For best results, work with volatility, not against it

If investors are to continue capitalising on the gains achieved since the depths of the global financial crisis, they should think twice about trying to remove volatility from equity portfolios. So says John Birkhold, partner at global equities investment manager Origin Asset Management, as part of a broader analysis of recent global equity trends and their implication for investors.

“Rises in global equity markets over the past 5 years can be attributed to normalisation post GFC. Investors who weathered the freefall and subsequent volatility have seen their equity investments rise on a per annum basis in the order of 10-12% since the GFC market lows,” explained Mr Birkhold.

“In this new “normalised” environment, investors with a long term horizon should continue to favour equities over other asset classes due to the substantial premium on offer. The trade-off is that they must accept equity volatility. That doesn’t mean buy and hold at all costs or not selling overvalued stocks, but it does mean stomaching fluctuations and understanding that it’s the price you pay for the performance premium equities have historically provided,” Mr Birkhold explained.

Mr Birkhold went on to stress that conversations about “winners and losers”, whether these be sectors or regions, can distract investors from focusing on hard evidence rather than prevailing opinion – to their peril. In essence, harnessing volatility through prudent and careful stock selection is the key to success.

“It is well-known that when views about certain regions or sectors take hold, markets can overshoot as investors take their eye off of current fundamentals and lead to periods of volatility,” Mr Birkhold said.

One recent example is the focus on emerging market stocks in the post GFC period. Many investors favoured the region at the expense of developed markets in order to try and capitalize on perceived superior GDP growth prospects. What investors failed to identify was that many emerging market companies were over-spending and accepting incrementally lower returns on their investments.

“In many cases, the reason for this was that companies were either state owned or controlled. And the imperatives which drive state decisions, such as creating jobs and increasing the tax base, are not always consistent with profitable growth,” Mr Birkhold explained.

Another recent example is in the IT sector which has recently experienced a severe sell-off in so-called ‘momentum’ stocks, as investors became spooked that some of the prices being paid for not-yet-profitable technology companies indicated a move into bubble territory.

“A good example of this is the proposed purchase by Facebook of WhatsApp for the staggering sum of $19 billion in cash and stock,” Mr Birkhold said.

“WhatsApp currently has very little revenue, only 55 employees and does not appear to be cash generative, so it’s not surprising that the market was unimpressed with the price tag.”

Mr Birkhold went on to say that whether or not the sale price of WhatsApp is justified remains to be seen.

“What we can be sure about however is that current competitive landscape for most industries is changing at an increasingly high rate. Barriers to entry are falling dramatically thanks to innovation-driven disintermediation and disruption, and this will continue to make life difficult for many CEOs. So, considering the impact of new technology from an investment standpoint means evaluating not just what kind of revenue a new entrant might generate, but also losses that legacy companies might incur as a result.

“In the WhatsApp case, some analysts predict losses to revenue for traditional telcos in the region of $50 billion per annum, as users adopt WhatsApp’s free messaging technology. This helps put Facebook’s offer into perspective,” Mr Birkhold explained.

In conclusion, Mr Birkhold said regardless of prevailing market sentiment, achieving strong performance in equity markets remains a case evaluating available evidence, and not being unduly influenced by perceived market trends or popular opinion about likely winners or losers.

“Equities continue to offer opportunities for reasonable returns, but investors must take a long term view, which means maintaining a focus on what is likely to drive wealth creation over time, while understanding that periods of short term volatility are inevitable,” Mr Birkhold said.