With the potential for continued market volatility, what can the early February equity market correction teach us as investors? Are there lessons beyond the wisdom offered during major volatility swings like stick to your long-term goals? We think so. As investors who actively search the market for opportunities in any macro environment, we see value in maintaining focus on two variables: an investable company’s fundamental strengths and its plans to deploy those strengths for consistent growth. In this blog post, we offer a quick post-mortem on the recent correction, and discuss a potential way forward for volatility-aware investors in search of opportunities.

What we learned from the last bout of volatility

First, the volatility and stock price declines from last month’s correction didn’t seem abnormal to us. After a long period of low volatility in the market, a crowd had formed in what is known as the short-volatility trade, also known as “buy the dip and short the VIX” (in reference to the Chicago Board Options Exchange’s gauge of market volatility). Investors who follow this strategy tend to buy stocks at every opportunity, particularly during declines: “buy the dip.” Then, they often borrow and sell securities—futures, options, and exchange traded notes, for example—that are related to the VIX: “short the VIX.”

What may be the potential benefit of this approach? These investors often expect to be able to reacquire VIX-related securities they can return to their lenders at prices that will preserve the gains they realized from their stock investments. The strategy is a bet that volatility will remain low. But unfortunately for these traders, volatility spiked in February and they were forced to acquire VIX-related securities as prices were increasing. Many had to liquidate other holdings, including stocks now trading at lower prices, in order to buy and return the borrowed securities.

Selling momentum accelerated. Correlations across equity sectors increased. At times, it felt like everything was falling at once and fast. While selling pressures can compound fear leading to more selling pressure (a vicious circle), we still viewed the volatility as normal in the grand scope of historical market activity.

As for the concerns about the potential rise in inflation’s effect on stocks, we viewed that as a longer-term concern worth monitoring, but far too early to justify dramatic portfolio repositioning.

Why we’ll check our emotions in the next bout of volatility

For investors seeking to put their money to work in the market, taking measured assessments of market conditions, particularly during times of stress and uncertainty, can provide context. Indeed, an investment approach based on logic, data, and appreciation for long-term trends can help investors:

  • Make sense of the long-term potential effects of macro influencers like a prevalent trading strategy’s role in short-term volatility.
  • Distinguish temporary influences on an individual stock’s price from more permanent effects to get at the substance behind the stock action.

So what will spark the next chain reaction of emotional trading activity? Could it be potential effects of tariffs on global trade, or another wave of worries from a yet-to-be-released economic report? Possibly, but we’d rather not spend time guessing.

Instead, we’d rather focus on fundamental strengths and balance sheet flexibility as measured relative to the current value of the company. Amidst the latest macro buzz, there’s wisdom in looking for companies that can generate strong cash flows and are likely to deploy their balance sheets effectively through actions such as:

  • Investments in plants and equipment
  • Expanded research and development (R&D)
  • Mergers and acquisitions (M&A)
  • Stock buybacks

These companies are often better able to determine their own destiny due to fundamental strengths rather than being influenced over the long-term by short-term market shifts.

Three case studies in focusing on the fundamentals

Patience can be an advantage, when waiting for a firm’s fundamentals to play out. A 32-year old engineering and building materials company is a good example. Its stock price languished in recent years despite a strong competitive position and efforts to grow new businesses. The stock price fell as investors grew impatient with the pace of the company’s initiatives. At the end of October 2017, the company announced a detailed improvement plan focused on organic growth; cost rationalization for enhanced profitability; and better capital management, balance-sheet discipline, and return on capital. The market reacted favorably to the plan and the stock price increased more than 21% during the four days following the announcement. Investors who recognized the company’s financial and management strengths were rewarded for their patience.

In another example, a global specialty chemicals company’s capacity to employ its balance-sheet strength offered the potential to enhance shareholder value through M&A. In early 2017, the company agreed to purchase the personal-care business of a competitor. The acquisition has the potential to complement the acquirer’s existing personal-care business, which lacked scale before the acquisition, while further diversifying its product portfolio and geographic reach. Solid third-quarter 2017 results, including reduced balance sheet debt, may position the acquirer to continue its growth. Investors who recognized the company’s innate balance sheet strength could potentially continue to benefit from their foresight.

Of course, investing in businesses that are working to grow organically or through M&A can also try an investor’s patience. The near-term effects of the effort can obscure long-term possibilities. An investors’ patience also can be challenged when companies adapt to changing industry conditions.

Take the experience of a hardware manufacturer, for example, as it seeks to reposition itself as a provider of software and services. If successfully accomplished, the transition could lead to higher, more stable, and less cyclical free cash flow, in our view. The value proposition for customers of the company’s R&D is the potential for more automated service solutions at the point of sale, which could support new employment strategies. As the transition continues, there could be bumps in the road and delays that discourage investors. Still, analyzing the success of each step in the company’s software and services initiative may offer more reliable validation of progress than quarterly financial reports or daily stock-price changes. If the company’s stock price declines, as it did in 2017, it may present a buying opportunity if the long-term proposition is still valid.

Perspective, experience, and insight can help sustain a long-term, consistent investment approach and process. A focus on fundamentals and careful stock selection guided by carefully developed long-term outlooks may help investors avoid short-term reactions and, most important, minimize investment losses.

Bryant VanCronkhite, CFA, CPA, and Jim Tringas, CFA, CPA, and other members of the Special Global Equity team are responsible for the investment of global, international, and domestic stock portfolios at Wells Fargo Asset Management.

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