The Value of Volatility

Volatility is an invaluable ingredient in life — Investors improve their portfolios by preparing for volatility — If prepared, real options pay off in times of stress.

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THE VALUE OF VOLATILITY

Volatility is an invaluable ingredient to life. Stress, pressure, and change drive us to grow and improve. Our bodies and minds react favorably to volatility, adapting and evolving.

A sedentary lifestyle is easy, but a healthy body requires exercise, the more volatile and unexpected the better (barring injury). Watching Netflix takes little brainpower, but without stress our minds rot. A change-free lifestyle feels easy, but long-term limits our potential.

Humanity's natural inclination is to fight this volatility. We skip exercise and postpone chores. It is a challenge to push ourselves, even when we know that growth requires this nudge. 

The stock market despises uncertainty, but volatility ultimately creates value, if your portfolio is prepared for it.

Taleb's Volatility Value

Nassim Taleb has taught us about the value of options. Owning options exposes an investor to volatility in a favorable way. Surprise favors the option investor and punishes the option seller. 

The market's predisposition against volatility and uncertainty creates an opportunity for investors, for options are everywhere. Investors do not need to own derivatives to get this attractive exposure. 

Equity investors naturally hold real options within their portfolios, although investors often fail to recognize their value.

The Cash Option

The simplest way to benefit from volatility is to hold some excess cash. Any available cash carries with it a real option. This is the option to invest the cash at any point in the future.

When volatility hits the markets, equities go on sale. Immediately prior to this volatility, cash appears to be a drag on returns. As markets grind upwards, investors watch their cash hold back their portfolio’s full potential. Volatile markets tend to occur when cash on the sidelines is scarce.

For those investors with the discipline to maintain this liquidity, even in the face of FOMO, this cash can be invested during volatile times, realizing the potential of the real option embedded within the cash holding.

Balance Sheet Options

Equity investors also benefit from the real option of cash on business balance sheets. Net cash balance sheets move cash holdings from an investor's portfolio to their investment's balance sheet.

In good times, this cash appears to be a drag on returns. Without volatility, this cash earns minimal interest and pressures a business's return on equity. The market pushes for leverage and buybacks, refusing to acknowledge the real option embedded in cash.

When volatility strikes though, businesses with strong balance sheets not only persist and survive, but have the opportunity to thrive. The best time to deploy cash from a balance sheet is during market downturns, when undervalued shares can be acquired, maximizing the value of the theoretical option.

 M&A Options

In good times and bad, strong balance sheets provide the capacity for mergers and acquisitions. Large, unexpected, accretive M&A deals are often a surprise to the markets. Investors who own businesses capable of executing against this real option stand to benefit.

Forecasting M&A is challenging, and deals often fail to create value. M&A driven growth is often hard to assign a value to, and few businesses in the public markets, typically only those with the most sterling track records of value creation, receive a premium multiple for their M&A prowess.

For the rest of the market, the option value of potential M&A is often heavily discounted.

Volatility Investors

The value of real options is often unseen. Capturing the value of real options takes courage.

To create value from these options, investors must first hold through non-volatile bull markets, where their conservative cash holdings appear to underperform. Next, management teams must also remain disciplined, waiting for the proper time to cash in their options (or balance sheet capacity). Finally, investors and management teams must have the courage to strike in the midst of volatile markets, making a contrarian decision to complete the M&A deal or repurchase shares as the broader market is selling off.

For investors willing to avoid the momentum game, preparing for volatility is a way to differentiate. Without volatility, portfolios look boring and returns lag. But when volatility strikes, opportunities for real, permanent value creation can be captured. In the long-run, benefitting from these often unseen and undervalued options is a true alpha driver.