Value Investing

Selling The Good With The Bad

One of our key beliefs at Burgundy is that owning the equity of high-quality businesses is the best way to preserve and grow wealth over the long run. This long-term philosophy does not mean that our portfolios are immune from short-term volatility; however, as Mark Gallien explained in his latest blog, we believe that our investment process allows us to turn volatility to our clients’ advantage.

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Q1 hedge fund letters, conference, scoops etc

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Along with stock markets at large, our portfolios experienced some of that volatility in February and March. Between January 26th and February 9th, the MSCI World stock market index declined by over 10% in U.S. dollar terms. Within that overall decline, a few days saw particularly sharp selling. February 5th saw the first daily decline of over 4% in the S&P 500 Index (the main index for U.S. large-cap stocks) since 2011.

Historically, these kinds of sell-offs are often driven by investors abandoning stocks and sectors that have suddenly fallen out of favour, such as high-flying “dot coms” in 2000 or financial stocks in 2008. In these situations, the difference in returns between the weakest performers and the strongest tends to be very large.

Let’s turn to the Financial Crisis in 2008-2009 for an example. On the 21 days when the S&P 500 fell by 4% or more, the average range between the strongest and weakest of the current S&P 500 stocks on a given day was roughly 45 percentage points. On those “sell-off” days, the average best performing stock delivered a return of 9% and the worst fell by 36%.

In February’s selling, the range between the best and worst performing stocks was much narrower. In fact, it set a record of sorts. On February 5th, the best performing stock in the S&P 500 Index returned just under 4%, while the worst performer fell by just over 9%. This return difference of roughly 13 percentage points between the best and worst performers is the narrowest that we see in the data for the S&P 500’s current holdings, looking back to the 1990s.

Another way of looking at this is to consider how many stocks’ returns fall within a narrow range on days when markets sell off. On February 5th, 85% of S&P 500 stocks fell between 2% and 6% (within 2% either way of the index’s 4% decline). During the Financial Crisis, however, only about 41% of those same stocks would have delivered returns within 2% of the index on days when the market sold off 4% or more. Stocks’ returns during the volatile days in the first quarter of 2018 bunched together more narrowly than they have in past sell-offs.

While the first quarter’s selling was abrupt, it did not follow the pattern of a traditional panic, where selling is focused on particular sectors or themes and individual stocks deliver widely varied returns. The relative evenness of the selling suggests that it may have been driven in significant part by “passive” or “index” strategies. Such approaches buy and sell all of the components of an index without focusing on the merits of the underlying businesses. These strategies have taken in assets at a dramatic rate in recent years. For example, passively managed assets in the U.S. are estimated to have grown from US$1.9 trillion in 2010 to US$5.4 trillion in 2017.1

If this pattern continues in future sell-offs or, in other words, if market declines are driven by index-based selling that sees most stocks fall by similar amounts (regardless of their business characteristics or quality), what are the implications for Burgundy’s investment strategy?

For a long-term, fundamental investment approach like Burgundy’s, less discriminating selling could accentuate the trade-off between short-term pain and longer-term gain. If market sell-offs become more index-driven, it is possible that Burgundy’s focus on quality companies may not provide the same short-term protection against volatility that it has tended to offer historically. When index-focused traders hit the “sell” button, they sell the highest-quality companies alongside their lower-quality peers. The flip side is that if quality companies are going to be sold off indiscriminately by index-driven traders, we might be able to buy quality companies at greater discounts than would otherwise be the case.

Only time will tell whether market behaviour is changing or if the selling pattern in the first quarter of 2018 was an anomaly. Either way, our view at Burgundy remains that the same: Our philosophy of owning quality businesses for the long run positions our clients to benefit from the occasionally peculiar short-term behaviour of stock markets.

Sources:

  1. Investment Companies Institute, quoted by Bloomberg

Article by Philip Doyle, Burgundy Blog