Since the end of 2014 we have seen an increase in the volatility of world stock markets. We expect this to continue during 2016—primarily due to the fact that valuations are towards the upper end of their historical range and the fact that the Federal Reserve is probably going to continue raising interest rates. It is impossible to completely remove stock market volatility from client portfolios. However, there are two things we can do that should help reduce the impact of stock market volatility.

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First, most of our clients have balanced portfolios between stocks and mostly high quality bonds. Short to intermediate maturity high quality bonds do not fluctuate much and will minimize the volatility of client portfolios. We will also periodically make minor modification to clients’ asset allocations—based on the overall valuation of the stock market. In December 2014 and January 2015, we decreased the equity holdings in balanced portfolios back towards their targeted equity percentage and increased their holdings in high quality bonds. The primary reason was not because we thought a stock market decline was imminent but because the P/E ratio of the stock market reached 19.5—the top end of its historical range. (Since the end of 2014 we have also kept some excess cash for new clients and existing clients that have added money to their portfolios. We plan to reduce these cash positions when the stock market valuation approaches its historical average and/or when we see attractive opportunities in individual companies.)

The second thing we do, to minimize the volatility of stock prices on portfolio values, is educate our clients about our value based investment philosophy. A key element of our strategy is trying to take advantage of the fact that a company’s stock price is much more volatile than its underlying intrinsic value. This is visually captured by the regular analysis of purchase and sales in our quarterly newsletters—when we do a graphical comparison between a company’s stock price and its intrinsic value. It is statistically captured in the table above (for a dozen companieswe own) that compares the annual standard deviation, or volatility, of each company’s stock price and intrinsic value over the past 15 years. The Volatility Quotient is the ratio between the volatility of the company’s stock price against the volatility of its intrinsic value. Generally speaking, a company’s stock price is about two to three times more volatile than their underlying intrinsic value. Investors often confuse stock price volatility with investment risk. This confusion has been further reinforced in themedia and academic circles where Nobel Prizes have been awarded. As long-term value investors, we believe investment risk is primarily related to the price of a company’s stock compared to its underlying intrinsic value—not to the volatility of its stock price. We continually try to take advantage of this fact by buying companies when they trade at a 20 to 50 percent discount to our estimated intrinsic value and selling them when this gap narrows.

We hope having a better understanding of the volatility of stock prices and intrinsic values will allow our clients to embrace our valued based investment philosophy, and have a higher comfort level with how their portfolio is being managed as we traverse volatile markets. I have a lot of confidence in our value based approach over the long-term. This confidence is one of the biggest reasons why I started Granite Value Capital seven years ago. (An equally big reason is that I always want to be able to do what is in the best interest of clients.) I encourage you to touch base with me if they have any questions/concerns about your portfolio or the recent volatility in the stock market. I appreciate the confidence and trust you have placed in Granite Value Capital.

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The above post has been excerpted from a recent letter of Granite Value Capital.

This newsletter contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized investment advice. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing in the stock market involves the potential for gains and the risk of losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. Any information prepared by any unaffiliated third party, whether linked to this newsletter or incorporated herein, is included for informational purposes only, and no representation is made as to the accuracy, timeliness, suitability, completeness, or relevance of that information. Granite Value Capital, LLC is an SEC registered investment adviser with its principal place of business in Hanover, NH. Granite Value Capital and its representatives are in compliance with the current notice filing requirements imposed upon registered investment advisers by those states in which Granite Value Capital maintains clients. Granite Value Capital may only transact business in those states in which it is notice filed, or qualifies for an exemption or exclusion from notice filing requirements. This newsletter is limited to the dissemination of general information pertaining to its investment advisory services. Any subsequent, direct communication by Granite Value Capital with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For information pertaining to the registration status of Granite Value Capital, please contact Granite Value Capital or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov).