Monday, March 2, 2015

Volatility: Friend or foe of the value investor?

Volatility is the variation in stock prices. Mathematically it is the square root of the variance. The more a stock moves up and down the higher the volatility. Investors typically fear volatility and are much happier in lower volatility environments as it is perceived is lower risk. But image if you know that you have the opportunity to buy something at various prices every 365 days at prices that differ by over 50%? Wouldn't this be very exciting for you if you knew the value of the underlying security?

Efficient market theorists will tell you that the higher the volatility the higher the risk of the business. This is because they believe that volatility implies that the value of the business is actually moving up and down on a daily basis – and because of the fluctuations it could go down as well as up which is risk.

Value investors believe that the higher the volatility the more the opportunity to buy businesses at a discount to fair value. If a stock is likely to move 20% up and down from today’s price the probability of buying it 20% lower than today’s price is higher than something that only is likely to move 5% up or down.

The index given its diversification should typically have much lower volatility than individual stocks as per the efficient market theorists. In order to make sense of the volatility I would like to present a graph of the difference between the minimum and maximum value in the 365 day period preceding each date as a percentage maximum value divided by minimum value minus one. (The example index in this case is the CNX NIFTY on Dalal Street in India)

I think it would not take much for me you convince you that the value of all the companies in the index should move by on an average 54% each 365 day period. This volatility is what you need to take advantage of by buying when the price is right. I am not suggesting you start trading the index as a value investment strategy but the underlying stocks in most cases are even more volatile than this.

You will experience deep fear every time you buy something that falls by 30% but you need to understand the underlying business and not fear the quote Mr. Market is giving you.