Volatility: A Market Feature, Not a Bug
After a reasonably benign start to the month of February, the rapidly changing outlook of the potential global impact of COVID-19 turned into a storm that felled virtually every tree in the forest. Regardless of investment philosophy, geographic focus or factor exposure – growth, value, momentum, income, low volatility, quality or size –there was nowhere in equity markets that were spared.
As someone once told me, the first thing that gets lost in a market correction is perspective; the second is sight of one’s investment philosophy.
Source: MSCI, FactSet, AIM
The chart above is fairly straightforward. The blue columns indicate the calendar year total returns for the MSCI World index in US dollars for every year from 2001 to current. The red columns represent the peak-to-trough decline in any given year, with the grey line the median decline of -12.2%.
The current correction is notable for how sudden and violent it has been, particularly given that the S&P 500 made an all-time high on Wednesday 19th February. It is the most rapid sell-off from an all-time high into a correction (a 10% drawdown) on record.
However, in taking a longer-term view, corrections have occurred in 14 of the last 20 years. This kind of volatility is part of equity investing, and ultimately unavoidable for anyone with a multi-year time horizon.
It is also good to remember the adage that it is time in the market rather than timing the market that makes a difference to long term equity returns. The chart below shows long run OECD inflation (from 30th June 2004 to 30 June 2019), and contrasts that the MSCI World Net Total Return index, as well as the index if you missed the 5/10/15/20/30/50 biggest ‘up’ days.
Source: MSCI, AIM
Equity is by its nature volatile but can demonstrably beat inflation and grow wealth in real terms over the very long run. Trying to trade or time the market on near-term news flow may feel psychologically better (i.e. you avoid the volatility and near-term distress it causes) but can seriously impact your long-term returns as evidenced by the gap between just owning the index and missing the 5 best days (see table below). Historically, many of those best days have come after periods of index weakness, volatility and uncertainty. If you were unlucky enough to be out of the market on more than 20 of the best days, you actually ended up eroding wealth in real terms.
Source: MSCI, AIM
To quote the great Peter Lynch:
“There is always something to worry about. Avoid weekend thinking and ignore the latest dire predictions of the newscasters. Sell a stock because the company’s fundamentals deteriorate, not because the sky is falling.”
The unique challenges presented by COVID-19 are substantial and will very likely cause further disruption. Markets can clearly continue to sell-off. However, for the patient, there will be good quality businesses on sale soon, if not already. In addition, high-quality businesses have an extraordinary way of managing their way through a period of crisis and disruption and come out the other end stronger, as they have the ability to invest when competitors much focus on preserving their enterprise.
Our investment philosophy is underpinned by the belief that companies that earn above average returns on invested capital will deliver superior shareholder returns in the long term. With that in mind, we remain focused on the fundamentals, and look to own high-quality business that can compound their cash flows through time.