2016 has officially been the worst start to a year in history for equity markets. Globally stocks are trading at levels they haven’t seen since 2013 or earlier depending on the market, and many markets are officially in bear markets defined by 20% declines. Over the last 7 years of this bull market we have a had very few corrections. This was an uncommon characteristic of this bull market as over history corrections occur every year or two at least. Over the last year, we have seen volatility begin to increase considerably. This has caused many market participants that don’t focus on fundamentals but instead are invested in ETFs and mutual funds to panic, which is understandable because they have no concept of what they own. Even before the 2016 decline, in 2015 70% of the stocks in the Russell 2000 are down 20% from their 52-week highs. That was also true of 49% of the S&P 500 and 68% of the Nasdaq. After this start to 2016, these numbers are clearly dramatically worse. Price have gotten much cheaper and interest rates are still very low.
In addition, with commodities in a depression, many commodity-reliant countries such as Saudi Arabia, Qatar, Kuwait etc. are facing acute fiscal deficits. These companies have built up hundreds of billions of dollars of cash reserves but they are still raising liquidity to deal with the deficits. This means that they are being forced to sell stocks and bonds, further pressuring prices. While this selloff has been extreme and fear is pervasive, ultimately it is normal in the historical context. The key is maintaining a disciplined and long-term approach. If your goal is attaining portfolio growth of 8-12% per annum over the long-term, you must expect to deal with volatility from time to time. By far and away the worst thing to do is to panic and give in to market fears. I’ve used the analogy before, but I think it is very appropriate. When you invest, you know 100% that you will experience periods of extreme volatility. If when that volatility occurs, your inclination is to panic, it is akin to jumping out of a plane when your first encounter turbulence despite knowing 100% that flying entails the periodic episode of turbulence. It is natural to feel that stress and fear, which is why I don’t recommend watching things on a daily basis because business fundamentals change over a much longer period of time, so evaluating performance on a day to day basis is asinine and non-productive.
All of our major positions are in the best financial condition they have been in in many decades. The big banks have gotten beat up with the overall market, but earnings have beaten expectations. All of the ones we own in size trade at very large discounts to a conservative estimate of liquidation value, despite the fact that they are growing earnings and growing tangible book value. All trade below 10 times earnings. In March, they will likely announce sizeable stock buybacks and dividend raises. The risk-adjusted return opportunities haven’t been this good since at least 2011 and perhaps 2009. Once the panic subsides and the sun continues to rise, these stocks are likely to go materially higher. Energy loans are only 2% on average of their portfolios and keep In mind that much of this is investment grade and asset backed. Even in a bankruptcy, the banks don’t necessarily lose money because their loans are so high up on the capital structure. Our largest position AGO has no real exposure to energy or China for that matter. Each quarter the company gets in better shape and it is working out the Puerto Rico situation which will be resolved this year. This will help us a great deal.
On put options that we have been exercised on, we have begun selling covered calls aggressively at prices above the strike prices of the puts when we got exercised. This generates considerable income, reduces risk, and still provides a path for material upside potential. We have quite a few stocks with dividends of 4 or 5% and by selling calls 15-20% higher than current prices, we were able to basically double that yield while maintaining ample upside. It is important to keep in mind that since the year started, we have not gotten a material relief rally. Eventually it will come and now that most of our options have expired and we either collected the profit, or are now long stocks, we will benefit much more materially from and big upside move and stocks are oversold dramatically. While the fear is obvious, it is important to note that this actually augurs well for equity prices as many people have already sold so when news gets a bit better, they will come back in but at that point many of these stocks will be way higher. Buying high and selling low is a surefire way to invest unsuccessfully. Things can change in an instant just like they have over the last 3 weeks. That is inherently what markets do. The key is to maintain a focus on fundamentals and ignore short-term mark to market fluctuations. I don’t see any permanent losses of capital developing from the recent panic in stocks in the companies that we own. Opportunities are the best I’ve seen since 2009. I’m investing more as prices drop and I’m very pleased to see many clients following my recommendation of adding as I believe that we are poised to really benefit from the ultimate recovery. As always, if you have any questions please don’t hesitate to give me a call at 805-886-8140. Thank you very much and I look forward to speaking with you soon.