February/March 2020 – Random Thoughts on Recent Stock Market Events
An enormous amount of paper value has been lost in just a few weeks however it is only a small set back when you look at the overall performance of the S&P 500 index in the past 5 years having gone from around just over 2000 to just shy of 3400 this past February and now sitting just over 2800. At 3400 your compounded rate of return in the index would have been over 11% per year. Now your return is sitting at 7.5%, which is still not that bad.
I will skip the dull regurgitation of the same popular quotes that you will read on Twitter or on personal finance blogs telling you to not sell and stay focused on the long term. This bull market has been going on for 11 years and usually what triggers a recession is mostly unknown to the market when it happens. Otherwise people would have already priced these types of events into stock prices well before they occur.
Could COVID-19 Virus be the cause of the next recession? Perhaps and it seems increasingly likely. But does it matter if you are evaluating companies based on the economics of their business over the next 10 years? Should you even be that upset that the market is down 15% if you have owned Apple in the past year and had seen it appreciate 92%? People have a tendency to measure the baseline of net worth based on their 52-week high regardless of their portfolio’s relative price to its true intrinsic value. Never mind that other stocks have appreciated significantly beyond their earnings growth in the past year as well. When a stock goes down by 10% it really hurts psychologically.
At a time like this it is best to take a step back and analyze the situation in as calm and rational way as possible. At all times, you should have an idea what the overall intrinsic value of your portfolio is and unless some new piece of information is presented as a result of the COVID-19 Virus, then you should not be worried unless you have a need to liquidate a large portion of your portfolio in the near term future.
Ways in which the COVID-19 Virus should cause concern is if you hold companies that have a lot of debt, where a short-term reduction in their cash flow could have a devastating impact on their ability to pay interest on their debt. For example, a highly indebted industrial company whose business is forced to shut down via a mandated order from the government. If that company can’t sell any of their products, then they have no revenue and cash to pay the interest on their debt. This could eventually lead to a quick demise.
High debt however is not a precursor to bankruptcy that is unique to the COVID-19 Virus. It is something that creates a high-risk enterprise which is vulnerable to any sort of short-term impact on their business. This is the problem with investing in companies with excessive debt or liabilities. When the economy is performing well, investors become confident in their ability to predict the future performance of businesses and increasingly, an investor finds ways to justify the excessive debt. They hence start to build in less margin of safety into their intrinsic value calculations and are willing to pay a higher price for growth.
The important thing to focus on at all times and during all events is to focus in on what matters. Investing is filled with a lot of noise when you read the news headlines every day. Each day there is a new story that the editors will push to get you to click on their links. They use a bit more sensationalism than is likely appropriate given the actual impact the news has on your daily life. Paying attention to these news headlines can leave an investor being more susceptible to their emotions which have influence over their investment decisions.
So, was last weeks events “the opportunity” for investors to jump in? Many companies are still overvalued and if COVID-19 Virus gets worst that I would expect the economy to perform much worse with the stock market following it. However, if you evaluated a company like Berkshire’s intrinsic value to be around $250 and invested at $230, then maybe you might want to buy some more at $198. If you bought a stock that was 5% higher 1 month ago, then you should be more than happy to be able to buy it 5% cheaper today.
Your portfolio construction should be built in a way in which you weight your stocks where the ones with the highest potential upside and have your highest level of confidence, are given a higher portion of the portfolio. Of course, this is simple in theory and harder in practice. At the same time, you have to factor in the cost of trading, the level of confidence in your intrinsic value calculation and the level of debt that the company might carry. Investing is a game of placing your money in your best available option at any given time. The answers are never black and white. It requires a lot of thinking and evaluation of probabilities given the information that you are presented with.
If you have any suggestions, comments or feedback that you would like to share feel free to email me at alex@StockWriteUps.com.
Enjoy the Journey,