Recessions Aren’t the End of the World

Dear Investors,

Today’s nonfarm payrolls number blew the top off expectations with a seasonally adjusted 312,000 job gains in December. After upward revisions to October and November, the U.S. added 2.64MM net payrolls in 2018. This was the best year for job growth since 2015. That is a very different narrative than the one market pundits have been spinning saying that a recession is imminent.

On Thursday, Apple’s stock got pummeled because of a major revenue miss in China. I don’t think it is shocking that consumers in China or anywhere else, don’t want to just keep spending $1,000 for a phone every upgrade cycle anymore when there aren’t major changes in the technology. I only really bring this up because Apple is by far and away the largest position in Warren Buffet’s Berkshire Hathaway portfolio, and the stock is now down close to 40% in just a few months. That speaks to the severity of this downturn leading into Friday’s great jobs number.

In addition, on Friday, The Fed chairman Jerome Powell signaled more flexibility on the direction of interest rates moving forward. It would be very beneficial to the economy and the market if rate hikes were paused, at least until inflation becomes more of an issue. Economists are continuously thinking we are close to full employment, but the stronger economy has been drawing more people to the labor force. Wages are growing at a more rapid pace too, which is much needed for Main Street. To be clear, markets are forward looking so I don’t believe any one piece of data is overly important, but on Wall Street narratives shift with the winds.

I had a client ask me what we would when there is a recession, which I think is a great question. All our investments are made with the premise that we could very well have to hold them through a weaker economic environment and/or recession. This means that we demand a margin of safety big enough between our purchase price and intrinsic value to protect us in these negative scenarios. I’ll give you an example of what I mean below.

Credit Suisse put out a great analysis on the big U.S. banks in relation to how they would be impacted by a reasonably significant recession. Remember that they have double the capital and double the liquidity and they are no longer in many of the troublesome businesses that caused most of the losses during the Financial Crisis. As an example, I’ll focus on Citigroup. Citigroup’s base case earnings per share in 2020 is $8.85. So, at a recent price of $52.60, Citigroup is trading at less than 6 times forward earnings, which is insane. That forward earnings yield is 16.67%, if they were to pay out 100% of earnings as a cash dividend.

Credit Suisse estimates that even if we were to endure a substantial recession, earnings per share would only drop to about $6.16 per share. That means that Citigroup is selling at just 8.53 times recessionary earnings. A recession is largely priced into many of these companies and it is very likely the market has overshot. Surely, things can always get worse and devolve into a situation where these companies earn less than these estimates, but it would take a depression in my estimation for them to actually start losing money in a year, which is very different than how it was before. Think about it, if I told you that you could buy a globally important company that would generate $11,700 in earnings for every $100K that you invest during the next recession, I’d imagine you’d view that as being quite attractive. In good times, this company can earn $16-$18,000 per year on each $100,000 invested at current prices. These are the types of positions in our portfolios. As time goes by, the earnings and fundamental developments will play out and we should do quite well. Below are the inputs that led to these assumptions on Citigroup and the recession. Thank you very much and enjoy your weekend!