Market variability is inevitable. It’s the nature of markets and economies to move up and down. That’s just what they do. And experts agree that companies must move with changing landscapes to meet investors’ changing demands. But what are the considerations, if you’re a holding company, for investing in environments that are not only variable but also volatile?
This is a relevant question for us, because South Africa is known for inherently volatile markets, as a consequence of prolonged uncertainty, rapid policy changes, unclear macro- and microeconomic factors, and perceived political risk. Granted, our recent political stabilisation has led to decreased fluctuation across the board – but we remain a volatile environment.
What exactly is market volatility?
Despite its name, volatility doesn’t mean that markets will always dip; in fact, volatility can lead markets in any direction – including upwards.
Volatility is unpredictability, typically measured by the standard deviation of the return of an investment. For instance, you might see the Standard & Poor’s 500 Index (S&P 500) have a standard deviation of about 15%, while a more stable investment, like a certificate of deposit, will typically have a standard deviation of zero, because the return never varies.
Our focus, in this particular article, is on mitigating against volatile surroundings by investing in companies where there is more control.
1. Diversify, narrowly
Diversification is essential; particularly, diversification across uncorrelated asset classes. If you’re a holding company, manage that portfolio carefully.
More often than not, there is concentration risk within a portfolio company, as acquisitions are made predominantly to enhance your market position or to create economies of scale. This can result in companies within common sectors that are closely correlated.
I believe that the answer lies in creating a comfort zone within change, if you will, rooted in ‘narrow diversification’.
Diversification in financial assets can be easily achieved through passive investing, but this is not the case for executive teams of portfolio companies, particularly smaller ones. It may even have the opposite effect, where companies enter markets with little or no experience, and fail.
Holding companies can try to reduce their risk in a particular market via strategic acquisitions; either vertical or horizontal. It’s a good move to make acquisitions that diversify the customer base and open up new opportunities and products to the holding company, while playing to your strengths.
This kind of narrow diversification means that you’re exposed to the risks of the sector you are comfortable with, while remaining more diversified within it.
2. Do what works for you
Should you play ‘the long game’? Well, match your investment horizon with the risk. Making long-term financial decisions based on short-term volatility data is risky, and visa versa. I’d suggest that as an investor, you should play ‘the right game’ or ‘your own game’, rather than the theoretical long game.
3. Make management matter
As to the investment opportunities inherent in volatile markets, it’s a good idea to adjust (decrease) the volatility of a company through your management and running of the business. I believe that volatility can be controlled to a certain degree; particularly, company-specific volatility. This is why we like to invest in companies where volatility is self-made and then correct it ourselves.
4. Go solid and dependable
It’s always advisable to invest in solid fundamentals. A company with a strong market position that enables it to be a price-maker, underpinned by solid and predictable revenue streams and good cash generation, is key to weathering volatility. Keeping in mind that it is key to adapt or change the commercial model of your business to reduce your risk, it is a lot easier for a company with a well cemented market position and a superior product to do this.
So, what’s the bottom line?
Instead of focusing on the commotion and confusion that is inherent in volatile surroundings, imagining what the market will do tomorrow and wondering whether you should act now, it makes better sense for holding companies to focus on building and maintaining a sound investing plan.
Take the time to access an appropriate view of the directions markets are moving in, and consider how these could affect your sectors. This will help you to avoid ‘short-termism’ and to ride out the moods of volatile markets.
As with many pieces of advice for dealing with fractious environments, go back to basics and don’t get caught up in the markets’ immediate sentiments, which can yield quick-fire decisions that go against your established strategy.
Greg Morris is CEO of MICROmega Holdings.