Volatility: a long time friend

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Volatility: a long time friend

Looking at financial markets over the first 6 months of the year, so far, we can definitely call 2013 the year of extremes:
 
Some reasons for the upside,

  • The US Federal Reserve has been buying US $85 billion in bonds per month;
  • Not to be outdone, the Bank of Japan announced plans to buy 7 trillion yen’s worth of its bonds per month (the equivalent of US $77 billion);
  • The S & P 500 gained 12.6%, the best start since 2008;
  • The Dow Jones Industrials Average (DJIA) and the Morgan Stanley index for Europe, Australia and Far East (MSCI EAFE) both enjoyed their best performance in at least 10 years;
  • And last but not least, the MSCI Japan index surged 32.6% for the largest 6 month gain since 1972.

For the downside,

  • The MSCI China index fell 13.5%, its worst performance since the 2008 financial crisis;
  • The Total Return Bond Market indices fell 2.5% in general, its worst performance since 1994;
  • Gold plunged 27%, its worst performance since 1981 and its second worst since 1971 when Nixon took the US dollar off the Gold Standard.

What’s next?
 
For us, this question is irrelevant. While most experts are trying to figure out where the market will go based on their macroeconomic analysis, we believe serious long term investors can take advantage of all the bargains created by the fear left by the markets of 2000-2002 and 2007-2009. It is a much more productive process to focus on the wealth creation capabilities of companies than to try to figure out when to get in and out of the markets based on an Ouija board. Did they not teach us in academia that stock market performance is a precursor of economic strength, not vice versa? If that’s the case, then, how can economists possibly predict the direction of financial markets?
 
Meanwhile, if we concentrate our efforts on finding wonderful companies at reasonable prices or reasonable companies at wonderful prices, we only need focus on maintaining a healthy level of optimism in the process. As long as the US economy ultimately recovers to its “normal “ state -- nobody actually knows what that state actually is -- and stands on its own two feet, our investments will be fine over the long-term.
 
Volatility: friend or foe?
 
The ebbs and flows of economic activity are exacerbated in financial markets, creating fluctuations that are exhilarating if you are on the right side of the market and depressing -- sometime even panic-stricken -- if you are not. In financial lingo, this is called “volatility”. As investors move from greed to fear and back to greed under the heavy artillery of stimuli provided by Wall Street and Bay Street assisted by the media, market volatility increases.
 
We can look at this in 2 ways:

  • If volatility creates anxiety for an investor because he believes that the temporary loss of value when markets decline is equivalent to a permanent loss, then he should definitely stay away from equities and even some bonds for volatility is inherent to investments and is something that he cannot control;
  • However, for a long term investor who does his home work by focusing on analyzing financial statements, volatility is his friend because it gives him the opportunity to take advantage of the schizophrenic nature of “Mr. Market” and buy wonderful companies at great prices.

As you must know by now, at Claret, we prefer to follow the latter rather than the former.
 
What about bonds?
 
We have been saying that interest rates will go a lot lower and stay that way for a lot longer than most people think. However, in today’s context, we are skeptical of the return prospect of bonds, especially government bonds. Looking at the recent yields offered to new investors, we can hardly get excited as we take a longer-term view. Most investors buy bond mutual funds by looking at past performances. Here therein lies the flaw that most mutual funds salespeople miss (or ignore). Bond performance comes from 2 sources: coupon rate and capital gain/loss. As interest rates go down, bond prices rise, providing a capital gain to the investor. For this source of return to perpetuate, rates will need to keep declining. If rates stabilize, the coupon rate will be the only source of return left. As of today, the coupon rate is around 2.50% per year for a 10-year bond in Canada and in the US. Heaven forbid if rates start rising, the capital gain will become a capital loss, as some investors have witnessed since mid-May.
 
A short discussion on stock selection
 
Many questions have been asked about our stock selection process. Apart from paying a lot of attention on financial statements, we also follow several principles that have served us well in the past:

  • We prefer companies that have pricing power on the products they sell;
  • We prefer companies that do not have a need for big capital expenditures as a going concern;
  • We prefer companies that generate free cash flow (as they say, follow the cash);
  • We prefer companies that operate in industries that are less subject to changing technologies;
  • We prefer companies that take advantage of new technology to help them reduce operating costs;
  • We prefer companies with committed and shareholders friendly management (i.e. significant insiders holdings).
  • We prefer less leveraged than more leveraged companies;
  • We prefer to avoid companies with “castle in the sky” promises, preferring to focus on facts instead.

After all that, it still depends on what price we have to pay. Let us not forget that “price is what you pay, value is what you get”.
 
Have a good summer.
 
 
 
The Claret team