What investors can learn from the volatility of the past

The rise in volatility during bear phases shows that fortune favours the brave – if you want to invest at the exact bottom levels of market falls, there will be volatility and a level of panic in the air. Also, if you get your timing wrong and, say, invest three-quarters of the way through, expect to feel a bit of a fool for a while. 

 I am quite sceptical that the volatility of a share accurately reflects the risk of owning the share.

As full-time fundamental investors, we aim to time investing at low(ish) levels by continuously monitoring the long-term value for money in shares.

This helps, but we still spend a fair amount of time feeling like fools. When shares are overvalued against their underlying cash flows it seems to us that they are risky, even when the economy is going well. However, assessing this is a full-time task in fundamental analysis and stock selection.  

Investors and investment theory view the volatility of equities as the price you pay for returns superior to holding cash or bond funds over the long term.

I am quite sceptical that the volatility of a share accurately reflects the risk of owning the share. My opinion stands against modern investment theory as taught academically, but here goes.

In modern investment theory the risk of owning a share is defined by its beta – the share volatility compared with the volatility of the equity market.

According to Bloomberg, that makes Legal & General (founded in 1836) one of the riskiest stocks to hold in the UK equity market and Admiral Group (founded 1991) one of the least – the betas being 1.8 and 0.7 – so L&G is more than twice as risky according to this measure, despite being in the same industry and buffeted by the same economic forces.

We believe that business fundamentals are the correct way to look at the risk of owning a share, rather than share price volatility.

Specifically, we ask: Does the company have a strong balance sheet and low debt so it can cope with hard times? And does the company make strong cash profits most of the time for shareholders – one indicator of which is the return on invested capital?

Looking at the Global Equity Index, the companies that today dominate by size are the following (also showing their net debt/cash levels and return on invested capital).