Why I Love And Hate Volatility

Investopedia explains volatility pretty well:

In other words, volatility refers to the amount of uncertainty or risk about the size of changes in a security’s value. A higher volatility means that a security’s value can potentially be spread out over a larger range of values. This means that the price of the security can change dramatically over a short time period in either direction. A lower volatility means that a security’s value does not fluctuate dramatically, but changes in value at a steady pace over a period of time.

Volatility is generally something a lot of investors fear.

That’s because people get emotionally attached to their investments.

When a stock drops in value, especially precipitously, this can and often does cause a significant (negative) emotional response. This emotional response can then prompt an investor to make bad decisions – like selling off a great business that is more or less still humming along.

I personally love volatility. I also hate it.

I Love Volatility

Volatility is often wonderful.

I see short-term volatility as a long-term opportunity. 

And I’ve put my money where my mouth is time and again over the years.

I can recall many instances in which I just loved to see volatility, because I knew it was an opportunity to buy shares in a high-quality business for less money.

After all, if you like a stock at $X, you should like it even more when it’s less than $X. If it becomes priced significantly less than $X, assuming the valuation hasn’t dropped in kind, you should probably love the stock.

Moreover, when talking about high-quality dividend growth stocks, this volatility can dramatically improve the yield that one is able to “lock in” at the time of purchase.

I remember when shares in Aflac Incorporated (AFL) dropped from ~$60 to $30 in 2011, over a rather short period of time.

The stock was cut in half.

Was the business cut in half?

Not really.

Aflac earned almost $5.00 per share in FY 2010. They earned closer to $4 in 2011.

So there was a drop in the company’s earnings, but this is an insurance company that can regularly report numbers that vary from year to year. In addition, GAAP EPS can be affected by numerous one-time events, making exact secular, upward growth very difficult.

This is something investors (should) know, yet the stock was absolutely hammered anyway. Of course, there were other concerns popping up at the time (like cancer risks), but to think a major company like Aflac – a company that has demonstrated proper risk management for decades – is suddenly worth ~50% of what it was just a few months prior is pretty silly (unless it was twice as expensive as it should have been prior to the 50% drop, which it wasn’t).

In addition, the company’s dividend wasn’t under threat at all. Quite the contrary, Aflac continued to pay and increase its dividend.

But I simply saw this short-term volatility as a long-term opportunity, buying up shares in the company when volatility took hold. I scooped up shares in the $30s in late 2011.

When the stock moved from roughly $60 to $30, its yield moved from 2% to 4% in the process. Price and yield are inversely correlated; all else equal, a drop in price will result in a higher yield. When the stock’s price drops in half, the yield doubles. If you like a stock with a 2% yield, you should absolutely love it when it yields 4%.

I can say that the investment in Aflac has turned out fantastic thus far.

I’ve been collecting growing dividends ever since I initiated my position. And the stock is now priced a bit above $80.

Indeed, it’s a major holding in my personal portfolio.

While short-term volatility isn’t always a long-term opportunity, it often is when you’re dealing with high-quality dividend growth stocks.

One will naturally want to make sure that a company isn’t somehow permanently impaired, rendering a valuation compression reasonable. If the dividend is under threat, this is another warning sign to stay away. And an overvalued stock can present significant short-term volatility, although the correction of a previously incorrect valuation isn’t necessarily an opportunity.

I Hate Volatility

Volatility is often wonderful when dealing with the day-to-day pricing of high-quality dividend growth stocks.

However, operational volatility, especially as it relates to the dividend, is something I actually strongly dislike. In fact, I’d go so far as to say I hate this kind of volatility.

I invest in high-quality businesses that reward their shareholders with growing dividends precisely because these businesses tend to generate fairly secular growth over long periods of time, limiting major drops in operational performance that can negatively affect a company’s ability to pay a growing dividend.

A lengthy track record of growing dividends is in and of itself a pretty strong litmus test of secular growth and business quality, as it’s not practical to pay out a growing dividend for decades on end while simultaneously running a poor business that can’t regularly generate increasing profit.

Using Aflac as an example once more, the company’s EPS has doubled over the last decade. It hasn’t been a totally smooth and secular run from FY 2007 to FY 2016, but the profit growth was largely up from year to year as the time frame moves to the right.

Most importantly, however, the company continued to pump out an ever-larger dividend annually, increasing the dividend as regularly as can be straight through that period.

In fact, if you didn’t pay any attention to the business and its operational performance at all, you essentially would not know that the company experienced any volatility in its bottom line whatsoever. All you would know is that your dividend every December was larger than the one that Aflac paid you the prior December.

If that’s not easy peasy, I don’t know what is. 

But if Aflac would have reduced its dividend or cut it completely, you can bet I’d be very upset.

Any volatility when it comes to my dividend, and the annual growth of it, is something I don’t enjoy at all.

Furthermore, significant volatility in operational performance, is also something I’m not a big fan of.

But this is exactly why I try to stick with the best businesses in the world – I want to largely avoid these issues.

Conclusion

I thought it was important to share this perspective, because the word “volatility” gets thrown around a lot.

I love volatility in the traditional sense, whereby the price on a high-quality dividend growth stock can drop far below what’s reasonable in the short term. I also love this kind of volatility on stocks I already own, even when I’m not actively acquiring shares, as it often presents an incredible opportunity for a company that’s buying back its own stock.

But I hate volatility when it comes to my dividend payments and dividend growth. The only percentage of volatility that’s acceptable for me when it comes to my dividends is 0%. And I also don’t like to see major disruptions or volatility in operational performance, especially if it’s more systemic in nature, because this can then affect the secular dividend growth I enjoy and rely on.

However, this dynamic between loving and hating volatility is exactly why I try to invest in wonderful businesses: I’ve usually been able to take advantage of the right kind of volatility when the market has presented it, while simultaneously largely avoiding the wrong kind of volatility.

Full disclosure: I’m long AFL.

What do you think? Do you love and hate volatility?

Thanks for reading.

Image courtesy of: digitalart at FreeDigitalPhotos.net.