Market volatility can be an investor’s friend

<p><strong>Emma Wall</strong>: Hello, and welcome to Morningstar. I'm Emma Wall and I'm joined today by Magellan's Vihari Ross to talk about market volatility.</p> <p>Hi, Vihari.</p> <p><strong>Vihari Ross</strong>: Hi, Emma.</p> <p><strong>Wall</strong>: So, there's lots to talk about when we talk about the causes of volatility. But the causes almost don't matter when it comes to individual investors. It's more how do they manage it. So, what should investors do when they see the market drop?</p> <p><strong>Ross</strong>: Well, when it comes to market volatility, it can be your friend. If you have cash that you are ready to deploy into the market at the right time, then you can find assets at very reasonable prices when volatility comes to the door. So, when we look for assets to invest in, we are looking for assets that become mispriced when that volatility comes to the fore. Businesses that maybe were in the short-term affected and their share prices dropped. But actually, in reality, is the true worth of the business being affected by this volatility? If it hasn't, that could prove to be a really attractive entry point into certain investments.</p> <p>If you think of an investment like infrastructure, a lot of their cash flows are set in stone. They have regulated asset bases and they are able to get a regulated return on those assets. So, their cash flows are incredibly stable. It's not just their share prices are stable, but their cash flows are stable as well, which is the thing that really matters. So, those are the types of assets we look for high-quality businesses that have resilient cash flows. But you need to be able to buy them at a reasonable price.</p> <p><strong>Wall</strong>: I think it's very interesting what you just said there in the last couple of sentences about the holding period. Because a lot of volatility is very short-term. I mean, in the last year, we've even seen market dips that only last hours, let alone weeks or months. So, it is perhaps about as hard as it is, ignoring that short-term noise and remembering that you are investing for 3, 5, or in the case of a pension, even 10, 20, 30 years.</p> <p><strong>Ross</strong>: Absolutely. I think one of the things that Warren Buffett famously said is the price doesn't tell you anything about the business that you are about to invest in. It just happens to be the price that you pay for it. I think when you are assessing what a potential investment that you should make, the first thing to do is to ignore the price and the first thing to do is to actually assess business quality.</p> <p>Is this a business that has a sustainable competitive advantage? Is this a business with stable cash flows? Is this a business that generates high returns on its invested capital? And does it operate in a business in which it can dominate the space that it's in? And if it sort of fulfils all of those criteria, then the next step could be, is this now actually trading at a reasonable price. The ideal thing to do would be to buy a business at a reasonable price and then never look at the price again until you are ready to sell it years down the road.</p> <p><strong>Wall</strong>: And other than infrastructure are there any particular sectors which lend themselves at the moment to this model. I know we were talking earlier at the Morningstar Individual Investor Conference about essentials, things that you will always have to buy, so those consumer goods which regardless of where we are in the economic cycle or even in the market cycle, people will still buy.</p> <p><strong>Ross</strong>: Absolutely. Consumer staples are one of those traditionally, sort of, defensive asset classes. You have to be very conscious of valuation. One thing that we've really seen in the very low rate environment is that the valuations of some of those very defensive staples, we always call them bond-like because they are so predictable in terms of what the cash flows are likely to be. A bad growth rate is 2, a good growth rate is 3.</p> <p>And so, for those businesses, what we've seen in this very low rate environment where there's been a search for yield and a search for return is that a lot of those valuations have become elevated in the low rate environment. In some recent volatility that we've seen this year, we've actually had some opportunities open up in that defensive space. We've been able to redeploy some of our cash into those investments.</p> <p>But you're quite right. People will still need to buy food, people will still need to buy dishwashing soap. People will still need to buy toothpaste. So, those elements of &ndash; that represent really the human element, the element of how we live our lives are actually always going to be there.</p> <p>One of the things that we really thing about though in that space is we try and be quite nuanced in trying to understand which of the industries that are truly resilient, and which are the sort of sectors or categories really that might prove to be disruptive over time. One of those examples is things like soft drinks. Soft drinks are no longer growing.</p> <p>People aren't buying soft drinks to the same extent as they used to. But is Coca-Cola still generating growth? Yes, because now they are selling people 200 ml cans instead of 600 ml cans and people are still happy to buy those. But are people buying more or less cereal, for example? They are buying less cereal over time. They are buying less processed foods.</p> <p>So, those health and wellness trends do genuinely impact the growth rate that those businesses can achieve over time. And on the other hand, we have things like Amazon moving into the grocery space that's had a very &ndash; many companies have (shuddered) in their boots to think about what might happen. But again, brand equity comes to the fore.</p>