Geoff Gannon February 27, 2020

How Can Long-Term Value Investors Make the Most of This Week’s Short-Term Volatility?

Andrew and I just did a podcast about volatility. And, of course, when we say “volatility” I want to remind everyone that’s a codeword for “downside volatility”. Nobody minds upside volatility. There are basically two topics worth discussing when it comes to volatility and how you as an investor should behave. One is how to “handle” volatility – psychologically and such. The other is how to take advantage of volatility. If we go back and think about Ben Graham’s Mr. Market metaphor – it’s really all about volatility. Mr. Market’s existence really only benefits you if he is giving you wildly different quotes over some period of time. Sure, it doesn’t have to be day-to-day. But, if all stocks are rising by similar, gradual amounts over time – a public quote for your shares doesn’t give you much benefit in selling one thing and buying another. You need either relative moves among stocks – where you own an airline stock down a lot and a healthcare stock that’s rising in price – or you need very different quotes on the same stock depending on the day. There’s an old article (but a good one) up on the Focused Compounding site that talks about the concept of “value trading”. This is where a value investor owns maybe 5 stocks he really likes for the long-run. But, in any given year – one of these stocks will rise a lot closer to his estimate of intrinsic value while others will fall. For example, Warren Buffett’s stock portfolio at Berkshire Hathaway rose something like 40% last year. Obviously, the underlying business’s earnings power barely budged. Maybe it rose 5%. Maybe not even that. You’ll notice that Berkshire’s wholly owned businesses didn’t have any increase in their operating earnings. I think Berkshire’s partially owned businesses did a lot better. But, they didn’t do 40% better. So, in a year like that, you have some of your stocks rising a lot closer to your estimate of intrinsic value while others don’t. The obvious example at Berkshire of a stock that rose far faster than its intrinsic value last year would be Apple (AAPL).

Now, Buffett can’t “value trade”. Or, at least, he shouldn’t try to. Buffett has to put more and more cash to work each month, quarter, and year. If he sells any of his Apple stock – he has to find somewhere else to put it. And, because he owns such big chunks of the public companies he’s in – that’s a problem. This is a problem even for much smaller investors. Andrew and I run a fund where we have allocations to specific stocks that are in part based on how much of the fund we’d like in those stocks – but, also partially based on simply how much of those stocks we can own. This issue mostly crops up when a fund has more assets under management than the market cap – or, at least, the “float” – of the company it is trying to buy shares in. Well, as an individual investor, you’ll almost never have that problem. You can nimbly move out of Apple and into something else. In fact, you can sell your whole Apple position in a single day. And – you can do so without moving that stock’s price.

This is the advantage Mr. Market gives you. Some stocks are liquid enough – and some investors have portfolios small enough – that you can reduce your position in one business you like a lot and increase your position in another business you like just as much but that is trading at a much lower price.

The “like just as much” is the hard part. I can’t tell you how many times I’ve owned two stocks where one is up 20-50% over a fairly short period of time and another is down 20-50% over a fairly short period of time – but, I like the BUSINESS of the stock that’s up 20-50% A LOT more than the BUSINESS of the stock that’s down 20-50%. That’s usually the problem with specific stock rallies and routs. Very often, a specific stock surges ahead when it has a lot of good things going on in the underlying business. And, very often, a specific stock collapses in price when it has a lot of bad things going on in the underlying business. There are sometimes opportunities to “value trade” among the stocks in your portfolio. But, I’ve been a lot more skeptical about this approach in practice than I am in theory. I know a lot of investors who trade around their positions. And, for lower quality businesses, it may work well. But, I also know some investors who were smart enough to find a good, unloved business early on and patient enough to hold it for the long-term – but, they made the mistake of trimming the position from time-to-time whenever it seemed to be “getting ahead of itself”. They recycled the “profits” from that great business where the stock was getting ahead of itself into a lesser business where the stock was getting cheaper and cheaper. At least among the very small number of value investors I know well enough to actually talk about when they did this and how it worked out – none has been able to go back into their brokerage statements and prove to their satisfaction that all this extra activity really added value. I should point out – these aren’t investors who underperformed the market. They just underperformed what they might have done had they never tried to trade out of higher priced shares of businesses they liked better and into lower priced shares of businesses they liked a little less. I did an article over at Focused Compounding – even older than that “value trading” article I mentioned – about the sell decisions I made over the years. In my experience, when I’ve been right about a business – I’ve been wrong to sell that stock when it seemed to be getting pricey and rotate into something else.

Having said that, there have been times where a stock I bought had a good 5-10 year run as a business, but then obviously deteriorated after that. You could say I was right about the business in the – what do you call 5-10 years, the medium term? – and wrong about the business in the long-term. Or, you could say I just didn’t look out far enough when I analyzed the business in the first place. But, I think that’s different. I think there are many good reasons to sell a stock you originally liked. This could include the stock getting ridiculously overpriced. But, the best reason is that the business has deteriorated from what you originally expected. Basically, looking forward to the NEXT 10 years, the business doesn’t look so good anymore.

Maybe Buffett should have sold his shares of stocks like Coke and Gillette in the 1990s. Coke got truly and ridiculously overpriced. The business eventually became less attractive too. But, what if Coke had only gotten half as overpriced? Should he have sold it then?

That is usually what we are talking about with “value trading”. Unfortunately, it’s rarely as easy as having two businesses you like just as much where one drops from a P/E of 15 to 10 while you own it and the other rises from a P/E of 15 to 25 while you own it. In that case, I’m all for selling the stock with the P/E of 25 to buy the one with the P/E of 10.

What tends to actually happen is what happened with me when I started managing money for others. Of all the stocks we bought in that year, the one I felt most “comfortable” with as a business – that is, the one I liked the most if we put aside the very important issue of price – was Computer Services (CSVI). Whereas the two stocks I felt least comfortable with as businesses – mostly because the rationale for their purchase depended mostly on their market values versus their asset values, these were “asset plays” – were Keweenaw Land Association (KEWL) and Maui Land & Pineapple (MLP). Well, guess what happened over the next year to year and a half with KEWL, MLP, and CSVI. Computer Services rose in price while KEWL and MLP either stayed flat at times or actually fell quite a lot. This could’ve been a situation you could value trade. And perhaps it’ll prove to be that in the very long-run I’d have been better off selling some of CSVI and buying some of KEWL and MLP. But, that’s not what I did. Because, unfortunately, the quality of those assets – MLP, KEWL, and CSVI as actual businesses – wasn’t very comparable.

Volatility among all stocks in the market – the kind of volatility you’ll get on days investors are worried about the new virus – works differently. It’s possible that some countries, some industries, and some stocks might fall more in price than others.

So, accounts I manage own a stock tied to airlines and own NACCO (NC). NACCO mines coal for utilities and earns a steady, contractual kind of profit per ton supplied. I’m simplifying a bit. But, that’s pretty close to the reality. Meanwhile, a stock tied to airlines depends a lot on how full those airplanes are flying. Well, obviously airplanes are going to be flying a lot less full in the days, weeks, months, and maybe years ahead than investors imagined throughout 2019. So, it’s likely that any stock tied to airlines will fall more than any stock tied to demand for a fuel used in the production of power by utilities. No matter what happens with this new virus – demand for electricity in much of the middle part of the U.S. (which is what NACCO’s production is tied to) isn’t going to vary much. However, the value of one airline seat is going to vary a lot. The supply of airlines seats can’t be contracted very quickly in a very big way even if all the major airlines around the world know that’s the right thing to do. So, you can quickly end up with a severe imbalance between supply and demand. This can be devastating to operators of cruise ships, airplanes, theme parks, casinos, and hotels. They all have high fixed costs. And the marginal cash contribution from one more room, one more airline ticket, etc. bought or not bought is huge. In some cases, these companies will be losing business that would’ve had close to a 100% cash contribution margin. Flights (and nights) that would’ve been profitable will now be burning cash. Those industries could be hit hardest. And the market would anticipate this by causing their stocks to plummet.

Of course, certain stocks in those industries should fall by even more than others. Which stock? The weakest financially. If you assume that whatever impact there is from this new virus is severe but temporary, the stocks you’d expect to be most imperiled would be anything that combines financial leverage with operational leverage and depends on trade or travel. Heavily indebted airlines, heavily indebted cargo ship owners, heavily indebted miners of globally traded commodities, etc. might all drop a lot in price for what turns out to be a short amount of time.

If you own some of these stocks already – or, you’ve researched them but passed till now, these are the stocks you might get the chance to “value trade” into.

For example, Quan and I wrote a report on Carnival (CCL) that is up on the Focused Compounding website (premium members can find it in the stocks A-Z section under “C” for Carnival). That stock has done poorly since we wrote it up. But, it’s done especially poorly since concerns about the virus have been at the front of investor’s minds. There will obviously be much, much worse headlines for cruise ship operators yet to come. It’s hard to imagine an industry more at risk than cruise ships. The last cruise I was on put me in close proximity to 6,000+ people from all over the world for a full 7 days. That’s not something anyone is going to want to do if they’re concerned about a highly contagious disease.

But, 10 years from now – there will be companies earning a lot of money from cruises. If some companies in the industry are financially weak – it’s possible there will be fewer players in the industry. So, it would make sense to start researching which companies in the industry have the best financial strength, which ones might be able to survive the longest with the lowest numbers of passengers, and at what prices you’d want to own the cruise ship operators most likely to last the longest.

There are probably half a dozen industries out there full of stocks that could be hit almost as hard as the cruise ship companies. Now might be a good time to study up on them and focus in on the companies who are likeliest to survive the longest. You might eventually get the opportunity to scoop their shares up at a price you couldn’t imagine back in 2019.