After an abysmal first quarter, stocks recovered so quickly that the 2nd quarter was one of the best quarters in history. Hopefully one lesson learned is the value of being in the market. The graph below, of the S&P 500, shows why we want to be long-term investors. There have been numerous 10-20% corrections in the last 10 years, in addition to the -35% March bear market. We’ve witnessed a lot of good and bad news alike over that time.
The second graph shows a composite of the Core stocks and the fundamentals we think are important for long-term investing, for the last 10 years. The top line (blue) is where it all begins: operating cash flow. Keep in mind what we have always told you—think like you own a piece of the company, and not a piece of paper. Ask any business owner how important is cash flow.
From cash flow, we subtract capital expenditures (shown by the red line) to get free cash flow (the green line). Capital expenditures are items such as a new roof, new trucks, technology, etc. A lot of spending by companies is to keep the doors open, although some is discretionary, to enable them to grow. Free cash flow are the funds management has to pay dividends, make acquisitions, pay down debt, and purchase their own stock. You will notice while capital expenditures increased from $2 to $4 per share, cash flow increased from $10 to $18, so free cash flow increased from $8 to $14.
The market trades on emotion in the short-term. When it looks like a promising drug to fight the coronavirus is coming, the market gets excited and jumps up. The next day, rumor has it a second wave of the pandemic is a probability and the bottom falls out. The best advice we can give you is to ignore the noise of the day-to-day market and focus on the long-term.
We are asked the question, “Did you see what happened today?” Our response could be: “Did you know 25 out of 26 of the Core stocks increased their dividends in the last 12 months?” We want to own companies that pay a good dividend and still have some cash left to purchase some of their own stock. The more shares they buy back, the larger our share of the company becomes.
The wall of worry the market climbs seems especially steep at the present time, with perhaps some barbed wire on top. Remember it is always darkest before dawn. I suspect there is still some bouncing around ahead of us, but I also suspect we will get through it, and our companies will continue to increase their cash flow and dividends.
The 10-year graph of the S&P 500 on the first page is pretty impressive, but keep in mind this was a period of exceptionally low interest rates, giving us a little wind at our backs. How will the market deal with rising interest rates? What kind of multiple (P/E ratio) will investors be willing to pay on corona-depressed earnings? We see headlines about a small-cap stock doubling in value overnight and wonder why we did not have some of that in our portfolio. The graph on the next page shows the percent of stocks in the Russell 2000, an index composed of 2,000 smaller companies, with negative earnings…in other words, they are not profitable. As you will see, 42% of these companies lose money and I would guess this number will go higher. As you look at this chart, which tracks this measure over the last 30 years, think back to the graph about the Core stocks’ nice, gradually upwardly-sloping cash flow.
The pandemic is a very serious worldwide tragedy and no one knows the outcome. Many companies have taken advantage of low interest rates to issue bonds, to have more access to cash or to go a step further and buy their own shares. Having a strong balance sheet with solid cash flow is especially important during downturns in the economy. We will continue to monitor our companies as they manage through this economic downturn.
–Written by Dave Meyer