Be Wary of Minimum Volatility Funds

I think it is a very, very dangerous game to make a stock market investment with the intention that it will experience minimum volatility in price. This line of thinking suggests that people aren’t really treating a stock investment as a fractional ownership position in a business but instead treat it as a cash-like number on a household balance sheet that ought to rise and rise at every snapshot in time.

To protect myself from this delusion, I keep a log of the story behind Starbuck’s historically amazing performance and the terms of volatility that needed to be endured in order to achieve those performance results. Since its 1992 IPO, Starbucks has grown its earning by 28.8%. Over the past ten years, the earnings growth at Starbucks has been 19.5%. If it has been tucked somewhere in a diversified portfolio, you would be fortunate to own anything else that has grown earnings at a faster rate over that time.

But that high earnings growth does not mean that the stock price performance at Starbucks is a one-way escalator moving incessantly upward. Instead, to borrow a simile from former Realty Income CEO Tom Lewis, it is more like a man walking up the stairs with a yo-yo. The yo-yo is moving up, but there are some downs along the way.

With Starbucks specifically, you had to endure the price of the stock falling from $20 in 2006 to $3.5 in 2008. You better have known what you were doing, as the stock price dropped 82% from the high of 2006 to the low of 2008. The profits grew from $581 million to $598 million even as the stock price crumbled. The long-term debt at the time was $549 million, meaning the entirety of Starbucks’ borrowings were less than a year’s profits.

Preparation for the inevitable market declines of an investing life are the most important topic I can cover because if you lack that emotional fortitude than the stock market will act as a destroyer of your assets. The costs associated with lacking the right emotional temperament are extreme.

If you bought $100,000 worth of Starbucks stock at the highs of 2006, there would have come a time when you would have seen that balance decline to $19,600. That was a necessary condition for experiencing long-term excellent returns. The person who looked at the profits, saw they were doing fine (actually growing!), had the debt at a low level, and kept a steady hand by recognizing that people would once again recognize the enormous economic engine that Starbucks possesses would receive handsome rewards.

By today, that same $100,000 investment would be worth $332,000 for a compounding rate of 12.77%. It’s phenomenally interesting–the same capital allocation decision in 2006 could have turned into either the value of a nice used car ($19,600) or a nice vacation home ($332,000) depending on your temperament once you are in the market.

Also, the ancillary lesson lurking in the background: Overvaluation on the eve of a stock market decline can be especially painful because a stock not only retreats to fair value but also goes down all the way to cheap territory. Starbucks hit a high of 45x earnings in the summer of 2006. At a minimum, it was around 33% overvalued. At the recession lows, it traded just a bit under 10x earnings.

And now, for the ancillary lesson to my ancillary lesson: This is why I counsel holding onto businesses with double-digit long-term earnings growth rates even as their valuation becomes stretched. I’ve read forums of people selling stakes in Visa, Nike, Brown Forman, and the like because the P/E ratio approaches 25 or 30. That sell decision is not nearly as responsible as it sounds in real time because the fair value base of these types of companies is regularly increasing so that today’s highs will become the lows of tomorrow. Even if you held Starbucks and saw the valuation get frothy at 45x earnings, you still went on to compound at 12.77% while the S&P 500 went on to compound at 7.43%. Adopt a very hard presumption against ever selling fast-growing things.

Since the 2008-2009 recession, many mutual fund outfits, banks, and investment houses have launched minimum volatility funds. I do understand their point of view–it is almost certain that someone owning John Deere stock will experience far more volatility over a 25+ year time horizon than someone owning Colgate-Palmolive stock–but these types of offerings seem to offer an illusion of safety that can’t be matched by the reality of how stocks actually trade over the centuries.

Also, as a skill set evaluation, it is much more difficult to try and manage a fund for volatility because you not only need to figure out what businesses will create wealth, but you have to make predictions about the specific short-term sequence of those earnings and make investment decisions based on how other market participants will interpret information.

It takes enough energy to figure out which few dozen businesses have the highest probability of reporting earnings that are substantially, substantially higher fifteen years from now than they are today. You enter the territory of crystal ball madness when you try to predict the incremental stock prices that you will encounter at periodic moments during the wealth-building process. Not only am I skeptical of an investment philosophy that suggests long-term participation in stocks without deep declines in stock price, but I am wary of how the Volatility Master can be served concurrently with a focus on implementing a strategy dedicated to sustainable long-term wealth creation.

Originally posted 2016-06-19 17:19:40.

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