Today, as I look at our portfolios (which as always are a collection of out-of-favour, abandoned, or simply undiscovered securities) I can make the following observations:
1. By design, we prefer to build our portfolios with the types of securities that have been shown to produce superior rates of return historically, such as: – securities that are “cheap” by various fundamental metrics which outperform because of the concept of “reversion to the mean”; – securities that are smaller in market capitalization because fewer “eyes” watch them and therefore they tend to fall through the cracks and therefore to be mispriced. Finding mispriced securities is the value-add that an active investment process should provide (see “What Has Worked in Investing” – Tweedy Browne ” for an extensive elaboration of these ideas).
2. A consequence of choosing such securities is that they can be more volatile than the market as a whole. They are what is called in technical jargon “high beta securities”. Beta is a backward-looking measure of the historic volatility of a security compared to the volatility of “the market”. For example, if a security has a historical beta of 3 and the market decreases by 1%, one would expect that security to decline by 3% – as it has done in the past. We are not talking here about changes in company values, but rather simply price changes due to market gyrations.
3. Furthermore, when securities have a large potential for appreciation given their current under-evaluation it can make sense to take – again by design- large (“concentrated”) positions. Added to the high beta characteristic of such securities, one can see how it is reasonable to expect that absent fundamental news/developments portfolios built in this fashion are likely to be more volatile than the market.
4. The solution to weather volatility is not to plan for or worry about particular levels of volatility because volatility (day-to-day market movements) reflects only these market movements and not actual developments affecting the underlying assets and is therefore not a risk to the invested capital. This requires that investors be patient enough to wait for the estimated underpricing of each security to be recognized in time by the market and corrected. In our case and like most value minded investors, we define risk as the risk of permanent impairment of capital, and see market volatility as just a (alas often unpleasant) nuisance that has to be tolerated to achieve our goals. We therefore view our portfolios as a concentrated collection of discoveries, each with tremendous capital appreciation potential as mentioned above. As securities mature toward their fair value, their volatility tends to decrease. Once sold, as they are progressively replaced by a new of opportunities, the level of volatility of the portfolio will change again.