Fundamental analysis allows volatility to be your friend
The crisis that began in 2008 started to stabilise in 2010, and since the beginning of 2012 the markets have sustained an extended period of bull run on the back of global economic recovery. Despite being on a prolific bull trend, the markets have seen a number of occurrences of spike in volatility during this period.
The most notable ones are the ‘Flash crash” of May 2010, the ‘summer of volatility” in 2011, ‘hard landing in China’ and the ‘Brexit’ in 2016. Post this, the markets witnessed a long-standing period of low volatility until January 2018, until the beast came knocking the doors again.
As a result, the global markets witnessed significant spike in volatility during the month of February 2018, resulting from strong US employment data coupled with robust earnings, which is likely to drive inflation closer to the US Fed’s target.
This perceived outcome sparkled fear within the markets, leading to sell-off within the global equity markets. It is also believed that the complacency seen in the markets is now being replaced with normal volatility, which likely to stay going forward. Having said that, the spike in volatility has been primarily driven by good news, which means that underlying fundamentals and robust earnings will continue to remain intact going forward. Volatility has always been a part of capital markets, something which should not be ignored while building investment strategy.
This is because sophisticated investors will generally capitalise on the volatility to enter into companies with strong fundamentals and sound business models. Since volatility is expected to become a new normal for the markets, it will be imperative for investors to mitigate risks by focusing on underlying fundamentals and adopt a disciplined buying strategy. On a rather important note, long term investing is also important in reducing the short term risks and leads to superior returns over a period of time.
While the short-term volatility can be triggered by a number of factors, such as stop-loss trigger, algorithm trading, investor sentiments, margin trading and panic selling, in reality it does not reflect the actual underlying value of a stock or company.
Consequently, fund managers with sound investment strategies tend to capitalise on such situations to accumulate stocks based on underlying fundamentals to enter at favourable levels with a long term perspective. Further, it is always advisable to have an active, knowledgeable and market based portfolio to mitigate the risks and optimise the returns to outperform the market or index portfolios in the long term.
Stock market returns
If we take a closer look at the pattern of stock market returns in the past 2 years, it clearly indicates the benefits of staying invested on the back of underlying fundamentals. To understand this better, let us consider the performance of leading global markets such as S&P 500 and the regional markets, Thomson Reuters GCC Index, to gauge the returns generated post the spike in volatility. The last spike in volatility was recorded in February 2016, reaching a high of close to 27, which was driven by fears of a slowdown in the Chinese economy.
The volatility stabilised post this event but the Brexit shock pushed the volatility index back to the levels of 25 in June 2016.
Assuming that one had entered the markets during this period based on fundamental analysis, S&P 500 would have yielded a return of 50.2 per cent until the end of January 2018 (period of two years), while the GCC index would have yielded 20.4 per cent. Though this is a simple and relatively straight forward example, these cases still do illustrate the importance of fundamental analysis that enable investors to minimise their risk and ignore the short term volatility.
Now that we have established the importance of fundamental analysis, it is equally important to understand the limitations of such during a period of high volatility. Firstly, to draw the true benefits of fundamental analysis, it often requires long term commitment as the ultimate value of a company will only reflect over a period of time.
Secondly, given the rapidly changing economic environment, it is always advisable to actively monitor the latest developments and accordingly change the investment strategy. In other words, the dynamics of a company can change due to an unexpected event, which will lead to alterations in intrinsic value. As a result, the stock will no longer make fundamental sense or yield any potential return going forward.
Lastly, the volatility in the markets can be extended for a slightly longer period but it will be important to ignore the noise, stay focused and back your conviction based on the long-term objective.
In conclusion, volatility has been an old friend of capital markets, which generally has many facets evolving from political unrest to disappointing earnings report. Substantial rise in volatility in the short term can rattle the nerves of any investor as the natural reaction in such situations would be to either reduce or eliminate the exposure to stocks to minimise the losses. Hence, it should be a reminder for every investor to remain disciplined and ensure that their investment strategy is aligned with the underlying fundamentals, coupled with long term goal. Market guru Warren Buffet rightly says, “The stock market is a device for transferring money from the impatient to the patient.” Therefore, volatility should be perceived as an “opportunity” by long term investors on the back of underlying fundamentals of a company. The writer is founder and CEO of Al Masah Capital. Views expressed are his own and do not reflect the newspaper’s policy.