Navigating volatility takes investor discipline

Focusing on bottom-up analysis rather than top-down economic factors may help investors navigate the macro environments that lie ahead, says Kathrin Forrest, equity investment specialist with Capital Group.

She said a careful review of company fundamentals should reveal opportunities for structural growth, be they through innovation, changing industry dynamics, improving operating performance, industry-specific tailwinds or shareholder-friendly capital allocation.

“We can find differentiated drivers of return at a company level that can collectively thrive in various different environments,” she said.

Speaking about market volatility on the latest episode of the Soundbites podcast, Forrest said trying to call the direction of markets is a classic investor trap.

“If you can get that right, it can be quite rewarding,” she said. “But there’s lots of room for error, both in terms of timing and direction. And it also doesn’t always translate directly into how equity markets or individual companies might fare.”

In volatile markets, loss aversion could become another trap, she said.

“If your goal is to grow wealth over some longer period of time, inflation is [an] important factor to think about,” she said. “If you invest your money overly conservatively, you may risk eroding purchasing power if inflation tracks above your investment returns.”

On the other end of the spectrum, employing an aggressive investment stance or being overly optimistic about markets can also be costly, she said. Anchoring to selloff reference points, for example, may make asset prices look cheap in volatile markets.

“Things don’t always revert back to the mean, certainly not over shorter periods of time,” she said. “Either way, deviating from your investment strategy can be dangerous because it can take your overall portfolio off track.”

Forrest said in volatile markets it is important to know what economic factors to downplay or ignore altogether. For example, market overreactions are often driven by changing investor sentiment or demands for liquidity.

“Prices may not reflect fundamental values,” she said. “Don’t get overly focused on short-term price fluctuations.”

She also warned that the liquidity profile of a portfolio can change when market conditions fluctuate.

“Building blocks that you thought might be liquid may not turn out to be easy to trade in a volatile market,” she said. “It is important to understand the market dynamics at work, and track their impact on investments, allowing for some drift, but not letting things get too far off target.”

She said another important consideration is an investment’s time horizon.

“Asset prices can overreact over shorter periods. They may not reflect fundamental values, but more so shorter-term sentiment or liquidity considerations,” she said. “Your risk tolerance might get tested beyond what you might have expected.”

Finding opportunities in unsettled environments depends on “leaning into fundamental research and applying a global lens,” she said. Some companies perform better than others in specific economic scenarios.

“When capital is expensive, look for companies that can generate strong free cash flow, that allocate capital thoughtfully and that can fund their own growth,” she said. “Those types of companies may be well-positioned to navigate more successfully through a broad set of different environments.”

Sector preferences

Right now, the investment team sees opportunities in health care, especially with the advent of new treatment options for obesity and diabetes, as well as related pharmaceutical projects that show promise.

“This broader concept [of weight-related treatment] goes beyond the major pharma companies that have solutions in the market today,” she said. “It goes into the broader supply chain, medical services, as well as other consumer products.”

Forrest said the investment team also likes the semiconductor industry, with its wide range of differentiated opportunities, stronger structural demands, varying cyclical pressures and ongoing reconfiguration of complex global supply chains.

It’s “an area of interest with differentiated bottom-up opportunities,” she said.

A third promising sector is energy security and the ongoing shift towards electrification over fossil fuels.

“When we take a wider lens here, opportunities might stretch across a broad set of sectors and that includes energy, materials, as well as industrials,” she said.

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This article is part of the Soundbites program, sponsored by Canada Life. The article was written without sponsor input.