There is no doubt that the recent selloff in global markets has been stifling. The percentages of stocks down 20-40% are incredibly high, but not necessarily shocking if you’ve been watching what has been going on. Market participants have been bidding up stocks to unsustainable valuations, which have been buoyed by ultra-low interest rates. Sometimes a nasty selloff is necessary to remove some of the froth from the market. Below are a few key points to keep in mind with your investing that should help you psychologically and mentally in dealing with this period of turmoil:
- Stocks are still attractive relative to bonds, as the earnings yield on the S&P 500 is quite a bit more compelling than comparable yields on bonds. This provides a boost to stocks and I don’t expect interest rates to rise by any significant degree in the near term.
- At TTCM, we have been negative on the Chinese economy and pessimistic about global growth. This means that our stock selections are not reliant on anything better than the stagnant recovery we have seen since the Financial Crisis. I do not forecast a recession but instead believe that areas such as housing, autos, and lower oil prices will keep growth reasonably steady. We are situated very well in that type of environment with our investments in financials, autos and airlines.
- Whenever you are investing it is essential to keep in mind your goals and your time horizon. To really build wealth, a long-term approach is necessary and equities generally provide the best opportunity, particularly in this environment with bonds yielding so little. This means that you don’t want to focus on short-term issues but instead the focus is on buying attractive business at discounts to intrinsic value. Over the long-term as earnings come through, the stock prices will reflect the intrinsic value of the underlying businesses.
- Our options strategy will have a very large impact on performance this year. It is important to understand that you will not see the full benefit of this until many of our options get close to expiration, which is in late January of 2016. At that point in time, volatility and time value will go to zero and the only thing that will matter is where the stock prices are relative to the strike prices of the options we have sold. Our worst case scenario is that we will end up owning stocks at much cheaper prices than we could have initially bought them at and then we get to ride the recovery. Historically, many of our largest long-term returns have been on stocks where we’ve been exercised into due to short-term selloffs. This is where that long-term mentality is absolutely essential to keep in perspective.
- While the price to book ratio for the S&P 500 is about 2.5, most of the stocks we own trade at less than half that level. I believe they have materially less downside than most stocks in the index. In addition, the P/E ratios of the stocks in our portfolio are incredibly low and many are likely to see substantial improvements in earnings and dividends over the next few years, which will likely bolster the valuations.
- Our energy stocks have become a smaller portion of the portfolio due to their poor performance. Stocks such as ESV and RIG were paying out dividends of $3 per share just a year ago. Keep in in mind that we only started buying them after they had declined substantially but we are still down on them. They have massive backlogs and while the short-term business outlook is clearly not good, over the next 3-5 years these stocks have the potential to double or even triple, while also dramatically enhancing their dividends. To generate outsized long-term returns you have to be willing to except short-term volatility and often mark to market losses. We are not going to get too big in energy producers because predicting commodity prices can be extremely difficult, particularly with the weakness in China. With that said we will keep a close eye on developments in the sector as selective opportunities will likely have incredibly strong returns for long-term oriented investors.
- Lastly, our concentrated portfolios allow us to focus on only the best opportunities that we can find. Companies like AGO don’t rely one iota on Chinese growth and its success as an investment will not be impacted by these short-term issues. Between 2000 and 2003, the Nasdaq dropped 75% from peak to trough. Many investors that piled into areas such as energy, housing, financials etc. posted fabulous returns during that period. This is a big reason that index funds bought at bad prices are likely to hurt many market participants that have joined that craze. When stocks are very cheap as an asset class, ETFs or mutual funds can make sense. While on TV, guys like Warren Buffett advocate for index funds, it is important to note that during his whole career he has never used them. This is because he knows that a prudent value investing approach is the superior way to invest but most people don’t have the time, patience, or discipline to execute it so recommending index funds for the general public can make sense. We will take advantage of this volatility and I believe the stage is set for strong outperformance as things play out. Time will tell and the great thing about this business is that we will find out for sure if we were right or wrong. We just need to be patient and see things through.