The past few months have given Canadian investors plenty to think about, and January was no exception. Similar to what we saw in November and December, the broad Canadian market ended January fairly close to where it began. However this simple observation ignores the fact that there has been a tremendous amount of intra-month volatility. An investor simply looking at their monthly returns could be excused for thinking that the past few months have been relatively unexciting, in so far as the S&P/TSX Composite Index (“TSX”) has been approximately flat each of the past 3 months. In reality however, the market’s daily volatility has risen to levels not seen since the beginning of the European debt crisis in summer 2011.
The average monthly “range” (highest price less lowest price) of the TSX during this time frame has been 1,080 points or 7.2%. This sharp jump in volatility is illustrated by the below charts.
We attribute this rising stock market volatility to acute concerns about the path of global growth as well as the consequence of increased volatility in other asset classes like interest rates, commodities and currencies. Certainly we are all aware by now of the impact that crashing oil prices have had on Canadian equities, but significant moves in other assets considered to be relatively stable have also weighed heavy on investors’ minds. After a period of prolonged stability, the very sharp, very short lived equity market corrections we have seen over the past few months seem to indicate that investor confidence is on the wane. Investors, feeling less incentive to commit new money at market highs have also been quick to sell at the first sign of trouble. For now, we believe that prices are being driven more by sentiment and momentum than fundamentals.
In the face of this volatility, our performance over the past six months has been solid. Despite the Fund’s unit price falling 0.5% in January, the ACE Fund has still gained 0.6% over the past six months, a period during which the broad Canadian market has lost 2.9% (including dividends).
In last month’s Commentary, we described our investment style as “Active Value” and characterized its three pillars as Quantitative Research, Fundamental Research and Risk Management. One of the important aspects of our Quantitative Research is to identify companies which not only have attractive valuations but also have both improving operating performance and market support. While “market support” encompasses both analyst sentiment and technical analysis (such as tracking a company’s trading volume), at its core you could say that market support generally means we look to own companies that the market is rewarding by moving the price higher.
It is interesting to consider the market support characteristic in the context of the current environment where the prices of energy and other commodity-related companies continue to test for new lows. We actually credit this part of our investment style for helping us to avoid losses towards the end of 2014 and expect this to be a key driver of downside protection for investors going forward. By requiring companies to possess a quantum of “market support”, we are attempting to eliminate one of the most challenging behavioural biases – the desire to catch a falling knife. What this means is that we are not tempted to risk capital in beaten up sectors or stocks until they shows sustained signs of coming back to life. Conversely, on the sell side we are also overlaying a crucial element of discipline with respect to how and when we exit positions. Not only did “market support” help us sidestep a large part of the energy decline, it allowed us to participate in the stocks which benefit from such an environment.
The charts below illustrate this process in action. On the left is Trilogy Energy (TET-T) a company we owned for a time last year before selling it on deteriorating market support. On the right is Airboss of America (BOS-T), an industrial company that replaced Trilogy in the Fund. Airboss, a rubber compounding company with strong global end markets, benefits from lower oil prices and a depreciating Canadian dollar.
The range of analytical techniques and investment strategies available to investors is vast and our individual preferences, with respect to how we pursue capital growth over time, is what makes a market. In this, and prior, letters we have sought to outline how we believe our “Active Value” approach benefits from discipline, structure and a unique process of catalyst-driven value investing, improving market support and dynamic risk management. While each of these individually represent important elements of our investment process, it is their functional coherence that gives us an edge.