Explore the importance of value investing in a volatile market and learn how to build a durable portfolio to help you weather the storm.Weathering the financial markets through a storm of volatility can seem difficult and unsettling.But if you’re able to build and maintain a portfolio whose building blocks are durable and fundamentally sound, thenyou may find yourself weathering the storm better than your peers.This is one of the core principles of so-called “value investing,” and a chief differentiator between value versus growth stocks.A stock that’s priced for high growth might produce higher returns over time, but might also be susceptible to higher volatility, which can drag down the “durability” of a portfolio.Here are a few things to keep in mind if you’re considering applying value investing principles to pursue a durable portfolio.
But remember: there’s a difference between “value” and “cheap.” As we’ll see below, sometimes a stock looks cheap, but because of deteriorating fundamentals or a weak outlook, is actually priced appropriately from a value standpoint.When extreme volatility hits the market, particularly during periods of secular decline, nearly all stocks are impacted—some more than others.
Stocks get tossed up and down, and in the case of a major cyclical downturn, a great majority of stocks see their prices decline.In such an environment, growth stocks can get hit particularly hard.So, in this context, what does it mean to have a durable portfolio? Durability refers to a portfolio’s capacity to avoid the largest drawdowns in price.It’s about reducing portfolio volatility despite greater conditions of volatility across the broader market.How might you accomplish this? By holding fundamentally sound stocks that are not greatly overpriced by some of the metrics described below.In short, by holding “value stocks,” you might be able to reduce the level of drawdowns in your portfolio, achieving a relative degree of durability, as the most overpriced stocks may draw down at a greater rate than fairly priced or underpriced stocks.What is a value stock? It’s typically defined as one priced below its intrinsic value.In other words, it’s worth more, according to fundamental criteria such as expected future earnings, balance sheet health, and cash flow, but the shares just happen to be underpriced.
Understanding the difference between a stock’s “price value” and “intrinsic value,” and buying what is underpriced yet fundamentally sound, is at the heart of a value investing approach.The theory behind this approach is that intrinsic value is like a tether: what is overpriced should eventually fall to its intrinsic value, and what is underpriced should eventually rise to its intrinsic value levels.When we refer to value investing, what we mean is that we’re investing with an understanding of where a company’s stock is priced versus its intrinsic value.In the short run, investor overreaction to headlines, announcements, and trends can sometimes move stock prices away from a company’s intrinsic value.
Overpriced stocks persistently trade above a company’s intrinsic value, while underpriced stocks trade below intrinsic value.Over the long term, investors tend to find that stocks converge with a company’s intrinsic value, meaning that overpriced stocks trend lower and underpriced stocks trend higher.But here’s an important question: how might you know whether a stock is priced appropriately according to its intrinsic value? Here are a few simple metrics that can help identify which stocks might be sitting in the bargain bin.During periods of market turmoil, diversification has generally been regarded as one of the more effective means to reduce portfolio risk.
Adding a value approach to the mix in some cases might even enhance the potential effects of diversification in terms of seeking durability and growth potential.Maintaining a diversified portfolio of stocks that are trading below their fair value may help investors avoid some of the violent corrections that often follow strong rallies in overpriced stocks.So although avoiding overpriced stocks at the height of a market rally may help reduce drawdowns—hence making a portfolio more “durable”—buying underpriced stocks during market declines may be an effective way to position your portfolio for growth once the market turns toward the upside.Pursuing both of these goals—durability and growth potential—is more or less what value investing is all about.
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