(first published February 29, 2020)
The spread of Corona Virus (“CV-19”) is an unfortunate event for the course of humanity. Tragic at worst, humbling at best. It exhibits the limits of human knowledge, but also demonstrates the ingenuity of the human spirit, as a vaccine will eventually emerge, and its spread will be ultimately contained. Until then, uncertainty remains.
In markets, risk is measurable, uncertainty is not – markets embrace risk, but deplore uncertainty. The market, as measured by the SP500 Index, declined 13% in February resulting from the CV-19 scare. This current panic is creating an exceptionally attractive opportunity for investors. Over the last forty years when markets declined over 10% in a five-day period, the average return that followed 90 days later was +14%. As intelligent long-term investors, this makes us salivate at the expense of another’s folly: if someone wants to sell us great businesses at bargain prices, we’ll take it.
We are (have been) prepared for uncertainty. We hold 65-70% cash, and our gold position is up 28%. While others are scrambling for cash and selling stocks, we sit patiently for fat pitches down the middle of our strike zone, and swing at pitches in our sweet spot. We don’t swing for the fences. We love singles and doubles, and will, on occasion, be surprised with a triple or home-run. We aim for high batting averages and high on-base percentages rather than many home runs, which is usually a low batting average affair.
This week we bought new company positions in enterprises that have fortress balance sheets with less than 10% debt on their books and are near global monopolies in social media and online advertising. These are safe companies that do not fully rely on global supply chains or the clustering of consumers or any other public health risks from CV-19 to threaten their ability to compete, generate expanding profit margins, and compound retained earnings. To the contrary, the digital and online network effect is the primary source of competitive advantage to increase their intrinsic value. These purchases are minor relative to the total pool of investable capital, and were made – more importantly - at bargain prices. We may even add more shares should prices drop further.
We buy when there is blood on the street, and sell when there is a party on the street. If we buy well (price significantly below intrinsic value), we should never need to sell, and enjoy the fruits future company dividends (rent checks) will provide. As intelligent long-term investors, we buy good companies at great prices or great companies at fair prices. The elusive sweet spot is great companies at great prices. We never rent, speculate, or trade stocks.
We are closely monitoring markets and expect further drops. It will be choppy as the Federal Reserve Bank expressed on Friday it will come, once again, to the rescue and provide additional liquidity to markets (via further interest rate cuts) should matters worsen. Another 10 to 15% drop in the market is well within the realm of possibility, while another 25 to 35% drop may register at the extreme end of possible outcomes.
What to look for: global supply chain disruptions affecting earnings, profits, and ultimately company performance. Many public companies are already managing expectations by lowering earnings guidance for the first half of 2020. This is meant to soften further stock market declines. Without hard, empirical evidence however, this is only an exercise in crafting public opinion and cushioning market volatility. Other structural fragilities include: further weakness in bond markets, which affects equity (stock) valuations through volatile interest rates, which are used as a discounting factor for future corporate cash flow calculations. Much uncertainty, indeed, remains.
Unemployment is a lagging economic indicator. Should we begin to see layoffs resulting from CV-17, the economic recession has already arrived. It has only failed to be officially reported. CV-17 would serve as the catalyst, not the financial cause of this recession. The distinction is important.
· Like prior financial crises, catalysts are rarely economic culprits. Usually catalysts open Pandora’s boxes that reveal other, hidden structural fragilities inducing systemic risk. More often than not, fragilities and risks arise in debt, lending, or bond markets when societies overextend themselves and live beyond their financial means. These underlying risks resulting from animal spirits and human folly are usually more intrinsic to the nature of economic recessions or financial crises than one of form, financial product, industry structure, or government regulation. Man’s inability to self-regulate or subdue his passions will ultimately be his own tragic undoing until, that is, forces of reason enter his fold, and provide the self-correcting mechanism to restore his balance and economic equilibrium, pain notwithstanding. Centuries of economic history teaches us that the pendulum swings’ between passion and reason, between greed and fear, and between extremes and moderation will inevitably lead to more opportunities to purchase quality assets at even more depressed, bargain prices.
Until then, we sit tight. Patiently.