Value Investors Know The Dangers Of Reacting To Short-term Volatility Via George Athanassakos, The Globe And Mail
Finance academics define risk as volatility, whereas value investors see risk as the probability that adverse outcomes in the future will permanently impair the business’s potential cash flow and investor’s capital. Which is correct? It all depends on your investment horizon. But if maximizing terminal wealth is of importance to investors, and it is difficult to argue otherwise, then value investors have it right.
Let me explain.
There are two types of fundamental analysts: short-term and long-term. Short-term fundamental analysts are the typical financial analysts. They accept the stock price as given and try to determine what will make the stock price move. Their price targets and investment calls are affected by the release of short-term economic or corporate news. They react to such announcements.
Value investors are long-term fundamental analysts. They do not react to short-term announcements. For example, the short-term noise of whether the next quarter’s earnings deviate from expectations is immaterial. What is material for value investors is whether the company continues to have strong fundamentals, be well managed and financially sound, as well as “cheap.” The stock price is not important; instead, it is the difference between the intrinsic value and the stock price that is important. If the stock price is significantly below the intrinsic value (by a predetermined margin of safety), then the stock is considered cheap, and value investors buy. Otherwise, they wait.
So, the investment horizon plays a key role in the discussion of what is an appropriate measure of risk. But truly, how much should you worry about short-term volatility? Not much. As Warren Buffett’s partner Charlie Munger says, “If you’re investing for 40 years in some pension fund, what difference does it make if the path from start to finish is a little more bumpy or a little different than everybody else’s, so long as it’s all going to work out well in the end? So what if there is a little extra volatility?”
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