The stock market has been in some pretty impressive short-term swings of late. We have seen several 100-plus-point moves in the major indices as markets have responded to continued economic weakness in Europe, earnings reports and the latest developments on the Ebola outbreak. The pundits and commentators are starting to talk about market volatility and its impact on investors. Of course, we should be clear about one thing: When we say, "volatility," that indicates the downward sort. If prices are rising 1% or more every day, no one really thinks much about volatility. Instead, that's characterized as a strong up move into a volatile market.
As a value investor, I have learned that volatility is not something to fear. In fact, volatility is my very best friend and partner. Benjamin Graham called volatility by its formal name, Mr. Market -- our manic-depressive business partner whose mood swings are a source of long-term profits. When he is too excited, he wants to pay any price for a percentage of our business. When he is depressed, he wants to sell it back to us at just about any price he can get, regardless of the value of our assets. When his mood is at either extreme, these represent opportunities for us to act in a contrary fashion for long-term gain.
The constant day-to-day focus on each little move in the market is not a healthy exercise for most of us. As Graham warned us in The Intelligent Investor:
Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.
In other words, short-term moves do not really matter if you adopt the private-equity mindset when you manage your portfolio.
Rather than hide from volatility or attempt to protect ourselves from it, we should actively seek it out, especially amid volatile markets that are moving lower. Consider the recent action in energy stocks. I can either be worried that some of my oil holdings are moving lower because of concerns that the Saudis are willing to accept lower prices, or I can be delighted that so many high-quality energy-related companies are selling at ridiculous prices relative to their respective asset values.
If I apply my private-equity viewpoint to the sector, I can see that it is highly unlikely the Saudis will chew up their own balance sheet by tolerating low prices forever, and that oil demand is likely to rise over the next five to seven years. Given that information, the idea of buying companies such as Nobel (NE), Rowan (RDC) and Gulf Island Fabrication (GFI) starts to make a lot of sense. These stocks are volatile, and they are likely to go lower in the short term, but odds are pretty high that they will trade at much higher prices several years from now.
This morning I am looking at the volatility in European banks in the aftermath of the European Central Bank stress tests. These things are trading all over the place today. The ones that passed are selling off right along with the failures.
If my mission were to avoid volatility, I would not go anywhere near these stocks. Instead I am looking through the results and reviewing the situations at large entities such asDeutsche Bank (DB) and Barclays, which are highly unlikely to fail in the future. I am intrigued that Alpha Bank (ALBKY) passed with flying colors, and that the stock is trading lower this morning. All of these are trading at huge discounts to book value, and they could be fantastic long-term bargains at these prices.
If you a little more aggressive in your approach to deep-value investing, that presents another reason to love volatility: It is one of the legs of the options-pricing tool, along with price, time and interest rates. When volatility picks up, you can sell options at higher prices. It can allow you to collect more cash when you sell cash-secured puts, and you can get back into almost-cheap-enough stocks at below-market prices.
Everyone fears volatility. But the truth is, you should embrace it and make it your friend. Wild price swings are what create bargains or cause outlandish valuations that represent an opportunity to sell. Most of the time the day-to-day moves have no impact on deep-value investors with a private-equity mindset, but at the extremes these can be a source of significant profits.
