more than make up for this shortfall. As share prices tumble, a cash reserve helps to cushion a portfolio against the full effects of the downturn, and, as we've seen, the cash can now be put to use as good stocks become available at discounted prices.
This pattern in the performance of some value managers is manifest in two significant ratios: up-market capture and down-market capture. These numbers, respectively, summarize a fund's performance during periods when the overall market is rising and periods when it is falling. If the market drops 20% in a given month, a fund with a down-market capture ratio of 50% may decline about half that much: 10%. This may be painful, to be sure, but not necessarily panic-inducing. And if the fund also captures 85% of rising markets, it may outpace the overall market over the full cycle.
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Even investors who know in their minds that markets are inherently cyclical may panic and sell when stocks actually begin to slide. By potentially moderating the impact of market volatility, a disciplined value strategy may provide investors with a more tolerable experience in the downward-trending phase of the cycle. It can also provide a potentially rewarding experience across the full market cycle.
Kimball Brooker, Jr. is deputy head of the global value team and portfolio manager at First Eagle Investment Management.
