4th Qtr Newsletter- Jan. 2020
For a moment, I want you to picture this: the year is 2009 and you are an investment fund manager getting ready to write your annual letter to investors. After a troublesome 2008, 2009 is shaping up to be slightly more encouraging, but profound challenges in the economy are still present and Dow Jones Industrial Average is sitting around 10,000. In your letter, imagine writing something along the lines of, “By 2019, we expect there will be $12 trillion of worldwide bond instruments yielding a negative rate to maturity. President Donald Trump will be facing impeachment and the Dow Jones Industrial Average will tick past 28,000.” I would be willing to bet you would have appeared foolish and that letter would have likely been the last of your career. But alas, that is where we stand today. So the question becomes, where will we be in 2029? Predicting the future is not only difficult, but I would argue it is nearly impossible.
So, rather than trying to predict the next ten years, let’s look back at 2019. After a rather uninspiring performance for equity markets in 2018, 2019 reversed course. Earlier in the year, the U.S. officially entered into its longest economic expansion, currently at 126 months and counting. At an approximate 2.3% annualized real GDP growth rate, it is also the slowest.
2019 was a year in which considerable anxiety was felt by some market participants due to:
- An inversion of the bond yield curve
- Negative interest rates overseas
- The US/China trade ‘war’
- Signs of slowing global growth
- Recession fears
- Concerns over corporate debt levels
- US manufacturing sector slump
Even with all the pessimism and negative investor sentiment, major U.S. stock market indices (Dow Jones, S&P 500, and Nasdaq) climbed to fresh all-time highs.
Although the market was up nearly 29%, it is important to put that return into context. The market has an annualized return since the end of 2017 of only 9.9%. Going back five years, it’s up 9.4% annualized. So, at first glance a 28%+ return this year may make the market look frothy, but when these returns are put into context, a different story is also discernible.
This isn’t to say the market doesn’t go down. Market pullbacks occur more often than many people may realize. The chart below plots the data in graphical form. In 22 of the last 40 calendar years, the S&P 500 has seen a double-digit pullback within the year. However, in the years when the S&P 500 did experience a double-digit decline, 14 of those 22 times – or 63.6% of the time – the market ended with a positive return. A key takeaway for investors here is that long-term success in equity investing involves being patient and not worrying every time the market falls.
Monarch’s Investment Approach
As investors it is our responsibility to make the best investment decisions we can in the absence of a clear outlook for the future. This means taking careful consideration of what could go poorly in the periods ahead and recognizing the future as quite unknowable. Successful investing requires behavior outside the norm. If you want differentiated results, you have to behave differently. The ability to understand that the price the market puts on a stock can be completely different than the value of the business that is behind that stock is a difficult, yet critical concept to grasp. Monarch spends considerable time assessing what companies we own and the reasons for owning these securities.
If a friend asked you this question: Which would you rather have, $1 million today or the outcome of doubling a penny every day for 30 days? Which would you choose? What if your friend increased the amount to $2 million today? Then which option would you select? The ability and rate at which capital is compounded is what makes the difference between a so-so investment and a great investment. What is the value of compounding in the above example, you may wonder? Doubling a penny for 30 days results in over $10.7 million, quite a bit more than $1 or $2 million. (Don’t believe it? The math to prove it is at the end of the newsletter.)
The core idea expressed by the illustration above is to buy good companies and let compounding take care of the rest. The trick is determining what makes a good business and then not overpaying. Even if an investor buys the most outstanding business, but overpays for it, he or she may end up with a mediocre result. An additional point is this compounding effect only works if the business continues to efficiently allocate the capital under its control to profitable investments – the company must be able to grow and sustain its high returns for long periods of time. This requires the business to have a durable competitive advantage (sometimes referred to as a moat) and even then, it’s not always a given that the company can maintain its returns. An investor must analyze both the quantitative as well as the qualitative aspects of the business and make an informed judgement on what the future will likely entail.
If we plan to own shares in a company for multiple years, our investment success will have far more to do with the economics of the underlying business than it will have to do with the company’s last stock price quote. If we own businesses that are growing, earning more money, and not diluting shareholders, the market will eventually push their stock prices higher. Although, it may not be on our timing. As the father of value investing, Benjamin Graham, once explained: “In the short run, the stock market is like a voting machine – tallying up which firms are popular and unpopular. In the long run, though, the market is like a weighing machine – assessing the substance of a company.” Said another way, short-term prices are often driven by sentiment, but long-term trends are driven by the true financial results of companies.
In order to determine the quality of the companies Monarch holds, we use a variety of measures. The table below shows a subset of metrics we use to assess our core portfolio holdings. The table also shows the comparison of the core stocks to the S&P 500 index.
Examining the trend of our core stocks over time, you can see not much has really changed. Gross Margins have consistently averaged above 50%, meaning that for every $1 of sales, $0.50 is retained by the company, which can then be used to pay other costs. This is above the 44.2% average for a typical company in the S&P 500 index. In addition, the operating margins of our core stocks are also above that of the average company included in the S&P 500 index.
Net Debt/EBITDA is another metric we use when evaluating a company’s overall leverage and its perceived ability to pay off its debts. Net debt is the total debt after subtracting out the cash and cash equivalents on the balance sheet. EBITDA is earnings before interest, taxes, depreciation, and amortization. By calculating a firm’s net debt/EBITDA, it allows an investor to see a more precise measure of corporate performance before the influence of accounting and financial deductions. Ordinarily, the lower this number is the better. Looking at the table, you can see this has been trending upwards, but is still low relative to the average company in the S&P 500 index. Why has this number been trending upwards? A primary reason is low interest rates over the past decade have allowed companies to borrow at cheap rates and use the money to buy back stock, acquire other businesses, and refinance old debt.
The last figure (FCF Yield) can be used to gauge how expensive a company currently is compared to the amount of free cash flow it produces. The free cash flow yield is similar to that of an earnings yield, but instead of earnings per share for the numerator, the free cash flow yield uses the amount of cash generated from operations subtracted by the amount of cash used for capital expenditures. As a general rule, a higher free cash flow yield is generally preferred as this means the company is generating more cash than is used to run and reinvest to grow the business. Based on this valuation metric, our core stocks are slightly less expensive than the typical company in the S&P 500 index. Another interesting item to note is the decrease in FCF yield from 2018 to now; this is due to the stock market’s 28% advance this year. With that being said, our stocks are still throwing off a 4.8% free cash flow yield, which is higher than the ~1.9% yield an investor would get from a 10-year U.S. treasury.
A Valuable Lesson
To conclude, I want to address a question that may come up from time to time, especially over the last few years: “The stock market has gone up so much. Should I cash out now?” As previously stated, the future is unknown. Yet various investors speculate about when is the correct time to get into/out of the stock market. Imagine selling out of your stocks completely at the end of 2018 because you were worried about a recession occurring and sending the stock market into a freefall. You would have missed out on the 28%+ up move this year, and would have likely had to pay capital gains tax.
Included below is a chart of the S&P 500 index.
The interesting thing to note here is that we did not include dates on the chart. This was done on purpose so the assumption would be made that you were looking at a current chart of the S&P 500. On the contrary, this is a chart of the S&P 500 from January 1950 to the end of January 1961. In this time frame, the market increased in value by over 3.5x. In the early 1960s jobs were plentiful and living standards were rapidly growing. At that time the price/earnings ratio of the S&P 500 was ~20x. Imagine not investing because you thought “the market has gone up too much.” If that was so, you would have missed out on the ~16% gain over the remaining 11 months of 1961 and a ~50% gain over the following 5 years (not to mention the gain from 1961 to today, over 5,000%).
Again, this is not to say the market doesn’t go down. There have been multiple drops in the market, but having the ability to not only get out of the market at the correct time, but also re-enter the market is a skill we do not pretend to possess. Trying to sit out a market crash can often cause more harm than good. However, this does not mean it is irresponsible to pare back equity exposure at what are determined to be opportune times, but rather, the principal idea is to not let human psychology (i.e. emotions and fear) cause you to make an irrational decision. Putnam Investments calculated that missing just the U.S. market’s 10 best days in the 15 years through 2018 would have cut your ending portfolio in half. Missing the 20 best days would have left you with two-thirds less. Peter Lynch said it best: “Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves.” Below is a chart of the S&P 500 index during the current bull market.
Look slightly familiar? The market has increased in value by roughly 3.6x since January 2009, and the forward estimate P/E ratio for the S&P 500 is ~18-19x. (Those numbers sound awfully close to a couple mentioned earlier.) But why would any rational person invest in stocks at a time like this, after they have increased so much in value? Obviously, times are different now than they were 60 years ago, but that is not the point. Perhaps the economy will enter into a downturn in the next year, or perhaps, the market will rally 10-20%. Either of these scenarios is a possibility, and a bear market will come eventually. Over the long term, though, owning companies that are able to grow and invest the cash they earn at high rates of return is likely to be a rewarding experience.
In closing, although we will not provide you with a ten year prediction on the market, we here at Monarch wish you a Happy New Year and thank you for your friendship.
— Written by Adam Beard