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Friend or Foe?

By Jay Skaalen, CFA

Changing the way investors look at volatility from “risk” to “opportunity” can be the most powerful tool investors can utilize to combat turbulent times.

2021 was one of the better years on record for financial markets. Aside from fixed income, all asset classes delivered positive returns and three – U.S. Equities, Natural Resources and Real Estate – were up over 20% for the year, a historically rare feat. Also rare was the lack of volatility that accompanied most global markets. The S&P 500, for example, only saw a 5% intra-year decline, the third lowest reading since 1980. While calm markets may be welcomed by investors, they can also breed complacency and make the inevitable return of turbulence feel much worse. Knowing this, our investment team tends to become unsettled during extended periods of tranquility and has learned to welcome volatility. We believe this mindset should be shared by all investors, but particularly by active managers like ourselves whose job it is to capitalize on irrational and emotional markets. In this article we explore this topic by taking a look at how prevalent volatility has been throughout history, explaining why we view volatility as an opportunity instead of a risk, and discussing how the Osborne Partners investment team has been able to take advantage of volatility throughout our long history. 

For new investors, enduring meaningful market volatility is a right of passage. These episodes are often unforeseen, typically uncomfortable, but also unavoidable, if you invest for any meaningful period. They can be slow and orderly or quick and chaotic, and despite having endured countless episodes of both varieties, I’m still unsure which is less painful. It is unnerving for investors who have never experienced them, but it can be anxiety-inducing for even the most seasoned investors. The ultimate truth is that living through market volatility is the price of admission in financial markets and there is little that can be done to avoid it. Need proof? Look no further than the S&P 500, which has averaged an intra-year decline of roughly 14% since 1980. Or consider pockets of the market like small cap U.S. equities that have been even more volatile, averaging an intra-year decline of nearly 19%. Recently, we saw the S&P 500 pull back by roughly 15% from its’ highs earlier this year, and while this may have felt unpleasant, statistically speaking it was a run-of-the-mill market correction.

There are a litany of reasons that volatility can emerge: geopolitics, natural disasters, global pandemics…the causes are often unexpected with the result commonly being increased uncertainty – a primary foe for investors. However, shifting the way one looks at volatility from a “risk” to an “opportunity” can be the single most important tool investors can utilize to deal with volatility and better position themselves for the future. Achieving this isn’t easy, and this mindset undeniably runs counter to how most humans are wired. Making matters even more complex is the inconvenient truth that more uncertainty and fear typically results in even better future results. For example, there were few, if any, reasons to be optimistic in March of 2009 or March of 2020, yet both environments proved to be impeccable buying opportunities.  But you don’t need a dramatic bear market to provide opportunities for attractive returns. Despite the S&P 500 averaging a 14% intra-year decline since 1980, it has also delivered positive returns in over 76% of those years, suggesting that markets have rewarded investors who have been skeptical of pervasive pessimism. But how and why do these “opportunities” come about?  In periods of elevated volatility, investments often become detached from fundamentals and trade increasingly on emotions. Uncertainty tends to provide a wide range of potential outcomes and negative headlines that can quickly get extrapolated into overly dire conclusions. As investments increasingly price in low-probability and overly negative outcomes the inherent risk-reward becomes progressively more attractive. One key point to remember, which we expand on below, is that without a disciplined investment process that allows you to objectively assess the risk-return of each investment, taking advantage of these opportunities can be incredibly challenging.

At Osborne Partners, we believe our investment process is one of our firm’s most unique attributes. The process involves deep fundamental analysis, crafting a differentiated narrative and thesis on each potential investment, and actively managing each position utilizing the risk-rewards that we constantly refine for each investment in the portfolio. It is time intensive and requires consistency, but by following this process time after time, it has not only enabled our team to limit costly emotional mistakes but also allowed us to take advantage of opportunities that few recognize. Importantly, our focus on underlying risk-reward means that not only are we often eager buyers during periods of market stress, but also willing sellers during periods of exuberance. This balanced approach enables our team to slowly raise cash during periods that offer unattractive risk-rewards and deploy this cash during environments where risk-rewards are particularly attractive.  Aside from a disciplined investment process, another advantage investors can lean on during volatile market environments is a long-term horizon. In fact, one way that volatility can directly turn into risk is having a short-term horizon and being forced to sell in unfavorable environments. As long-term investors, we are not focused on next week or next month, but focused on how companies will deliver shareholder value over a multi-year time frame. Investors that act on short-term fears and emotion often prove to be a long-term investor’s biggest asset by selling investments at discount prices and which often provide attractive risk-rewards for patient investors.

“The most common cause of low prices is pessimism. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer.” – Warren Buffett

One of the primary reasons our investment team enjoys writing articles like this is to shed some light on the process going on behind the scenes. We believe it is important for our clients to know that an incredible amount of thought, energy and effort is being put forth into each and every decision we make in your portfolio. We hope this article provides some perspective on why our team makes certain investment decisions in different market environments and maybe even provides some additional comfort as we continue to experience volatile markets. As always, we appreciate the trust you put into our firm each day and look forward to sharing more with you soon.

Jay Skaalen, CFA

Jay is a Principal of the firm and Investment Analyst with over 15 years of experience and is in his 8th year at OPCM. Jay is a member of the OPCM Investment Management Team, and is responsible for research coverage in all asset classes. Prior to OPCM, he was a Portfolio Manager at Wells Fargo and a member of their National Equity Research Team. He also worked in Corporate Finance and Investor Relations for Qualcomm Incorporated. Jay is a member of CFA Society San Francisco and CFA Institute. Jay received a Bachelor of Science degree in Finance and Accounting from California Polytechnic State University at San Luis Obispo and is a CFA Charterholder.
The opinions expressed herein are strictly those of Osborne Partners Capital Management, LLC ("OPCM") as of the date of the material and is subject to change. None of the data presented herein constitutes a recommendation or solicitation to invest in any particular investment strategy and should not be relied upon in making an investment decision. There is no guarantee that the investment strategies presented herein will work under all market conditions and investors should evaluate their ability to invest for the long-term. Each investor should select asset classes for investment based on his/her own goals, time horizon and risk tolerance. The information contained in this report is for informational purposes only and should not be deemed investment advice. Although information has been obtained from and is based upon sources OPCM believes to be reliable, we do not guarantee its accuracy and the information may be incomplete or condensed. Past performance is not indicative of future results. Inherent in any investment is the possibility of loss.