Living with Uncertainty and Volatility

September 27, 2019

Over the past twenty-five years, the internet has profoundly changed many facets of our lives. And the pace of change has accelerated in the past decade with the proliferation of internet-connected mobile devices. Billions of people worldwide now have access to a wealth of knowledge. It’s a never-ending flow of news and information – instantaneous and unfiltered. While these devices offer many benefits to improve our daily lives, they come with costs as well. For investors, we would argue that this “always connected” world has possibly become an impediment to sound long-term decision-making. Attention-grabbing headlines invite agitation, imploring you to act in response to today’s news – and with access to a brokerage account in your pocket, you can do it now. That’s the world in which we live, and it isn’t going away.

Particularly during times of stress, it may be difficult to see through the fog and differentiate between what’s relevant and important versus what’s noise. We often hear from clients wondering how we are thinking about recent developments, from company specific concerns to questions about the global macro environment. The question of how to “correctly” digest – and ultimately act upon – an endless stream of data points that may or may not be relevant is an interesting one. How do we think about this in the context of our primary objective – generating attractive long-term rates of return for clients while holding broadly diversified portfolios?

We start by being honest with ourselves – and with our clients – regarding what’s realistic.

The future is always uncertain. At every point during the current bull market, there have been reasons for concern. There’s never an all-clear signal. Without the proper mindset and perspective (most notably one’s time horizon), it’s always a difficult time to invest. We live in a dynamic world prone to periodic surprises.

Given that fact, how do we invest for our clients in the face of uncertainty?

First, we prepare and plan for uncertainty in the construction of client portfolios. We diversify across the major asset classes, as well as within those asset classes. We are mindful of the potential impact of macroeconomic variables such as interest rates, inflation, and Fed policy, among others. We construct client portfolios to minimize the impact of any significant changes among the factors that we generally consider unknowable, particularly in the short-term.

Second, as it relates to equities, we endeavor to own companies that will not be dependent upon outsiders for funding, regardless of how difficult the economic environment may become in the short-term. Taking that a step further, we actively look to invest in businesses that stand ready to capitalize on opportunities that may present themselves during displacement in the economy or in capital markets. We’re thinking of companies that have fortress balance sheets and would most likely benefit over the long run from short-term disruption in capital markets or in the economy (it would enable them to do things like repurchase their own stock or acquire companies more cheaply). While their financial strength is something of a headwind during periods of euphoria and easy access to capital (it’s an attribute that few are worried about now), it’s a strength that should benefit them at more difficult points in the cycle.

Third, we think owning publicly traded securities offers other benefits for investors. Specifically, there is an extra dose of rigor and discipline that is required of publicly traded companies.

The recent experience of commercial real estate company WeWork is instructive. The company, which has raised money at higher and higher valuations in the private markets over the past few years, filed for its IPO in August. Immediately, the company’s financials, transparency, and its corporate governance came into question. Since that time, the company has announced numerous changes to its practices in hopes of garnering the support of potential investors. The scrutiny of the public market put WeWork in a position where they were all but forced to make changes that were amenable to those investors’ interests (including the recent departure of the CEO).

That’s not to say public markets always encourage proper decision-making. There are plenty of companies (managers) that respond to this pressure by becoming overly focused on short-term results, even when that means making decisions that are detrimental to the long-term health of the business (that pressure is often applied by institutional investors, who in turn may be responding to the pressure to deliver short-term results that they often feel from their clients).

While we respect the market’s ability to digest and transmit information in an effective manner (reflected in market prices), we also believe that it is subject to periodic mistakes. As Seth Klarman noted in a 1996 letter to his investors, this is a balancing act:

“We regard investing as an arrogant act; an investor who buys is effectively saying that he or she knows more than the seller and the same or more than other prospective buyers. We counter this necessary arrogance (for indeed, a good investor must pull confidently on the trigger) with an offsetting dose of humility, always asking whether we have an apparent advantage over other market participants in any potential investment. If the answer is negative, we do not invest.”

We put in a lot of effort to gain confidence in our conviction. And when we think we have a sound reason for an investment, we do not outsource our analysis to Mr. Market’s short-term changes in sentiment. When approached with that mindset, volatility can become a benefit: it presents opportunities to intelligently invest capital. We work to put ourselves in a position to maintain the proper state of mind during stressful times so we can make good decisions for our clients.

Conclusion 
As we near the end of 2019, the S&P 500 is on pace for another strong year (as of September 27th, the total return for the index is a gain of roughly 20%). But as always, where the market will go from here is unknown. For investors with a long-term time horizon, that uncertainty should not be disheartening. That uncertainty is the price of admission for outsized rates of return over the long run relative to safer alternatives like highly-rated fixed income securities.

The key tenets of our investment philosophy account for this reality. We are focused on the long-term; our time horizon is measured in years, not weeks or months. We do not try to time the market; we invest consistently, with a desire to own high-quality businesses regardless of the current market environment (volatile or stable). Over the long run, a company’s stock price will be dictated by the value created for owners, not the short-term price swings many focus on. Finally, we hold diversified portfolios that minimize our clients’ exposure to idiosyncratic risk.

This approach has worked well during the favorable market environment that we have lived through over the past ten years. But more importantly, we expect that it will also work well for our clients in the less accommodating market environments that inevitably lie around the corner.

Interested in working with The Fiduciary Group? Please reach out to us to get started.

AUTHOR:

JOEL GOODMAN, CFA