Global equity markets have dropped 10% in recent weeks, erasing gains for the year. Our large cash reserve has provided a cushion from the brunt of the recent fall. While performance has declined a bit further this month, our losses have been a fraction of those suffered by equity indices, which have shed five to ten percent in October alone.
Given increasing volatility and corresponding investor skittishness, we thought it might be helpful to put recent market action into perspective, while reinforcing our investment discipline at Broyhill. There are just three key points we would like to make in this letter. If you have questions on any of them as it relates to your portfolio or our process, please don’t hesitate to pick up the phone. We’d be happy to go into as much (or as little) detail as you’d like.
Broyhill: Investors should be prepared for increased levels of volatility
1) Following last year’s massive rally in stocks, which on some measures exhibited the lowest volatility in decades, investors should be prepared for increased levels of volatility moving forward. Markets have a tendency to extrapolate periods of low volatility into the future. Reality is rarely this tranquil. Stable environments sow the seeds of their own demise as speculators respond to rising prices with greater leverage to magnify lower returns. Some folks will just never learn. Magnified leverage ultimately results in magnified volatility.
2) It is important to emphasize that increased volatility does not necessarily translate into increased risk. The only risk investors should concern themselves with is the risk of losing money.
The riskiest thing in the world is consensus belief that there is no risk, which seduces many to chase returns. Chasing returns drives prices higher (and future returns lower) making assets more expensive and hence, more risky. Paying too high a price is the simplest way to increase risk of loss. Luckily, it is the easiest risk to avoid.
The best way to reduce risk is to buy at a lower price, which provides the astute investor with a margin of safety. As asset prices decline, the herd may view them as riskier. Truth is, assets become less risky at lower prices. As a result, increasing volatility, coupled with growing fear that the market is risky, can actually make it quite safe.
3) Increased volatility does, however, provide us with increased opportunity. As we said in our Annual Letter, “The greatest buying opportunities arise when liquidity is in short supply and anxious investors, consumed by fear, are forced to sell securities as prices fall. Leaving the party early will almost always result in short term underperformance during the later stages of bull markets, but it is the only way to ensure that you have the resolve, the discipline, and the dry powder to buy when risk is lowest and expected returns highest.”
We left the party early last year while many of our peers decided to stick around for last call. Experience has taught us that nothing good happens that late in the evening.
Broyhill: Building an inventory of ideas
Investors would be better served to head home early for a head start on building an inventory of ideas for tomorrow’s opportunity set. There is just no reason to settle for lower quality opportunities before last call, when Mr. Market is sure to serve up much more attractive dishes tomorrow. One of our greatest advantages at Broyhill is the flexibility we are afforded to commit as little or as much capital as we determine based upon an independent appraisal of valuations and expected returns.
Subdued volatility created a scarcity of opportunities that met our return requirements over the past year. That has begun to change. While broad markets remain expensive and near all-time highs, we have recently uncovered a number of individual opportunities trading at attractive valuations after suffering much steeper declines.
Recognizing that I promised “just three points” at the outset of this letter, this concludes our regularly scheduled programming for the quarter. For more color on the growing opportunity set, feel free to flip ahead to the brief appendix, which encapsulates our recent communications with a good friend and current investor.
Christopher R. Pavese, CFA
See full Broyhill Asset Management Letter in PDF format here.