Quarterly letters

Value Perspective Quarterly Letter – 4Q 2017

31/12/2017

The Value Perspective team

  • 2017 was characterised by consistently rising markets and very low volatility
  • The impact on risk-taking behaviour and increased leverage point to mounting risks
  • Deep value strategies stand to benefit from any increase in volatility or rising bond yield?

Who killed volatility?

The volatility of the US stockmarket hit its lowest since the 1960s this autumn, pulling down the derivatives-based VIX index of expected volatility (also known as Wall Street’s fear index) to its lowest ever reading.

This phenomenon is not restricted to the US; the volatility of the MSCI World index has sunk to its lowest level since at least 1972.

The chart below shows the MSCI World delivered a positive return in every month of the year:

   

Past performance is not a guide to future performance. 

 

Alongside this, the index experienced a maximum drawdown of only 2% in 2017! 

 

 

Source: Thomson Reuters, Datastream. Data shown to 31 December 2017

The unusually low implied-volatility of markets today is apparently justified by low and predictable interest rates, steady global economic growth, and healthy corporate earnings. As a corollary, yield-hungry investors have further dampened share price swings.

Why does this matter?

The problem isn’t low volatility itself; it is the impact on risk-taking behaviour, and, by extension the use of leverage. A period of low volatility makes investors feel more comfortable.

Investors increase the use of leverage and take riskier decisions in the belief that the future will be as benign as the recent past.

The danger is that the current equanimity of markets is encouraging investors to pile on more risk. Moreover, volatility is often, erroneously, used as a proxy for riskiness in risk management models.

When markets are calm, these models indicate that investors should incur more risk and take on more leverage.

There appears to be a negative feedback loop building between low interest rates, increasing debt levels, and financial models that allocate risk based on volatility, and this phenomenon is closely tied to the rapid growth in assets that are linked to volatility in some way or another.

The volume of such assets is likely to be hundreds of billions of US dollars, with some estimates in excess of US$2 trillion.

In a market where stocks and bonds are both overvalued, financial engineering is being employed to feed a global hunger for yield. Like any build-up of risk in financial markets, this strategy will work until it doesn’t.

Any spike in realised volatility, even to historical averages, could drive a significant amount of equity selling. Given the process of buying and selling is increasingly automated, such selling would increase volatility further, which in turn calls for more deleveraging and more selling.

No one can know whether an increase in volatility is just around the corner, or even if it will come at all. We also cannot be certain that it would have a catastrophic effect on markets.

What we can know, however, is that investors betting on low volatility are betting that the current benign environment will persist. As the economist Hyman Minsky put it, “the illusion of stability of the system will, over time, create its own instability”.

That is, the paradox of tranquillity: the benign environment triggers two actions (leverage and additional risk), which themselves create instability.

Low volatility = Maximum complacency 

What does this mean for us as stockpickers?

The bad news is that low volatility limits the number of new investment opportunities. A period of low volatility naturally constrains our ability to take advantage of the emotions of other market participants and to either buy or sell companies at better prices. 

As stockpickers, we thrive on volatility. The true value of a company does not swing about as aggressively as its share price.

The true value of a company increases slowly as it reinvests cash into its business, and makes an economic return on that investment. However, a company’s share price swings about in the short term depending on the number of buyers and sellers on any particular day.

Share price volatility is typically symptomatic of emotion in the stockmarket, rather than a reaction to fundamentals.

By being long-term stockpickers we are able to take advantage of these moves; buying when short-term concerns provoke unjustified moves downward, and selling when the market is excited about the prospects of a company if those expectations appear unrealistic.

While any given share price may be influenced by sentiment, over time a company’s stockmarket value reflects its fundamental worth.  This allows us to profit from being long-term fundamental-focused investors.

The calm before the storm?

It is not our job to opine on future events that are inherently unknowable. It is our job to vigilantly manage risk in each of our portfolios.

Today, we are looking for attractive investments in a world that is, broadly speaking, expensive and indifferent to risk. This situation has gone on for far longer than we would have expected, but history tells us that nothing is permanent.

Just as stocks priced for perfection eventually disappoint, stocks trading at a discount to the fundamental value of their underlying businesses are unlikely to maintain that discount forever.

Some of the most costly investment mistakes come from buying below-average businesses at a time when profits are buoyed at a favourable point of the economic cycle.

We believe we are at such a point for many businesses, and are doing our utmost to ensure we do not become complacent. Instead, we remain vigilant and are operating conservatively and prudently to preserve and grow our clients’ capital over the coming years.

 

Author

The Value Perspective team

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Important Information:

The views and opinions displayed are those of Ian Kelly, Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans and Simon Adler, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated. They do not necessarily represent views expressed or reflected in other Schroders' communications, strategies or funds. The Team has expressed its own views and opinions on this website and these may change.

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Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.