Antonio Garufi is an instructor at European Investing Summit 2016.
The title probably sounds a bit pretentious or, to say the least, odd. As a matter of fact, all the business schools in the world teach a fairly different concept. In the value investing world, however, this is a pretty familiar notion: volatility is not a measure of risk. It is a very poor one.
Volatility is calculated by observing past fluctuations in price. It is not a forward looking measure. So how can we state that volatility measures future price fluctuation risk? By arguing so, we imply that the past behavior of a stock is indicative of its future patterns. That seems a bit pretentious too.
Value investors believe that the true measure of risk is the “margin of safety”, the difference between price and intrinsic value. The lower the price and the higher the intrinsic value, the better it is for the investor. More margin for error is there to protect him. It appears obvious if one thinks about real estate investments. The less you would be paying your house compared to market value in that specific area, the more shielded you would be from market price fluctuations. Your chance to gain from that investment is much higher if your purchase price is lower. Would you purchase a house just because its past price fluctuations where small in the past? I doubt it. There is no question that you want to pay less for the value you get. So why not apply the same framework to companies and stocks?
I always find that people are very good at due diligence when it comes to villas and apartments, but very superficial when it comes to stocks and companies. Actually, something funny happens when investors consider allocating capital to the financial markets. Many investors tend to buy when prices are rising, following the typical “missing out fear” behavioral pattern. And guess what happens to volatility when prices rise? It actually decreases. So, wait a minute, someone might think, are you saying that volatility is inversely proportional to risk? Sometimes it happens. Let’s think about the “decreasing prices” scenario. Most investors learned through bitter experience, or if they didn’t they will soon, that when prices fall, they fall off a cliff. 2008 is a fresh memory, but let us not forget 2001, 1929, etc.
What about the famous American Express case? When did Buffett purchase the stock? After a great fall in price caused by the uncovering of a fraud. Guess what happens to volatility when the fall is so fast? It skyrockets. I can hear you thinking: “So are you saying that Buffett bought a risky stock”. Well, for him it was not risky at all (it was a steal actually), whereas for the average business school professor or student, it was very risky. He bought it precisely because he was getting the intrinsic value of the company (unchanged by the recent scandal) by paying a lot less. Easy to say, and difficult to do.
It is against human nature to buy assets when prices are going down fast. It is basically the same thing as saying: “I know better than the market does”. For an investor, the cost of being wrong could be very high in these situations. Did it ever happen to you, portfolio managers out there, to hear your boss say: “You bought a stock that lost 20%, what do you want to do?” Scary thought. As Jeff Gramm said in an interview when he was asked how did he knew if a stock would get cheaper after the first purchase: “It will get cheaper”. What he meant is that nobody can predict price fluctuations, especially in in the short term, but some people are fairly good at predicting where the price of an asset will go in the long term. As the great Ben Graham put it: “It is a mystery but somehow it will converge to its intrinsic value”.
The value investor must have the stomach to bear the consequences of his portfolio’s volatility. He would have to be brave enough to buy more stock at a lower price (if the intrinsic value is unchanged), precisely when everyone is selling. Here is the thing. What would you do if you bought the apartment we mentioned before and, after two years someone offered you the flat next to it so you can have a larger house, and the other flat was marked at a 50% discount on what you paid in the first place? Would you be scared and think you lost money on your previous purchase (in other words, would you be marking to market your first investment), or would you be piling up another mortgage and purchase the new flat right away? If you did your due diligence, you would be in the condition to judge if you are buying below the intrinsic value of that investment. If someone dropped an atomic bomb in the neighborhood, the intrinsic value of your investment would have changed, obviously.
Big problem: how do you measure intrinsic value? It should be the subject of a different article. Many great minds have undertaken the challenge. It is not an easy quest, which is the exact reason why nobody teaches anything about intrinsic value in business schools (except a few ones). It is precisely the reason why the financial community is so adamant about volatility. Volatility is very easy to measure and academics just love what they can measure. It is just a mathematical function, whereas the intrinsic value of a company is a subjective measure. Its accuracy depends on the skill of the analyst and on a certain degree of luck (luck is not a very popular concept in science). Moreover, let us not forget that intrinsic value is a moving target. If the analyst is not wise enough to re-examine its reasoning as prices move and misses something material in its calculations of the intrinsic value (for example changes in the industry dynamics, barriers to entry, etc.), losses could be too high to bear. Investments cemeteries are full of people that kept averaging down their purchase price until there was no capital left. Having said that, by buying cheap assets relative to their intrinsic value, thereby increasing his margin of safety, the wise investor can tilt the probabilities of avoiding errors and misjudgments in his favor. And after all, avoiding errors is what investing is all about.