Risky business


We hate to admit it, but academicians have pretty much overrun the money management business since the late 1960s. A key weapon in their conquest of investor thinking is Modern Portfolio Theory (MPT). First conceived by Harry Markowitz in the 1950s, MPT states that portfolios can be optimized for expected return based on a given level of market risk, with risk defined simply as price volatility. In layman’s terms, a stock or a portfolio which swings up and down in price more than average is “riskier”, and, all else equal, should therefore generate greater returns over time than one which is less volatile.

We have some differences with this formulation, and these differences have never been starker than today, a period of historically low volatility for U.S. share prices. This essay will lay out some of those differences, and provide our take on a key ingredient in today’s market mix which the academics may be missing. Spoiler alert: we think there may be a tad more risk in current share prices than a record low “VIX” might indicate, and investors need to be prepared for it. Not panicked or unnerved or anxious, but prepared.

There is no doubt that markets are quiescent. Stocks, bonds and currencies have all been in low-volatility mode for much of the past 8 years. The S&P 500, for example, hasn’t dropped more than 5% since just after the Brexit vote in June of last year. This is only the third time since the mid-1960s it has gone this long without such a decline. It has been over 18 months since a 10% correction. The chart below shows intra-year declines (red dots) vs. annual returns (black bars) for the S&P 500 Index since 1980. Year to date in 2017, the 3% March dip (if you blinked you missed it!) is the smallest since 1980. And this 3% drawdown continues a 6-year streak of intra-year drawdowns that are far below the long-term average of 14%. The widely-followed VIX Index of general stock market volatility remains near multiyear lows as well.

Given the dearth of market volatility, MPT advocates would say U.S. stocks are signaling a low-risk, low return investing environment (low volatility=low risk=low returns). But is Mr. Market really telling us to “Come on in—the water is fine!”?

We’re skeptical, for a couple reasons. First, the wellspring of market placidity is readily identifiable—it’s the money printing by the U.S. Federal Reserve and other central banks around the globe. In an effort to drive down interest rates and reignite economic growth, central banks have acted as buyer of first and last resort for financial assets since 2008, pumping a total of $14 trillion in fresh cash into world markets. This newly created money (Quantitative Easing or “QE” in banker-ese) has provided a “put” for sellers of stocks and bonds everywhere, effectively buffering each market decline before it starts.

But what happens when the Fed and other central bankers take the punch bowl away? With 4 U.S. interest rate increases in place since 2015, and a big balance sheet unwinding on the way, the Federal Reserve has already begun the process of reversing QE. As Jamie Dimon, the well-respected CEO of J.P. Morgan, put it recently: “We’ve never had QE like this before, we’ve never had unwinding like this before. Obviously that should say something to you about the risk that might mean, because we’ve never lived with it before.” He’s basically saying that reversing historic levels of money creation has the potential to skew the investment environment in ways that even he, one of the savviest bankers around, can’t predict.

And isn’t that really a better way to define risk? If you don’t fully understand a situation, and you can’t readily envision a range of future outcomes, haven’t you captured the average person’s definition of risk? We think so. Never mind the backward-looking, academic version that equates “quiet” markets with “safe” markets— particularly when the main reason markets have been quiet (central bank largess) is going away.

The second reason we’re a bit leery of buying heavily into U.S. stocks is price. Domestic stocks are not cheap. The S&P 500 index is selling at a price/earnings (P/E) multiple of about 19 times expected earnings for calendar 2017. This level is neither super high nor low relative to the long-term average of about 16, but it doesn’t leave a lot of room for the future to turn out different from the current market consensus, either in terms of corporate profits (high) or interest rates (low).

This doesn’t mean there aren’t dozens of good businesses selling at reasonable prices in the U.S. stock market— there are—and we think we own some of them. We’re long term investors in these businesses, not the broad market, after all. And we know that owning a portfolio of well-run companies is the best way to build wealth over time. This doesn’t change. But should corporate earnings begin to disappoint, or the Fed decide to take a quicker path to raising interest rates, we think a lot of the backward-looking market calm of the last few years could evaporate. This would not be a reason to change our process, or deviate from the careful plans and portfolios we’ve put in place over the years, but instead to take advantage of the opportunity to put capital to work at better prices than today.

And this last point gets us to what we believe is the true definition of investment risk: Risk is the price you pay for an investment relative to what you get for your money— not how much the price fluctuates in the days or weeks before or after you buy it.

Notice there are two components here—price and value. Let’s talk price first. If you think about it, there is no future outcome that you cannot discount if you pay a low enough price for an investment. Patience, and the ability to know what a business is worth, are obviously required.

The investing world rarely offers the opportunity to buy great businesses at bargain basement prices, so we don’t try. Instead, we try to own a portfolio of good businesses at a price which allows us to earn a reasonable premium over the long term, risk-free interest rate, typically the 30-year U.S. Treasury rate.

Second is value—what we get. We need to know what a company is worth on a fundamental basis. This involves understanding the “who, what and why” of a company. Who is leading the firm? Do they have a successful track record, and is their compensation aligned with shareholders? What are they trying to accomplish in terms of profitability and shareholder returns? Do they operate a mature business in a mature industry, or are they growth minded? How are they financed, and why might they fail? Answers to these questions help us build the conviction to act when the price is right. Price and value go together.

In the end, investment risk is not about how much the quoted market price of a business or portfolio fluctuates from day to day, but how much value it builds over time. The formula is simple: Know what a company is worth on a fundamental basis, be patient enough to buy it at a price which makes it a good investment for you, and hold onto it. Even a stodgy old finance professor can see the sense in that!

Nathan Boxx, Bradley Newman, Jason Seltzer

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