Quarterly letters

Value Perspective Quarterly Letter - 2Q 2014

30/06/2014

The Value Perspective team

It’s quiet out there. The S&P 500 index, a benchmark of America’s largest companies, has gone 49 days without a movement larger than 1% (either up or down); the longest such period since 1995. Volatility, as measured by the VIX index, is back to its all time low set in the ‘goldilocks’ economy of 2007.

Low volatility is not confined to equities, as volatility in commodities, bonds and currencies are also at multi-year lows.

Given the stuttering improvement in global economies and heightened geopolitical risk, it is reasonable to ask what’s going on, and consider the implications for equities.

As stock pickers, 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 stock pickers 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 (as they frequently are). Whilst a given share price may be influenced by sentiment, over time a company’s stockmarket value reflects its fundamental worth, allowing us to profit from being long-term fundamental focussed investors.

The suppression of global interest rates and the actions of central banks in the USA, Europe and Japan with their ‘unconventional monetary policy’ (also know as Quantitative Easing, or QE) has led to a compression of volatility as fear has subsided. As a corollary, yield hungry investors have dampened share price swings.

From an academic perspective, whilst we can show that periods of high volatility tend to be short-lived and followed by outperformance for value investors such as us, there appears to be no inverse relationship. Periods of low volatility can continue for a significant length of time and are not indicative of future underperformance.

The bad news is that low volatility constrains 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. 

Furthermore, a period of low volatility can suggest an increasing level of future risk. A period of low volatility makes investors and companies feel more comfortable. They increase the use of leverage and take riskier decisions in the belief that the future will be as benign as the recent past. These two actions increase future volatility in what the economist Herman Minsky termed the paradox of tranquillity. The stable environment triggers two actions (leverage and additional risk), which create instability. Whilst there are few signs of this today, by definition it is difficult to see these indicators without the benefit of hindsight.

In an environment of low volatility and consequently few new ideas, it can be difficult to sit still. We are looking at the same number of potential investments for portfolios, but given higher prices, fewer are attractive. Despite this, it is difficult to ignore the compulsion to be acting on our work, and to trade. However, history tells us that 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 defend the capital gains made in the portfolio over the past few years. 

Author

The Value Perspective team

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.