Worldwide Expansion Propels Markets to Record Highs – The synchronized expansion in global activity provided a steady backdrop for markets as several key indexes reached record highs during the third quarter of 2017. Economic data indicated continued expansion in both manufacturing and services, while consumer spending remained healthy – although, increasingly concentrated online. International stocks led the global stock market rally for a second quarter in a row, bolstered by a weaker US dollar. Economically sensitive stocks generally provided stronger returns than defensive sectors. Information technology, energy and materials stocks led market higher.
Despite increasing tension with North Korea and the start of a particularly destructive hurricane season, markets experienced unusually low volatility. Fixed income markets were mixed as Canadian bonds experienced losses following the second rate hike in as many quarters while US Treasuries held gains despite solid economic data.
Volatility is Not a Measure of Investment Risk – The phrase “investment risk” is a rather ambiguous term that is often used by money managers interchangeably with volatility. Volatility, as measured by standard deviation, is the academic’s choice for defining and measuring risk. It is a unit by which an investment’s return varies from its average return over time. The higher the standard deviation, the higher the risk according to theory. Using a simple statistic to measure the complex nature of risk has its advantages. However, volatility, like Corsi, should not be used in isolation. Volatility, along with time horizon and an investor’s individual characteristics, contribute to the assessment of risk. However, ultimately, an investment’s risk is the probability of a permanent loss of capital.
Canadian philosopher Marshall McLuhan once said that “we drive into the future using only our rear-view mirror”. Nowhere is this description more accurate than when volatility is used for managing risk of an investment. For many, the investment industry often operates on the premise that price volatility equals risk and accordingly it should be minimized or avoided. This is faulty logic because price volatility is independent of risk. In fact, better long-term investments are often made in adverse or volatile market conditions when valuations are more distorted. Here is an example.
Canfor Corporation is a Canadian integrated forest products company. In 2015, it’s share price sank nearly 61% from a high of $31.89. The decline followed two years of historically low implied volatility. In theory this suggested that the stock’s price risk would also have been low. However, the unanticipated price drop was caused by a combination of a rising US dollar and the expiration of the Canada-US Softwood Lumber Agreement. After the price plummet, the stock traded near its 4-year low and featured a 5x Enterprise Value to EBITDA multiple. At this valuation, most risk factors were reflected in the share price despite the implied volatility exceeding it’s 5-year average by more than 40%. Accordingly, we started buying the stock for client accounts at $14.97 in January 2017. In less than 10-months, the shares have climbed 60% and now fully reflect the company’s strong fundamentals and intrinsic value. The example demonstrates that buying a high-quality asset at an attractive valuation, while price volatility was elevated, resulted in a great investment return.
Individual investments, such as Canfor, can increase or decrease in price without correlation to the market. These changes are company specific (unsystematic risk) but can be mitigated through diversification. Diversification involves sizing a position correctly relative to other portfolio assets, with the objective of reducing risk and volatility without lowering expected returns. Nevertheless, a diverse portfolio of stocks remains imperiled by systematic risk. Systematic risk arises from the overall market and commands a return in excess of the risk-free rate. Over the long-run, an investor’s desired return corresponds with their desired exposure to systematic risk. To diversify against market risk an investor must assign a portion of their portfolio to uncorrelated assets (for example, cash) or employ hedging techniques.
As long-term investment managers, we attempt to strike a balance between offense and defense. Asset classes are priced above or near all-time highs from both a price and valuation perspective. Concurrently, perceived risk (as measured by CBOE Volatility Index) is near record lows. Therefore, we continue to invest with caution. Our investment management tools focus on future metrics … we’re looking through the windshield to avoid permanent losses of capital.