Volatility and risk in investment terms are often lumped together like coffee and milk. But while they go together they are quite different and can frequently stand alone.
Indeed, as Warren Buffett notably said: "Volatility is far from synonymous with risk."
Risk comes in many forms and is open to interpretation at a personal and professional level.
In simple terms, it is defined as permanent loss of capital. At a company level, it generally comes about when something has gone badly wrong at a fundamental level, for example operational issues, management changes, poor merger and acquisition choices, or indeed fraud.
Volatility is temporary in both absolute terms and when compared to an index. It is driven by sentiment and can be emotionally and behaviourally difficult to stomach. It becomes risky when investors crystallise losses by selling stocks as a reaction to market gyration. Risk can be mitigated generally through diversifying stocks by sector and geography and sometimes by investment style, but the last concept can simply neutralise returns.
The investment industry likes to measure things as it offers a veneer of control and assumes certainty.Volatility cannot be helped except by taking a long-term view and rolling with the punches. Over time, things tend to sort themselves out so long as corporate fundamentals and prospects are sound. It can also provide opportunity and attractive points of entry for investors during periods of drawdown.
A word of warning: the investment industry likes to measure things as it offers a veneer of control and assumes certainty. Such metrics are applied to risk (Sharpe ratio) and volatility (standard deviation/tracking error) and often conflated, which can be unhelpful given that risk and volatility are not the same thing.
Active investing
As long-term active growth investors, Baillie Gifford funds and trusts will experience periods of volatility against the market. We aim to find exceptional companies and invest in them with conviction. As a result, we will quite often find ourselves at odds with a short-term market sentiment. However, over five and 10-year periods we expect the fundamentals of the companies we select to be positively reflected in their share prices.
As a result, we target significant outperformance versus relevant indices over such periods. This does not make us innately any more risky than other asset managers, just more volatile than those whose portfolios look more like the index. Indeed, we, like many other asset managers, are blessed with considerable resource and rigour when it comes to assessing risk to our portfolios.
Volatility cannot be helped except by taking a long-term view and rolling with the punches.
It could be argued the biggest risk for us and our investors is simply picking poor stocks, which we do from time to time. However, we strive to find winners rather than avoid losers. After all, in glib terms, you can only lose 100 per cent of any investment whereas the upside can potentially be unlimited.
As we know, the past two years have been extraordinary. As investors, we have seen remarkable volatility in our funds and their underlying holdings.
The extent of this volatility has been beyond the expectations of ourselves and our clients. In 2020, several of our funds went up by more than 100 per cent. However, in the past six months many of them have gone down by around 25 per cent.
In for the long-term
Does this make us risky or even bad investors? Only time will tell, but historically we have provided our investors with strong returns. We are sticking to our patient approach and tried and tested investment process.
This may be of little consolation to those who invested with us when performance was stellar and have recently endured sobering drawdowns. Yet it may be some comfort to know that volatility and its acceptance is a part of our investment proposition. Hence, we plead for patience, which in turn avoids crystallising loss.
The truth is we were neither heroes in 2020 nor villains more recently. During the pandemic, many of the long-term themes we were enthusing about became central to behaviours during the pandemic. We saw more use of e-commerce, food delivery, online entertainment, online communication for work, school and play. All this required more cloud computing power to make it work.
Many of the companies we had owned for some time such as Netflix, Amazon, Spotify, Zoom and Hello Fresh saw significant operational progress and share-price growth. Allied to this were breakthroughs such as the strides taken forward by Tesla in the manufacturing of electric vehicles and the Covid vaccine success at Moderna. It was a year in which many of the businesses we owned saw increased demand brought forward by necessity speeding up and eventual adoption.
It should not come as a surprise that 2021 was different. Several factors combined to change investor sentiment away from growth companies, especially those that had done so well the year before.
Markets had to contend with multiple unknowns and areas of risk, such as the impact of economies re-opening, prolonged supply-chain disruption, price inflation, tightness in the labour market and wage inflation, emerging variants of Covid, and a regulatory crackdown in China.
While macro-economic analysis is not our area of expertise, these elements have had a pronounced impact on the performance of our trusts and funds. More recently, market sentiment has been fluctuating because of the conflict in Ukraine.
Such factors combine to make investors understandably cautious and myopic and have driven the prices of growth stocks through the floor in the short term. But what of our companies and their actual long-term prospects? Against such a gloomy background, can we expect them to grow their earnings and that eventually this growth will be reflected in share price terms? We believe so.
By way of an example, take the fluctuating fortunes of Moderna – now a household name. Its technology platform has been validated by Covid and it is much more than the one-trick pony that the market perceives.
In glib terms, you can only lose 100 per cent of any investment whereas the upside can potentially be unlimited. It currently has 44 development programmes spanning respiratory, cancer, HIV and rare diseases in progress.
This offers an extensive vision of hyper-personalised vaccines. Yet the shares are back where they were at the start of 2021, they have de-rated to less than 1/10th of the company’s pre-Covid revenue multiples – in other words, Moderna is more than 10 times cheaper in price-to-sales terms today than it was before the approval and outperformance of its Covid vaccine, and before the substantial financial de-risking that came from Covid cash flows. The de-rating is even more dramatic when adjusted for the enormous cash balance.
Today, this is a company with $17.6bn (£13.5bn) on its balance sheet, which earned $18.5bn in revenues at 66 per cent net margin last year.
How does this make sense? Volatility can make fools of us all.
Having begun with the 'Sage of Omaha', let’s also finish with more of his wisdom: “The stock market is a device for transferring money from the impatient to the patient.”
James Budden is head of distribution and marketing at Baillie Gifford
