Trading Strategies: FTSE 100 volatility is a buying opportunity

The stock market has been exceptionally volatile over recent weeks. Having slumped by 5% in the first three trading days in August, the FTSE All-Share index has subsequently risen by around 3%. Even on an intraday basis, equity markets have displayed extreme levels of volatility as investor sentiment remains highly changeable due to an uncertain near-term outlook for the global economy.

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In the short run, further stock market volatility would be unsurprising. Inflation in the US and Europe remains above central bank targets, while the Bank of England expects inflation to rise from its current level of 2% during the second half of the year. Continued sticky inflation could constrain the ability of central banks to implement monetary policy easing, which may ramp-up investor concerns about an economic slowdown.

Even if further interest rate cuts take place in the UK and Europe, while the Federal Reserve loosens monetary policy in the US, time lags mean that their impact will take several months to be fully felt. This could mean that policymakers are limited in what they can do to change the course of their respective economies over the coming months. This is likely to prompt even greater fear among investors, thereby causing further volatility in share prices.

Accurately identifying risks

Of course, there is a great difference between volatility and the risk of permanent capital loss. A company is no more likely to fold because its share price has become extremely volatile over a short period. Similarly, a firm that has a relatively stable share price is no less likely to go bust.

Indeed, market valuations can become significantly detached from underlying, or intrinsic company values over the short run. This means that long-term investors should not become overly concerned about heightened volatility among their holdings.

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It could even be argued that volatility is irrelevant for investors with a long time horizon. Unless an individual is likely to sell a stock in the short run, they can simply ride out periods of high volatility in the knowledge that large swings in share prices do not accurately represent the underlying performance, or long-term potential of their holdings.

Long-term investors can also use periods of high volatility to their advantage. Should a high-quality company’s shares slump due to declining investor sentiment towards equity markets, rather than weak company-specific financial performance, it may be possible to purchase them at a relatively large discount to intrinsic value. This additional margin of safety can provide scope for higher returns over the long run.

Focusing on fundamentals

Clearly, investors should always pay close attention to the threat of permanent capital loss. And while heightened share price volatility does not equate to additional risk in this regard, a global economic slowdown could increase the potential for a permanent loss of capital as it prompts more challenging operating conditions across a wide range of sectors.

It is therefore prudent to continue to ensure that any portfolio holdings have sufficient financial strength to overcome a period of potentially weaker financial performance. For example, generous interest coverage and low gearing could mean a firm is under less financial pressure should its profits decline amid weaker economic conditions.

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A clear competitive advantage, as evidenced by factors such as return on equity and profit margins relative to sector peers, is also likely to be particularly beneficial during an economic slowdown. It could mean that a firm is less impacted by a weaker operating environment that its rivals.

Clearly, stock market investors can never fully eliminate the risk of permanent capital loss. It is, after all, an inherent part of equity investing. However, they can reduce its impact on their portfolio’s value by diversifying across a wide range of companies. When coupled with a focus on fundamentally sound firms, this should provide significant risk reduction over the long run.

A high-quality business

Past performance is not a guide to future performance.

FTSE 100 retailer Next (LSE:NXT) has experienced elevated share price volatility in recent weeks. Its shares slumped by 6% in just two days at the beginning of the month before subsequently recovering by 4% to their current level. This follows similarly volatile periods over recent years, notably during the pandemic and when rampant inflation prompted a cost-of-living crisis.

Despite experiencing periodic bouts of high volatility, the company’s shares have surged 59% higher over the past five years. A key reason for this is the firm’s solid fundamentals. For example, net interest cover in its latest financial year was in excess of 12. This shows that it is likely to be able to afford debt interest costs even if a worsening economic environment prompts a severe downturn in its profitability. And with a return on equity figure of 57% last year, the company appears to have a strong competitive position that bodes well for its long-term financial performance.

While investors are concerned about the near-term economic outlook, the firm’s solid financial position and clear competitive advantage mean that the risk of permanent capital loss is relatively low. Although its share price could remain volatile in the near term amid wider equity market turmoil, the company is set to ultimately benefit from an improving outlook for UK consumers.

Indeed, the firm’s latest trading update showed that its performance in the second quarter was ahead of its own expectations. While it anticipated a 0.3% decline in full price sales after a strong comparative period last year, it recorded growth of 3.2%. This contributed to a 4.4% rise in full price sales in the first half of the year, versus company guidance of 2.5%, and resulted in an upgrade to the firm’s financial outlook. It now expects profit growth of 6.7%, rather than 4.5%, for the full year.

Improving long-term prospects

Over the long run, the outlook for Next’s profitability is likely to further improve. While the Bank of England expects inflation to rise between now and the end of the year, it is still forecast to remain below 3%. This should mean that pressure on disposable incomes which prompted a cost-of-living crisis in the recent past is unlikely to be repeated.

Moreover, the Bank of England is widely expected to implement a sustained period of monetary policy easing that should encourage higher levels of consumer spending. This should provide an increasingly upbeat operating outlook for the firm. And with falling interest rates in other developed economies set to have a similar impact on the wider global economy, Next’s focus on expanding its international presence appears to be a sound strategy. Alongside further investment in its infrastructure and in acquiring new brands, it has several clear long-term growth catalysts.

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Of course, Next’s share price rise over recent years means it now trades on a relatively rich price/earnings ratio of 14.6. While there are undoubtedly cheaper stocks available across the FTSE 350, the company’s solid fundamentals, improving long-term operating outlook and sound growth strategy mean it still offers good value for money.

Certainly, its market valuation may fluctuate significantly in the short run as changeable investor sentiment prompts further wild swings across equity markets. But for long-term investors who can look beyond inherent stock market volatility, Next offers a favourable risk/reward opportunity and scope for further capital growth over the coming years.

Robert Stephens is a freelance contributor and not a direct employee of interactive investor.