How value investing helps investors weather volatility

With economic data suggesting we’re in “late-cycle territory” of the longest bull market in history, investors who ignore market volatility and look for long-term value in stocks could enjoy superior risk-adjusted returns, according to a report from Toronto-based Manulife Investment Management.

The report, written by Alan Wicks and Jonathan Popper, both senior portfolio managers with Manulife’s value equity team, argued that “markets and investors remain preoccupied with stock prices, viewing their moves as a proxy for risk and a company’s value.” Rather than focusing on stock price, Wicks and Popper suggested investors focus on a company’s underlying business and its potential for creating value.

The report recommended avoiding companies under threat from new competition. Instead, Wicks and Popper look for companies that have “a sustainable competitive advantage, high and stable profitability, and a strong management team.” They also avoid highly leveraged companies and companies with inflated values, which they believe are “unlikely to produce market-beating returns over the longer term.”

The report recommended a sector-agnostic approach to portfolio construction, in which stocks are judged “not on whether they belong to a certain index or region, but on whether they can create business value according to rigorous but adaptable criteria.”

The authors argued that a major slump in one of the Toronto Stock Exchange’s three main sectors (financials, energy and materials) could have “severe” effects on the overall index.

“However, by seeking companies with strong longer-term earnings potential, investors can be more confident that whatever the short-term movements in the market, the businesses’ fundamentals will not necessarily deteriorate along with the broader index,” the report said.

To evaluate the risk of a company, Wicks and Popper recommended looking at the company’s earnings through multiple business cycles, as well as its financial leverage. They also look at the strength of a company’s management, which can be measured through length of time in business, governance standards and skill at allocating capital.

“Amid the late stages of the longest bull market in history and the short-term market swings that come with it, we believe in the importance of focusing on companies with demonstrable long-term value,” the authors wrote. “Looking at underlying business risks can help investors weather volatility, get a clearer picture of where business value is being generated — and reap the benefits of potentially more consistent returns.”

Read the full report from Manulife Investment Management.