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What Is Risk?

Volatility is not synonymous with risk. Distinguishing between the two is central to our efforts to add value over the long term.

March 2021

St. Louis Cardinals left fielder Lou Brock attempted to steal a base 1,245 times over the course of his career. In the process, he became Major League Baseball’s all-time leader in times caught stealing.1 Yet Brock’s calculated risk-taking also served as the foundation for his impressive success: He amassed a whopping 938 stolen bases over his 19-year Major League career.

Like Lou Brock, Sands Capital believes in taking calculated risks. As active, high-conviction, long-term investors, we know our portfolio will frequently incur more volatility than the index. We believe this differentiation is central to our efforts to add value over the long term.

We know volatility is a source of concern for our clients, and the term is often used interchangeably with risk. However, we don’t view the two as the same. Rather, we take a nuanced approach to risk management that recognizes the differences between risk and volatility. This approach involves being diligent and thoughtful about our research and evaluation of risk and opportunity, but it doesn’t mean prioritizing volatility management. 

“Show me a guy who’s afraid to look bad, and I’ll show you a guy you can beat every time.”

— Lou Brock

If Volatility Isn’t Risk, What is It?

Volatility measures an asset’s price fluctuation over time. The prices of publicly traded stocks move constantly, as investors with different objectives attempt to “price in” a constant stream of information. Often, this analysis and its associated reactions are based on short-term information. For example, 39 sell-side research firms offer earnings estimates for Apple—the largest weight in the MSCI All Country World Index—for fiscal year 2021; yet only one firm has an estimate for 2025.2

We are investors, not traders. We believe a myopic focus on the short term misses what really matters. Stock prices change far more frequently than a business’s structural opportunity. This is especially true for new industries that are disrupting the status quo. For example, we often see heightened volatility among businesses within ecommerce, internet, and life sciences, where a negative company announcement or media commentary can drive frantic trading. Although this fleeting news can ignite volatility, it shouldn’t change the long-term trends that can drive growth in these businesses.

In addition, the market has difficulty valuing earnings growth for companies with disruptive business models. For example, prices of software businesses have seen periods of extreme volatility, as investors have tried to understand their longer-term potential. One source of misunderstanding: These high-growth businesses often front-load their research and development and sales costs to develop new products and aggressively pursue market share. These actions can result in losses or paper-thin margins in early years. An investor who focuses only on a near-term valuation and scant profits could overlook the company’s true earnings potential after growing out of its investment years, when recurring subscription revenue and the business’ inherent margin leverage can translate to exponential earnings growth.

When stock prices swing, we try to look beyond the movement and instead determine the drivers of those swings, so we can evaluate whether price movements legitimately reflect changing fundamentals. For example, is volatility due to factors outside the business, or the result of factors specific to the business? If the concerns are business-specific, are they credible? If so, is the problem solvable, or does it reflect a permanent impairment in the business’s earnings potential?

Tolerating volatility can generously compensate patient investors over the long term. We seek to apply our deep research experience in areas that many people may not understand or may be unwilling to evaluate beyond a two-year time horizon. We therefore view volatility as the price of admission for investing in high-growth businesses, and this enables us to potentially benefit from the asymmetrical nature of stock returns.

Figure 3. Source: FactSet. Data as of December 31, 2020.

What, Then, is Risk?

To Sands Capital, risk reflects the potential for permanent impairment of clients’ capital. Because we believe that business fundamentals drive investment results over the long run, risk is therefore anything that erodes the earnings power of the underlying businesses.

Figure 3. Source: FactSet. Data as of December 31, 2020.

Our laser focus on business fundamentals gives us confidence in the face of uncertainty: If we get the fundamentals directionally correct, stock prices should follow.

This focus on long-term fundamentals requires us to think like business owners, which involves answering questions such as: Does the business add value for its customers? Will it be viable in five years or more? Can it weather difficult environments? The answers to these questions feed into what we view as the most important question: Does the business fit our six criteria?

In addition to considering fundamentals, we use other tools to help us mitigate risk, including:

  • Position sizing: We set strategic portfolio weights based on our confidence in the investment case, how well the business fits our investment criteria, and the output of our expected returns framework.
  • Macro frameworks: We analyze drivers and trends behind the sustainability of countries’ economic growth, fiscal and monetary health, and political governance.
  • Portfolio-level considerations: We ensure a balance of different industries and economic drivers. We evaluate implied exposures to understand what outside factors could influence businesses and stocks. We track liquidity. And we assess valuations relative to businesses’ long-term prospects.

We believe these tools increase our chances of above-average outcomes. Our long-term orientation helps as well, because investment results historically have been more stable over longer periods. For investors with long time horizons, results over long, rolling periods are far more important than performance in any single year.

Figure 3. Source: FactSet. Data as of December 31, 2020.

We view opportunity cost as another very real, costly risk. It materializes in the instinct to avoid businesses with high perceived risk (typically volatility) or high valuations. But this approach often ignores business fundamentals and longer-term opportunities. For this reason, when we conduct research, we explicitly focus initially on the business—not on the traded stock. We would far rather find an exceptional company, and later decide not to invest due to valuation, than ignore the potential opportunity altogether.

While not observable on an account statement, opportunity cost can be devastating over the long term. Often the best days for stock returns occur within two weeks of the worst days. Over time, missing those best days can seriously erode returns. While stock-price declines are never enjoyable, we believe our long-term approach helps us resist the temptation of timing the market. Patience is a virtue. Over the long run, we know that business fundamentals and prices usually converge.

Three Certainties in an Uncertain Market

The market is an uncertain place. One thing we can say for sure is that it will undergo periods of volatility. And we know that our portfolios will face periods of underperformance and extreme fluctuations.

To us, the third certainty is the tendency for stock prices to follow business fundamentals over the long term. We will continue to seek the businesses best positioned for above-average growth—frequently built on innovative disruption and misunderstood or underappreciated by the market—that we expect to generate excess long-term investment results.

Rickey Henderson later broke Lou Brock’s record for times caught stealing.
Factset. Apple is not a holding in any Sands Capital strategy. Weight in MSCI All Country World Index as of 12/31/2020.

Disclosures:

The views expressed are the opinion of Sands Capital Management and are not intended as a forecast, a guarantee of future results, investment recommendations, or an offer to buy or sell any securities. The views expressed were current as of the date indicated and are subject to change. Past performance is not indicative of future results. A company’s fundamentals or earnings growth is no guarantee that its share price will increase. You should not assume that any investment is or will be profitable. GIPS® reports and additional disclosures for the related composites may be found at Sands Capital Annual Disclosure Presentation.

The Russell 1000® Growth Index is a subset of the Russell 1000® Index, a capitalization-weighted, price-only index which is comprised of 1,000 of the largest capitalized U.S.-domiciled companies and are included in the Russell 3000® Index. The Russell 1000® Growth Index measures the performance of those Russell 1000® Index companies with higher price-to-book ratios and higher forecasted growth values. The S&P 500 Index is a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies. Broad-based securities indices are unmanaged and are not subject to fees and expenses typically associated with managed accounts or investment funds. Investments cannot be made directly in a broad-based securities index. The MSCI All Country World Index (ACWI) is a stock index designed to track broad global equity-market performance. Maintained by Morgan Stanley Capital International (MSCI), the index comprises stocks of about 3,000 companies from 23 developed countries and 26 emerging markets.

If Volatility Isn’t Risk, What Is It?

St. Louis Cardinals left fielder Lou Brock attempted to steal a base 1,245 times over the course of his career. In the process, he became Major League Baseball’s all-time leader in times caught stealing.[i] Yet Brock’s calculated risk-taking also served as the foundation for his impressive success: He amassed a whopping 938 stolen bases over his 19-year Major League career.

Like Lou Brock, Sands Capital believes in taking calculated risks. As active, high-conviction, long-term investors, we know our portfolio will frequently incur more volatility than the index. We believe this differentiation is central to our efforts to add value over the long term.

We know volatility is a source of concern for our clients, and the term is often used interchangeably with risk. However, we don’t view the two as the same. Rather, we take a nuanced approach to risk management that recognizes the differences between risk and volatility. This approach involves being diligent and thoughtful about our research and evaluation of risk and opportunity, but it doesn’t mean prioritizing volatility management.

[i] Rickey Henderson later broke Lou Brock’s record for times caught stealing.

Volatility measures an asset’s price fluctuation over time. The prices of publicly traded stocks move constantly, as investors with different objectives attempt to “price in” a constant stream of information. Often, this analysis and its associated reactions are based on short-term information. For example, 39 sell-side research firms offer earnings estimates for Apple—the largest weight in the MSCI All Country World Index—for fiscal year 2021; only one firm has an estimate for 2025.[i] Further, according to eVestment, the average global fund had turnover of approximately 50 percent in 2019, which suggests that the funds hold securities for an average of just two years.[ii]

We are investors, not traders. We believe a myopic focus on the short term misses what really matters. Stock prices change far more frequently than a business’s structural opportunity. This is especially true for new industries that are disrupting the status quo. For example, we often see heightened volatility among businesses within ecommerce, internet, and life sciences, where a negative company announcement or media commentary can drive frantic trading. Although this fleeting news can ignite volatility, it shouldn’t change the long-term trends that can drive growth in these businesses.

More than 60 U.S. retailers have gone bankrupt since 2015, many citing losses due to ecommerce. However, ecommerce still accounts for only 15 percent of retail sales in the U.S.

Global internet penetration doubled from 2009 to 2018, but nearly half of the world’s population still isn’t connected. Most of these future users are in China and India.

In 1980, it took seven years to double the world’s medical knowledge. Now, it is estimated to take as little as 73 days. This compounding effect is leading to new scientific fields and new potential treatments.

In addition, the market has difficulty valuing earnings growth for companies with disruptive business models. For example, prices of software businesses have seen periods of extreme volatility, as investors have tried to understand their longer-term potential. One source of misunderstanding: These high-growth businesses often front-load their research and development and sales costs to develop new products and aggressively pursue market share. These actions can result in losses or paper-thin margins in early years. An investor who focuses only on anear-term valuation and scant profits could overlook the company’s true earnings potential after growing out of its investment years, when recurring subscription revenue and the business’ inherent margin leverage can translate to exponential earnings growth.

When stock prices swing, we try to look beyond the movement and instead determine the drivers of those swings, so we can evaluate whether price movements legitimately reflect changing fundamentals. For example, is volatility due to factors outside the business, or the result of factors specific to the business? If the concerns are business-specific, are they credible? If so, is the problem solvable, or does it reflect a permanent impairment in the business’s earnings potential?

Tolerating volatility can generously compensate patient investors over the long term. We seek to apply our deep research experience in areas that many people may not understand or may be unwilling to evaluate beyond a two-year time horizon. We therefore view volatility as the price of admission for investing in high-growth businesses, and this enables us to potentially benefit from the asymmetrical nature of stock returns.

Asymmetric Returns: R1000G Top & Bottom 5 Stock Returns

What, Then, Is Risk?

To Sands Capital, risk reflects the potential for permanent impairment of clients’ capital. Since we believe that business fundamentals drive investment results over the long run, risk is therefore anything that erodes the earnings power of the underlying businesses.

Stock Returns Are Correlated With Earnings Growth

Our laser focus on business fundamentals gives us confidence in the face of uncertainty: If we get the fundamentals directionally correct, stock prices should follow.

This focus on long-term fundamentals requires us to think like business owners, which involves answering questions such as: Does the business add value for its customers? Will it be viable in five years or more? Can it weather difficult environments? The answers to all these questions feed into what we view as the most important question: Does the business fit our six criteria?

In addition to considering fundamentals, we use other tools to help us mitigate risk, including:

  • Position sizing: We set strategic portfolio weights based on our confidence in the investment case, how well the business fits our investment criteria, and the output of our expected returns framework.
  • Macro frameworks: We analyze drivers and trends behind the sustainability of countries’ economic growth, fiscal and monetary health and political governance.
  • Portfolio-level considerations: We ensure a balance of different industries and economic drivers. We evaluate implied exposures to understand what outside factors could influence businesses and stocks. We track liquidity. And we assess valuations relative to business’ long-term prospects.

We believe these tools increase our chances of above-average outcomes. Our long-term orientation helps as well, because investment results historically have been more stable over longer periods. For investors with long time horizons, results over long, rolling periods are far more important than performance in any single year.

Long-term Returns Are Less Volatile Than Short-term Returns

We view opportunity cost as another very real, costly risk. It materializes in the instinct to avoid businesses with high perceived risk (typically volatility) or high valuations. But this approach often ignores business fundamentals and longer-term opportunities. For this reason, when we conduct research, we are explicit that the initial focus be on the business and not on the traded stock. We would far rather find an exceptional company and later decide not to invest due to valuation than ignore the potential opportunity altogether.

While not observable on an account statement, opportunity cost can be devastating over the long term. Often the best days for stock returns occur within two weeks of the worst days, and over time, missing those best days can seriously erode returns. While stock-price declines are never enjoyable, we believe our long-term approach helps us resist the temptation of timing the market. Patience is a virtue, and over the long run, we know that business fundamentals and prices usually converge.

Three Certainties in an Uncertain Market

The market is an uncertain place. One thing we can say for sure is that it will undergo periods of volatility. And we know that our portfolios will face periods of underperformance and extreme fluctuations.

To us, the third certainty is the tendency for stock prices to follow business fundamentals over the long term. We will continue to seek the businesses best positioned for above-average growth—frequently built on innovative disruption and misunderstood or underappreciated by the market—that we expect to generate excess long-term investment results.

DISCLOSURES:

The views expressed are the opinion of Sands Capital Management and are not intended as a forecast, a guarantee of future results, investment recommendations, or an offer to buy or sell any securities. The views expressed were current as of the date indicated and are subject to change. Past performance is not indicative of future results. A company’s fundamentals or earnings growth is no guarantee that its share price will increase.  You should not assume that any investment is or will be profitable.  GIPS®-compliant presentations and additional disclosures for the related composites may be found at Sands Capital Annual Disclosure Presentation

The Russell 1000® Growth Index is a subset of the Russell 1000® Index, a capitalization-weighted, price-only index which is comprised of 1,000 of the largest capitalized U.S.-domiciled companies and are included in the Russell 3000® Index. The Russell 1000® Growth Index measures the performance of those Russell 1000® Index companies with higher price-to-book ratios and higher forecasted growth values. The S&P 500 Index is a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies. Broad-based securities indices are unmanaged and are not subject to fees and expenses typically associated with managed accounts or investment funds. Investments cannot be made directly in a broad-based securities index.

 

i. Rickey Henderson later broke Lou Brock’s record for times caught stealing.
ii. Factset. Apple is not a Sands Capital strategy. Weight in MSCI All Country World Index as of 12/31/19.
iii. eVestment
iv. https://www.cbinsights.com/research/retai l -apocalypse-timeline-infographic/
v. Kleiner Perkins
vi. Kleiner Perkins
vii. https://www.ncbi.nlm.nih.gov/pmc/articles/PMC3116346/

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