Make Cheap Volatile Stocks Your Friend

This article on cheap volatile stocks was written by Evan Bleker. Evan is a small investor employing Graham's highest performing value investing strategy, net net stocks. In 2014, Warren Buffett explained that the net nets he bought in the 1960s helped him achieve the highest returns of his career. Evan has been studying Buffett’s early investments since 2010, and stumbled upon 4 rare articles written by Warren Buffett himself that cover his highest conviction picks in the 1950s. Download these original articles in How To Choose Deep Value Stocks Like A Young Warren Buffett for FREE right now. Click Here. Article image (Creative Commons) by Konstantin Leonov, edited by Net Net Hunter.

Investors fear volatility. It's natural — we are bombarded with news carrying headlines about a volatile stock going crazy, or volatility spikes when the S&P takes a dive. We link volatility with negative returns and start trying to avoid cheap volatile stocks at all costs. 

Is this healthy for our portfolios? It depends on what you are after. For an investor who isn’t looking to grow their wealth, sure. 

But what if you are looking to grow your wealth? Perhaps you think that purposefully buying volatile value stocks couldn’t possibly work?

What if I told you that a certain super value investor has done this and owes his early success to investing in cheap volatile stocks? Read on if you want to stop minimising your returns and to start supercharging your portfolio. 

What Is Volatility? 

Without delving into statistics jargon, volatility represents how much an asset price swings around its average.

There are different ways to measure a stock’s volatility, such as looking at its historical returns or calculating its standard deviation. For simplicity’s sake, I am going to use the beta method to discuss volatility. 

What is the beta of a stock?

The beta of a stock compares how much it is expected to move relative to a benchmark (the S&P 500, FTSE100, or whatever is most applicable). 

For example: When looking at two stocks, Stock A and Stock B, you see that Stock A has a beta of 0.9 and Stock B has a beta of 1.88.

Of the two, Stock B has the higher beta so it is much more volatile. If the S&P 500 drops 3%, you can expect Stock B to drop even more; meanwhile, Stock A is expected to drop slightly less than the S&P 500.

Stock B seems to have a lot more downside risk. But, notice I said “expected to” — this isn’t a guarantee, and in fact, there is a type of cheap volatile stock that has built-in downside protection that we will discuss later in this article. 

While we tend to see “volatile” as a synonym for risky or uncertain, volatility works both ways.

If the S&P 500 shot up 5%, you could expect Stock B to outperform it, like the roaring tech stocks we see today. A stock with a high beta can also go on a tear, rising much higher than the broader market. This gives us opportunities to sell our stock when it’s riding a wave of enthusiasm and provides us great bargains when volatility crushes a company’s share price. 

But we don’t need to invest in overpriced tech stocks in order to use volatility to our advantage. In fact, there is a whole world of cheap volatile stocks just waiting to be explored. 

Small Companies = Big Rewards 

On the whole, small cap stocks are riskier and more volatile than their large cap brothers. How come? Well, just imagine Amazon versus your local mom-and-pop store.

If a recession hits, who is better equipped to weather the storm? Who has the resources to pivot its business in a new direction? Who can invest more in marketing? Of course, it’s Amazon. This is the argument for most large vs small cap stocks. Large caps are seen as stable and more able to survive short-term issues. This can often explain the market’s over-pessimism when it comes to small cap stocks, where a small company’s price is often punished for the smallest issue. 

Another factor is the liquidity risk. While you can get in and out of most megacap stocks with ease, it is not as simple with smaller companies. These small caps often have a fraction of the number of shares being traded, meaning getting in and out of a position, even a small one, can take time. This is crucial when you need to get out of a stock ASAP — and adds on to the associated “risk.”

This perceived riskiness is shown in a small cap’s volatility. Many small companies have a beta higher than 1, meaning they move more than the S&P 500 with each swing of the market. But as we discussed earlier, this increase in volatility can be used to our advantage — read on to find out how!

The flip side to the risk in small cap stocks is that these cheap volatile stocks have much more growth potential. It is not unheard of to see a small company grow its earnings by double digits quarter-on-quarter and see its stock price double. This is much harder to do with large, established businesses. When your earnings are already in the billions, it just isn’t likely that you will be able to keep doubling those kinds of numbers. 

In fact, between 1985 and 2015, small caps outperformed large caps by 3.24% per year on average. Compounded over 30 years, this would have made a huge difference to your portfolio. 

There are also more opportunities to be found in small caps, as large funds don’t have the mandate to allow them to invest in these companies. This is great for independent investors like you and me, who can research this segment without the extreme competition of the larger, more popular funds. 

Just as the market is quick to punish small cap stocks, the reverse is also true: One small piece of good news can send a beaten-down cheap volatile stock skyrocketing. One savvy investor understood this and made a killing. 

Warren Buffett’s Cheap Volatile Stock Secrets

The Oracle of Omaha got his start with his investment partnership, focusing on small companies trading below their net current asset value (NCAV), as laid out by his mentor Benjamin Graham. Buffett believes in this strategy to this day, as he is quoted in the 2016 book, Warren Buffett’s Ground Rules:

“In fact, we are still earning those types of returns on some of our smaller investments. The best decade was the 1950s; I was earning 50% plus returns with small amounts of capital. I could do the same thing today with smaller amounts.”

The NCAV stocks that Buffett loved were certainly volatile; by definition, they would have to be in order to achieve those kinds of returns. 

Net net stocks are cheap relative to their NCAV, a conservative valuation measure that Graham would call their “liquidation value.” You calculate a stock’s NCAV by only looking at a company’s current assets, minus all of its outstanding liabilities, both long and short term. The beauty of NCAV is that it is simple, logical, and naturally conservative, and the more conservative our valuation, the wider our margin of safety. This isn’t the only margin of safety that net net investing provides, as you will see later on.

The more complicated a valuation method, the more room for error. The less conservative your valuation, the higher that valuation is in dollar terms, and the less likely the stock is to actually rise to meet that valuation. This is especially important with net net stocks, which by definition are cheap volatile stocks that have been chewed up by the market for one reason or another. 

Statistically, a net net will revert back to its NCAV, as the net net’s discount is the result of an over-exaggeration of market pessimism. Generally, the smallest piece of good news is enough to send these beaten-up stocks sky high. 

Consider the case of Trans World Entertainment (NASDAQ: TWMC) in 2011: This net net had been hammered as it suffered through the decline of the retail CD and DVD business, losing 96% of its share price, from a high of $15 to $0.60. 

While most investors would see that kind of drop and run, the business did have a couple things going for it: A healthy current account ratio of over 2.00x, a high percentage of insider ownership, and the fact that it did possess money-making retail locations. Management had a way to reverse the business’s fortunes, and as they were so highly invested in the company, it was likely that they would pursue it. 

And pursue it they did — TWMC started closing its unprofitable locations, and soon after was even opening brand new locations. This shift in strategy was welcomed by investors who quickly bid up shares to just over $5.00 — a 733% rise from its lows!

This case is also a reminder to investors on how important it is to keep qualitative facts in mind at all times. In 2011 it had all the criteria to be a successful net net. Today it has crashed down to $2.50 and is a bankruptcy candidate.

Many net nets are unloved businesses that have lost the majority of their value, only to shoot right back up again temporarily on some good news. How can it be that some of the most conservative investors such as Buffett, Walter Schloss, and Charlie Munger (yes, even Munger — look at his 1970s investments) were crazy about these crazy cheap volatile stocks?

It’s because volatility is a perceived risk that these superinvestors minimised by stacking the deck in their favour. 

The discount to NCAV was just one way they stacked the deck. Not only did cheap stocks relative to NCAV statistically provide amazing returns, but the downside was minimised as NCAV was also seen as the “liquidation value” of a company.

If a business is not able to recover and decided to close, the business would most likely be dissolved at a price close to its NCAV, as this valuation is based on the net current assets that the company has on hand. Just buying at a discount would have increased the chance that investors would have earned a profit in this example. 

This conservatism provides investors with a margin of safety and the downside protection we need when investing in cheap volatile stocks. As stated before, a volatile stock can swing down as well as up, and we want to minimise the downswings and maximise the upswings. 

Net Net Hunter was created for such a task. It uses seven core criteria — things such as low debt/equity ratio — to filter and leave you with only the highest quality NCAV stocks, providing you the downside protection I talked about earlier. Criteria such as a catalyst, or improving earnings, are all factors in maximising the chance of a move up.

Finally, there are general rules that investors can follow in order to manage the volatility on a portfolio level. Simple things like holding a diversified number of stocks can smooth out the ups and downs experienced with individual positions, helping to guarantee a return in-line with net nets as a class. Joel Greenblatt famously discussed this in You Can Be a Stock Market Genius:

“Owning two stocks eliminates 46% of the nonmarket risk of owning just one stock. This type of risk is supposed to be reduced by 72% with a four-stock portfolio, by 81% with eight stocks, 93% with 16 stocks, 96% with 32 stocks, and 99 percent with 500 stocks.”

We can see that there is a sweet spot between eight and 16 stocks, but after that the law of diminishing returns takes hold, and eventually you would simply be owning the entire market (and lesser quality net nets!). Those new to net net investing will want to hold more, however, due to the increased chance of making mistakes.

Remember — when you are investing in cheap volatile stocks, you want to minimise those downturns to increase the odds that a volatility spike pushes your stocks upwards. 

Cheap Volatile Stocks: You Gotta Risk It To Get the Biscuit 

We have understood that if we want to outperform, we have to be ready to bear some volatility. The key is managing that by maintaining a large margin of safety and choosing high-quality net nets with high upside potential. This is the core of what produces long-term outperformance. 

Don’t take my word for it: look at Buffett during his partnership days. He handily beat the market, all by investing in his cigar butts. These small cheap volatile stocks were the key to his investment success. He knew how to conservatively value the companies to give the best odds of a volatile spike upwards in price. 

In the markets, as in life, it's all about risk-reward. If you want to succeed, you have to be willing to put yourself out there. And just as in life, you want a margin of safety when you take risks, in order to maximise the odds of a good outcome. You’d only go bungee jumping with the most reputable company, who has the best track record, and invests in the newest, safest equipment, right?

It's so obvious in life, yet many forget to apply this to their investments. Investing in net net cheap volatile stocks is the best way to protect your downside, while increasing the odds of extraordinary returns. 

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