Red days, green returns: a 6-step framework for volatility

March was a tough quarter. Markets held up reasonably well at the index level - during the quarter, the S&P 500 fell 4.6% and the ASX All Ordinaries Index was down by 1.95%. For many smaller companies, it was a very different story. Share prices fell hard, with the Small Ordinaries Accumulation Index falling 10.9% and many individual stocks down 40-50%.

For many investors, whether in funds or direct equities, these periods of negative returns, known as drawdowns, are uncomfortable - not just financially, but psychologically. They are also unavoidable, especially for those like Forager that like to seek opportunities among smaller companies.

So making sure you have a framework for dealing with them is important.

While each drawdown has its own flavour, the underlying dynamics are often the same. Through plenty of trial and error, Forager has evolved a framework for dealing with them that has been very handy over the past few months.

#1 - Be prepared

The first step is to use more buoyant markets to prepare for a market downturn. It is not easy when everything is going well, but gradually increasing cash holdings and focussing on portfolio diversity when there appears to be little to worry about is important.

In stronger markets, that often means selling investments that have run ahead of fundamentals and building cash. It can feel uncomfortable at the time. But it creates optionality when conditions turn and is part of the preparation for potential future volatile periods.

That preparation matters, and is key to the process. At Forager, we aim to prepare for, but not predict, what markets will do. Heading into the recent volatility, both of Forager’s Funds were holding meaningful cash positions. That has allowed the team to take action when prices of businesses on the watch list fell, rather than being forced to react defensively.

The aim is not to avoid drawdowns entirely, but to make sure you have the ability to play offence when everyone else is starting to worry.

#2 - Incorporate new information

Drawdowns are often driven by factors that have little to do with underlying business performance. In smaller companies especially, flows, liquidity and short-term positioning can dominate. The price may simply be reacting to market sentiment, forced and passive selling, or a lack of buyers.

Small cap companies also tend to be more exposed to the macroeconomic environment, interest rates, wars, oil prices and foreign currency changes. Sometimes whatever is scaring everyone else really is worth worrying about. Therefore, our starting point is always to revisit the underlying business. Has anything fundamentally changed? Are earnings, competitive positioning or balance sheet strength deteriorating? And based on this, is the investment thesis still intact?

This sounds simple, but it requires discipline. Over the past few months, the team has revisited a large number of holdings across both Funds. In several cases, we found businesses continuing to execute well while their share prices fell materially.

That creates opportunity - but only if you can distinguish between a genuine deterioration and a temporary dislocation.

#3 - Re-visit the overall portfolio

Drawdowns are not just about individual stocks - they are a portfolio-level stress test.

We use periods like this to reassess position sizing, liquidity and downside risk across the entire portfolio. That includes asking some uncomfortable questions:

• Are we too exposed to a particular theme or risk factor?
• Are there any assumptions that need to be updated?
• Which positions would we increase if prices fell further?
• Where could we be wrong?

This process is what leads to action. Some businesses may no longer stack up under tougher conditions. Those get trimmed where our conviction has weakened, or exited completely if the thesis is now broken. Others emerge stronger, with share prices falling well below what we see as a conservative assessment of value, and this is where capital gets reallocated.

#4 - Lean into opportunity, carefully

Periods like this are where long-term returns may be set up. Volatility can create chances to buy quality businesses at better prices.

But not every falling stock is an opportunity. The key is distinguishing between structural problems and temporary price dislocations.

The type of setup we look for is:

• A business we know well
• A management team we trust
• A strategy that remains intact
• A share price that no longer reflects reality

An example of this is Catapult Group (ASX:CAT). Catapult is a global leader in athlete performance analytics, with a strong position in elite sports leagues and a growing subscription-based revenue model. It’s a business we have followed for many years and one the Forager Australian Shares Fund owned in the past. The team exited the position prior to Christmas after a strong run.

During the recent selloff, Catapult’s share price fell significantly, despite little change in the underlying business. The company continues to grow recurring revenue, expand margins and strengthen its competitive position. The Fund has since re-invested at materially lower prices:

12-month Share Price Chart for Catapult (ASX:CAT)

Plenty of Catapult’s software peers have experienced similar share price falls. Some of them will also be good investments. But in times of market panic, sticking to what you already know and understand is key.

#5 - Accept that volatility is part of the process

There’s a tendency to treat drawdowns as something to be avoided, but in reality, they are the price of investing in less efficient parts of the market.

Smaller companies, in particular, offer the potential for stronger long-term returns. But that comes with more volatility along the way. The dispersion we’ve seen, where outcomes vary widely between companies, is exactly what creates opportunity for active investors - the trade-off being short-term discomfort.

Trying to sidestep every downturn usually results in missing the recovery. And historically, those recoveries have been sharp and concentrated.

The COVID crash and recovery happened over a few months.

During volatile periods, the team stays focused on the process and ignores external noise. We continue meeting management teams, updating models and testing our assumptions. We don’t try to predict short-term market movements, but aim to ensure that when conditions stabilise, the portfolio is positioned to benefit.

# 6 - Communicate clearly and honestly

Periods like this are just as challenging for investors in our Funds as they are for us managing them. This is why times like this are also when communication matters most. Client trust is built over time, and is tested in periods like this.

We believe it’s critical to communicate openly and with clarity: what’s happening, what we’re seeing, and what we’re doing about it. That includes being honest about mistakes, acknowledging uncertainty and highlighting where we’re finding opportunity. Our approach is to be upfront about performance, explain the drivers, and outline how the portfolio is positioned from here.

It is worth you doing the same even if you don’t have clients to write to. A written record of how you felt at the time and what actions you took (and didn’t take) will help you improve your own process and can be very useful reading the next time a drawdown occurs.

Staying grounded when it matters most

Drawdowns are an inevitable part of investing, particularly in the part of the market Forager operates in. They test conviction, discipline and temperament, but they also create the conditions for future returns.

The goal isn’t to avoid these periods; it’s to navigate them well. Having a clear framework - separating price from value, re-evaluating the portfolio, leaning into opportunity and communicating openly - doesn’t eliminate the discomfort. What it does is provide a structure for making better decisions when it matters most. It’s a process we’ve refined over many years and many cycles.

While the path is rarely smooth, it’s often those decisions, made during the toughest periods, that the groundwork for future returns is laid.

Managed Fund

Forager Australian Shares Fund

Australian Shares

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Plenty of opportunities are still arising due to the current market volatility. If you are interested in finding out more, register for Forager's monthly and quarterly reports, and other investing updates.