Trade disputes, low and declining interest rates, an unpredictable political environment, and a potential pandemic all point to a future beyond the scope of existing forecasts. The significant market volatility of the last few days has prompted some clients to question how their investments are handled in uncertain times. We hope to address some of those concerns in this piece.
Warren Buffett has famously said, “Rule Number 1: Never lose money. Rule Number 2: Never forget Rule Number 1”. We certainly agree – focusing on protecting clients’ assets when markets decline is at the core of our investment process at Burgundy. However, it is important to remember that declines due to market volatility are not the same as losses due to investment risk.
The mood of the market and the way it perceives risk tend to shift in reaction to the news cycle, leading to constant fluctuations in company share prices. These short-term shifts in valuation are not based on any long-term changes in the value of a company, however, but are simply responses to temporary conditions. The intrinsic value of a business is more strongly impacted by the expected cash flows over the next five, ten, or more years into the future rather than the results for the next quarter or two. At times, however, the share price of a business may change substantially in response to a temporary event. This volatility can create opportunities to buy great businesses at a significant discount to intrinsic value.
In contrast to the temporary nature of market volatility, investment risk is the permanent impairment of capital. This risk may be realized when an investor buys shares at a price not justified by that company’s intrinsic value. Or it may arise when a business underperforms due to poor operational effectiveness, increased competition, or too much debt, for example. In any case, this investment risk comes about not because of changing, short-term circumstances but due to persistent conditions.
During periods of volatility, clients watch the value of their investments fluctuate. We often guide clients through these uneasy periods by recommending they stay the course. If a portfolio has been properly structured for an individual’s unique objectives and tolerance for risk, a short-term blip in the markets shouldn’t matter. These periods may be uncomfortable, but they should still be approached with a sense of rational optimism.
Far from finding these periods uncomfortable, many investors recognize the opportunities that volatility brings and relish the chance to hunt for bargains. After all, the thrill of the hunt is what drives value investors. At Burgundy, we appreciate that volatility brings opportunity in an environment where opportunity is scarce. We are always looking to take advantage of these moments when appropriate; the question is how.
While there is no specific formula for finding bargains, there is a road map. As a member of the U.S. Small & U.S. Small/Mid Cap investment team, I find this road map helps streamline the process of identifying actionable ideas and can be referred to during less rational times. By systematically working through these opportunity sets, investors can find rewarding opportunities while keeping their emotions in check.
1) Evaluate Current Portfolio Companies:
- The first step is to evaluate the current companies in the portfolio. These market swings may allow some of our position sizes to be increased at potentially better prices. We may add to a position by using any cash in the portfolio or rebalancing current fund holdings to the most attractive opportunities. These periods of volatility should allow for an optimization of current portfolio holdings.
2) Review Dream Team Companies:
- Similarly, companies on the Burgundy Dream Team List are assessed. These are high-quality companies that we would like to own, but are not yet trading at large enough discounts to their intrinsic values. Ideally, we aim to purchase businesses when they are trading at a 30% discount to what we believe they are worth. If the volatility leads to a decline in the security price, the investment team will revisit the original thesis and conduct further analysis on the underlying business fundamentals. If the company now has a large enough discount to its intrinsic value and the investment thesis still holds, a purchase decision may follow.
- During the market correction of Q4 2018, we saw a large sell-off in the Russell 2500 Index¹ as cycle concerns gripped the market. In the ensuing period, we were able to purchase five Dream Team / Watch List companies at very attractive valuations. It was one of the better investment environments caused by a temporary market correction we had seen in years.
3) Review the Watch List:
- After the Dream Team List comes the Watch List. These are good businesses that we would consider buying if the valuations were extremely compelling (i.e. trading at significantly greater discounts than 30%). These are the opportunities that are more on the value side of the quality-value investment spectrum. During times of heightened volatility, these businesses can get extremely cheap and become great bargains as market pessimism takes hold.
4) Scan Companies with Rapid Declines Over Short Periods:
- Finally, companies not captured in the above lists that have had a significant decline in price over a short period of time should also be reviewed. We find this exercise can provide a useful indication of market sentiment. Reviewing the companies the market has no interest in buying can be a good starting point for a contrarian investor.
Last year, we saw price declines in industrial companies as investors were concerned about the trade war and prospects for global growth. Most recently, the rapid spread of COVID-19 (the coronavirus) has caused the market’s mood to sour, creating additional concerns about economic output as worker productivity declines, global supply chains become impaired, and tourism shrinks. Although no one knows how long the effects of the virus will last, we would currently characterize this event as one that appears to be more temporary in nature and we do not expect any of the businesses we own to be permanently impaired.
We will not always be successful in the search of a bargain during each volatility event. However, by conducting fundamental bottom-up company analysis and following the road map outlined above, we are confident in our approach. In recent days we’ve been honing in on our Dream Team candidates and will opportunistically add to our Watch List as events unfold. Sometimes there simply is nothing new to buy or no adjustments to make to the current portfolio. What is most important is to look beyond the temporary and recognize when the volatility of the market hands you an investment opportunity.
1. The Russell 2500 Index is a broad index comprised of 2500 small and mid-sized U.S. companies.
This post is presented for illustrative and discussion purposes only. It is not intended to provide investment advice and does not consider unique objectives, constraints or financial needs. Under no circumstances does this post suggest that you should time the market in any way or make investment decisions based on the content. Select securities may be used as examples to illustrate Burgundy’s investment philosophy. Burgundy funds or portfolios may or may not hold such securities for the whole demonstrated period. Investors are advised that their investments are not guaranteed, their values change frequently and past performance may not be repeated. This post is not intended as an offer to invest in any investment strategy presented by Burgundy. The information contained in this post is the opinion of Burgundy Asset Management and/or its employees as of the date of the post and is subject to change without notice. Please refer to the Legal section of this website for additional information.