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Volatility is not the risk that matters

‘You need to understand what you are buying.’

SANDTON – Volatility in global equity markets has increased significantly in the past few months. Issues such as the economic slowdown in China, expected rate hikes in the USA and debt issues in Europe are all impacting on sentiment.

This has spooked many investors who are concerned about the performance of equity markets in these conditions. So how does one approach investing given this current volatility?

Speaking at the Money Expo at the Sandton Convention Centre on Friday, Zwelakhe Mnguni, chief investment officer of Benguela Global Fund Managers, said that if you are investing for the long term, even when short-term volatility is high, it is not the risk that matters most.

“What is important, in our opinion, is that to invest money you don’t have to predict the future,” he said. “You just have to look at the present very clearly. That means that you need to understand what you are buying.”

He argued that investors need to appreciate that the biggest risks that they face have nothing to do with share price movements.

“The reality is that when you buy a share you are buying a piece of a business, and that business has to work and generate cash for you,” Mnguni said. “Market price risk is what a lot of the market concentrates on, but that is secondary. The real risks are in the business.”

He highlighted five factors that investors should consider when looking at companies to invest in. Understanding these allows one to separate high quality companies from their lower quality counterparts.

The first is business risk. This is whether the business model itself is sound and what risks are inherent in what the company is doing.

Financial risk is the second. How does the company manage its debt and how strong is its balance sheet?

Thirdly, one must consider growth risk. Is the business still able to grow further, and what opportunities exist for it to do so?

Mnguni also highlighted environmental, social and governance (ESG) risks that are becoming increasingly important. He said that businesses can no longer just run for their shareholders, they have to consider their interactions with the environment and communities around them.

The fifth factor is management risk. Is the company management making good capital allocation decisions or are they destroying value?

Judging a company on these five factors allows an investor to separate the good from the bad.

“And if you can do that, there is a good opportunity for you to out-perform,” Mnguni said. “If you had invested in high quality businesses over the last 15 years, you would have made three times as much as you would have in low quality businesses.”

He said that high quality businesses also show better resilience in down markets. When markets fall, they tend to show smaller share price losses.

From a risk point of view, that is a crucial consideration.

“The important thing to keep in mind is that small pull-backs in the market are normal,” Mnguni said. “Those shouldn’t spook you. If you actually understand what you are buying and make an effort to separate the good companies from the bad companies you can generate better returns than the market.”

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