When Opportunity Knocks

September 2021

In this note we explore how we think about market volatility when it arrives, and how we act in periods where the word “correction” is plastered across every finance news site.

The Facts about Market Timing

To begin with, we subscribe to the view that the attraction of equities is the availability of compound total returns ahead of inflation over time. This comes with a cost: investors will only enjoy the effect of the compounding process if they remain invested for the medium to longer-term. An investor’s friend is time, conviction, fundamental research and a business ownership mindset.

Nevertheless, the temptation to ‘take some risk off’ is ever-present. While each individual investor will have unique circumstances driving their personal asset allocation, we don’t attempt to engage in market timing within the Fund. (A piece of investing wisdom we take to heart is that there are two types of investors when it comes to market timing: those who cannot do it, and those who know they cannot do it).

We believe that the reasons for market timing rarely working can be boiled down to two underlying issues:

1. The risk of missing out on big ‘up’ days can have incredibly negative impacts on long-term returns… and not surprisingly, the big ‘up’ days tend to be clustered around the big ‘down’ days during periods of increased volatility. Giving in to the temptation to ‘get out’ on the big down days dramatically increases the risk of missing the rebound.

Many studies have borne this phenomenon out; according to a recent piece of research by JP Morgan Asset Management, $10,000 invested in the S&P 500 on 3 January 2000 would have turned into $32,421 by 31 December 2020 for an annual compound rate of return of 6.06%. Missing the 10 biggest ‘up’ days cuts that compound rate of return to 2.44%, while missing the 20 biggest days reduces it yet further to a paltry 0.08% per year. Missed the 30 best days? You would actually end up with less money than you started, having compounded at -1.95% per year for 20 years. ‘Getting out’ to avoid the psychological pain of short-term paper losses is not worth the increased risk of long-term damage to returns, in our opinion.

2. Markets are second-level systems. It is not enough to accurately predict an event; one must also correctly predict what the market was anticipating prior to the event and then correctly deduce how the market might react to the new information. We think that getting all three of those variables correct – and then being right on the timing, to boot – is nigh-on impossible to do repeatably.

Since 1950, the S&P 500 has experienced 36 separate drawdowns of 10% or more. Ten of these double-digit declines ended up exceeding 20% (the popular definition of a ‘bear market’) peak-to-trough, while the other 26 ended up somewhere between -10% and -20% (a ‘correction, euphemistically.) Statistically speaking, if there have been 36 double-digit drawdowns over the past 70-odd years, it works out that investors should expect this to happen with a frequency of about once every two years.

Corrections and pullbacks are essentially an unavoidable part of the investment journey – and when seen in perspective as a period of prudent capital allocation with a margin of safety, is more likely to provide opportunity than lasting damage.

Investor Time-Horizons: Shorter Than Ever

Closely linked to this point – using periods of market weakness to allocate capital – is the fact that investor time horizons have almost never been shorter. Based on an analysis of turnover, the average investor in US equities hold their positions for less than a year.

As the chart above shows, investor holding periods have been steadily decreasing since essentially the early 1990’s, meaning this dynamic is not a new one. Over the past 18 months or so, access to cheap leverage and commission-free trading has likely exacerbated the trend.

We recently tested this thesis on some of the high-profile, high-growth businesses that have come to market since the start of the pandemic. After adjusting for management ownership and strategic investors, it appears to us that a number of businesses essentially see their free float turned over in full every two to four months. Keep in mind, this is for businesses where the drivers of value lie several years in the future. We have very little doubt that there is substantial short-term speculating about long-term variables occurring in the equity of certain businesses.

Of course, shortening holding periods also create opportunity. If an investor can simply take a 12 to 18-month forward view, one is already looking out further than the majority of the daily activity in markets. (We generally try to formulate a view on a 3-to-5-year basis). When a high-profile business suffers the inevitable disappointment relative to the sky-high expectations embedded in its price, the pullback can provide a window to the patient investor.

The narrative behind any pullback can be varied: stalled US debt ceiling negotiations, fears of a slowdown in China, rising energy prices, ongoing supply chains disruptions, resurgent COVID cases or lockdowns all seem like likely candidates. However, to the investor who takes a business ownership perspective and understands the quasi-permanent nature of equity ownership (particularly in competitively advantaged businesses), such pullbacks usually provide the time to wisely allocate capital. Getting scared off by a compelling narrative around risk is exactly what causes inactivity when the market goes on sale.

The Psychology of Uncertainty – Prepare, Don’t Predict

Fred Schwed Jr. was a professional broker active on Wall Street active during the crash of 1929. Several years after the event, he wrote the seminal Where Are The Customer’s Yachts?, in which he provided a true, timeless and hilarious view on the inner workings of investment markets and Wall Street culture. Despite being nearly 100 years old, the observations in it remain timely, and we highly recommend it to our investors – it is a quick read, and extremely funny to boot.

In Where Are The Customer’s Yachts?, Schwed writes:‍

For one thing, customers have an unfortunate habit of asking about the financial future. Now, if you do someone the single honour of asking him a difficult question, you may be assured that you will get a detailed answer. Rarely will it be the most difficult of all answers – “I don’t know.”‍

We strongly agree with this statement. The one thing markets (and by extension, investors) hate is uncertainty. Uncertainty leads to volatility, which leads to those troublesome corrections everyone is trying to avoid. It is therefore no surprise that market commentators hold forth on a variety of subjects with great certainty: “inflation will do X”, “the currency will do Y”, etc.

The problem is this: absolutely no one knows what will happen with 100% certainty. All of the knowable facts lie in the past, while all of the value lies in the unknowable future.

Following the recent experience of navigating markets in 2020, one maxim of the Constantia investment team is that among the four most dangerous words in investing (alongside Sir John Templeton’s famous “this time it’s different”) are “we know for sure” – particularly when it comes to macro-economic prediction. Instead of selling you certainty, we believe in working alongside our investors to get comfortable in living with the psychology of uncertainty. Our motto in this regard: prepare, don’t predict.

We limit our predictions about the future to businesses we believe we understand, and by sticking to this circle of competence – and owning businesses with prodigious amounts of cash on hand and cash being generated – we believe we are prepared for the ‘vicissitudes of fate’ that will play out in the real economy. When we believe we have both an edge in understanding as well as a margin of safety, we prudently invest your capital, effectively handing it over to the right business managers at the right price. We believe this approach is likely to lead to far more beneficial outcomes over time than trying to predict and position for short-term macro-economic outcomes.

Sustained, Incremental, Sensible

As exciting as it may feel to time the market, worry about every headline promising impending doom and trading in and out based on some forecast of an imminent correction (which may or may not happen), the evidence proves that such strategies rarely work. Instead, far more is achieved when sticking to a strategy that allows for the aggregation of small gains – in other words, compounding – to build up over time.

Practically speaking, this means that most investors are almost always going to be better off by simply using a dollar-cost averaging strategy through time. By mentally sticking with an allocated amount to invest through thick and thin, investors generally do better over the long term than by making big calls to get in and out of the market. The reason is simplicity itself: this strategy keeps you invested – and more importantly, still investing – when the proverbial lean years come around in the market. (Logically, one may consider whether it is appropriate within their personal circumstances and risk appetite to accelerate such a strategy when market volatility offers a greater margin of safety when a correction (or bear market) does occur.)

If the conclusion to this note seems somewhat boring, we have achieved our goal in writing it. ‘Sustained, incremental and sensible’ as a capital allocation strategy is hardly going to get the blood pumping on any particular day, but it makes all the difference when adhered to for long periods of time through the wonders of compounding. Through a number of market cycles, we have found that time in the market matters more than timing the market.