When we think about the prices of items that we purchase, there is always a question about how much “value” we are receiving. Investments are no different. When you own a company, in theory, you are receiving a share in the company’s future cash flows. This sounds great when the company makes money. But what about when the economy is slowing? Less cash flow means a lot less stock price.
The steadiness of cash flows matters to investors and companies know this. Companies want investors to see them as solidly profitable, growing, and able to deliver enhanced products and services. Running a company comes down to managing the business through changing economic environments (i.e., pandemics and recessions). The ability for us to understand our companies starts with understanding the value the shares represent and continues with understanding the quality of the company’s earnings. In both areas, there is a need to balance risk and safety.
Investment theory states that to achieve higher returns, investors must take higher risk. If investing was riskless, then everyone would buy, and the advantages would disappear quickly as prices rose. As investors, we must take a long-term (i.e., 7-10 years) view of the companies we own and the economies they operate within. Conventional wisdom states that when you are in a storm, it is best to get out of the rain. And people have the tendency to look at the current state and assume it will continue (recency bias). But in investing, this is often short-term thinking, and it’s counterproductive. We have to step back and to realize that all storms end and the sun will come out!
As an example, consider the VIX index, a measure of expected volatility in the stock market over the next thirty days.
The pattern over the prior year shows three peaks on December 6, January 23 and March 7. The blue and red lines are the 50 and 200-day moving averages, respectively. Higher volatility (a higher VIX index) usually equates to more fear among investors and lower stock prices. And because the blue line is increasing faster than the red line, we know that volatility and fear have increased recently. There are two reasons for this; the Fed announced multiple interest rate increases and Russia invaded Ukraine.
US markets have had unusually high levels of liquidity for many years. By raising interest rates, the Fed hopes to combat inflation. But this often leads to other problems, like a slower economy. And while Russia’s invasion of Ukraine doesn’t seem like it should affect the US economy, it does. Because Russia supplies much of Europe’s natural gas, sanctions and shortages have disrupted the flow of oil and gas everywhere.
We will continue to watch these global events as they unfold, and we are always mindful of how economic events are likely to affect the companies in our portfolios. We have even taken advantage of the recent turmoil in the market to make a few adjustments to our portfolios. After all, volatility can be an opportunity, especially when it gives us the chance to buy more quality companies at lower prices.
There was a saying made popular during World War II, “keep calm and carry on”. Perhaps during these trying times, rather than inventing new sayings and slogans, we would do better to embrace the insights of older generations who faced and overcame significant challenges. Stay safe!
– Steve Davenport, CFA