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Don't Just Survive... Thrive on Volatility

May 7, 2016

Our very good friend, Mr Market (aka Volatility), like God, helps those who help themselves. But unlike God, Mr Market does not forgive those who know not what they do.

In the first two parts of this series, we learned that Mr Market is a manic depressive and that we must stay till the end of time to come out on the other side as a winner. Today, in the third and final part of this series, we look at how to profit from volatility.

Nassim Taleb, in his brilliant book, Antifragile: Things That Gain from Disorder, writes about how to benefit from the present chaotic environment.

He asserts that, to profit from uncertainty and volatility, one must learn from errors. The key here is that potential losses need to be very small while potential gains should be huge.

It is not about being 100% right. It is the magnitude by which you are right or wrong that determines your returns.

This asymmetry between upside and downside is what provides safety and excess returns.

How does Warren Buffett benefit from volatility?

He started to acquire The Washington Post Company in mid-1973 when shares were one-fourth of what he calculated to be the intrinsic value of the enterprise. The company consisted of three distinct segments: the flagship newspaper, Newsweek magazine, and five television and radio stations. The paper had a dominant share of the Washington DC market. But despite its leading market share, its financial performance continued to disappoint.

According to Buffett, most analysts would have appraised the company at approximately $400 million. Yet, the business was trading at about $100 million.

By the end of 1974, despite the improving business performance, the market value of the company declined 25%. Buffett's investment was trading at a loss. Mr Market was playing mind games as usual. And market analysts called the stock risky.

But was it?

For Buffett, the volatility was an opportunity. The ratio of expected returns to price was 4:1. But a year and a half later, that ratio had improved to 5:1.

Per Buffett's analysis, the company's earnings were on a path to recovery. Furthermore, The Washington Post Company repurchased its shares. Over time, its per-share business value soared and Buffett made a killing.

Let's take an example from the Indian context.

We looked at the Nifty from 1999 to the present and found that Mr Market was prone to mood changes.

Price-to-Earnings Band
Under 12 1%
12-16 24%
16-20 36%
20-24 34%
Over 24 5%
Total 100%

The average long-term returns for the Nifty were about 15%. However, purchases made when the index's PE was below 12x (when things seem hopeless) resulted in a massive outperformance over the average returns of the next five-to-seven years. On the other hand, purchases made when the Nifty traded above 24x (when the mood was exuberant) saw below average returns.

The lesson here is that one must treat volatility as an opportunity to be exploited rather than an obstacle that impedes progress.

Embrace Volatility.

Happy Investing!

Devanshu Sampat

Devanshu Sampat (Research Analyst) has a degree in commerce and nearly 5 years of experience in equity research. He draws inspiration from successful value investors across the globe and constantly endeavours to refine his own unique stock picking approach. While a firm advocate of the principles of value investing, he believes in adapting a versatile investing strategy in response to varying market conditions. Devanshu contributes to our Megatrend investing service The India Letter.

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