In the last several weeks we have seen extreme volatility in global markets. Most notable is the decline in crude oil prices, which have come down in excess of 23% from their highs. There are a variety of excuses for the selloff such as weak economic growth, EBOLA and ISIL. The reality however, is that most of these negatives, and more such as Ukraine and a slowing China, have been present in the market while it has been rising higher. I’ve written many times this year about a level of complacency that has been quite extreme with market participants acknowledging that many stocks were overvalued, but not wanting to exit because they had been doing well in them. The S&P 500 and the DOW have given up all of their gains for the year.
While there are certainly negatives, I think it is important to point out some of the positive developments. Low oil prices have materially weakened Vladimir Putin’s position in regards to his expansionist plans in Eastern Europe. Russia is highly dependent on crude oil; an economy that has already been struggling in the midst of economic sanctions now is likely to endure a significant recession if oil prices stay this low. From a geopolitical standpoint, I view Russia as a far bigger threat than ISIL, as it has the largest nuclear stockpile in the world. In addition, lower oil and gasoline prices should benefit consumers and most of the real economy. With the holiday shopping season coming up, the timing couldn’t be better for this to occur.
These macro and geopolitical issues are important but are not nearly as important as the individual security selections that we make. Remember, when we are buying stocks, we are buying fractional shares of a business. Your attitude should be the same as it would be if you owned a bank, an insurance company, a restaurant, etc. in the private market. A 10% decline in publicly traded stocks would have no impact in your estimate of the intrinsic value of a private business. Stock prices change far more quickly than business values do, as value investors we take advantage of that disconnect between price and value.
As far as our portfolios are concerned, I feel that we are well positioned. All year, we have been harvesting profits on energy investments. We certainly are invested moderately in oil and natural gas stocks, which have been hit, but I believe these businesses are very undervalued and we’ve mainly used long-term cash-secured puts, as opposed to buying stocks. This will provide us with about a 10-15% cushion on average before we would begin to take losses, assuming we hold the options till expiration and that the stock is below our strike price. We’ve bought some additional energy stocks in this selloff, but I do believe oil prices can continue to go lower. This could actually be a long-term benefit to natural gas prices; most onshore energy drillers are focused almost entirely on maximizing oil production, as a result of natural gas prices having been so weak relative to oil. Most pure natural gas plays have not seen any investment because they not economic at current prices, but in many oil-rich wells, natural gas is still produced. If the number of rigs declines due to lower oil prices, that will also reduce natural gas supply, which ultimately should push prices higher to where it might make more sense to tap some of those gas wells. Most of our energy plays have fairly large natural gas exposure.
Our portfolios are very heavy in financial stocks. While we are still early into earnings season, the big banks are already off to a solid start in relation to their financial results. Both Bank of America and Citigroup posted solid profits despite huge legal settlements, which now are mostly in the past. I expect to see significant stock buybacks done at large discounts to intrinsic value in many of our insurance positions. Financials should be just fine in this volatile environment and there compelling valuations provide ample room for appreciation. While low interest rates challenge net interest margins and investment income, they also should bolster mortgage origination and ultimately real estate. The big banks’ are highly diversified so net interest margins are just a portion of their earnings profile. We have no exposure to the glamor social media or high-tech stocks that have been trading at absurd multiples. Those are the types of investments that will likely lead to permanent losses of capital.
While volatility can be uncomfortable, the best thing to do is to understand that it is a natural aspect of financial markets. We use it as our friend by avoiding leverage and focusing on a deep value discipline. It can be frustrating to see gains dissipate due to short-term market movements, but this volatility is what sets the stage for future gains. Already we have seen signs of panic from market participants but I’m happy to say that we’ve seen none from our clients. We’ve been through this many times and it will occur many more times, but keeping a level head and focusing on the key aspects, which define investment success will allow us to endure. If you have any questions or if we can assist with anything at all, please don’t hesitate to contact me!