Is the Market Correction a Buying Opportunity?

 

Last year, and in particular the last three months of 2018, were a difficult period for the stock market. There was nowhere to hide.

The S&P/TSX Total Return Index was off 8.9% in 2018, while the S&P500 Total Return Index expressed in $US was down over 4%. To keep things in perspective, the FTSE All-World index, ex US, was off 17.9% and the Stoxx Europe 600 was down more than 15%, and the Chinese market, as exemplified by the Shanghai Stock Exchange Composite Index was down 26%. 2018 was not a good year for stocks anywhere.

The US market dropped almost 14% in the final quarter of 2018, one of the worst performing quarters in almost 80 years. Let’s see what happened after previous large negative quarters in the market. The chart shows the worst three-month periods over the last 78 years with one, three and five-year returns following the end of the negative quarter.

In every case, the following few years were excellent for equities. We are not predicting, but the weight of history is definitely on the side of up versus down for the next few years.

             S&P500 since 1940                                         Forward Performance

Quarter ending

Performance

1 year

3 years

5 years

Sept 1974

-25.2%

38.1%

72.7%

117.5%

Dec 1987

-22.6%

16.8%

48.8%

109.0%

Dec 2008

-21.9%

26.5%

48.6%

128.2%

June 1962

-20.6%

31.2%

69.2%

94.8%

Sept 1946

-18.0%

6.5%

24.5%

115.4%

June 1970

-18.0%

41.9%

57.4%

56.3%

Sept 2002

-17.3%

0.3%

27.0%

66.3%

Average

-20.5%

23.0%

49.7%

98.2%

 

In today’s market environment we are finding many bargains, the types of opportunities that are normally associated with market bottoms. High quality, well capitalized companies with clear plans to increase in value over the coming few years that are the focus of our strategy look very cheap to us.

This past year was frustrating, as the businesses we own outperformed their share prices. The stock market looks more attractive to us than it usually does. The divergence among individual stocks has allowed us to structure a portfolio that we believe is more undervalued relative to the market than usual.

The companies in our portfolio are higher quality, better businesses, and sell at lower prices than the market average. These companies generate more revenue than the average public company, earn more profits, have much higher returns on capital, pay generous dividends, yet they sell at prices that are approximately two-thirds of the overall market price. We like cheap stocks; our stocks are cheap and high quality.

 

Kingwest Equities

60% TSX. 40% S&P500

Investment

$100

$100

Revenue

$84

$51

Net Income

$7.73

$6.95

Price / Earnings

12.9x

14.4x

Dividend Yield

2.8%

3.0%

Book Value per share

$45

$42

Return on Equity (ROE)

17%

12%

 

The decline in stock prices in 2018, combined with higher corporate earnings, has reduced the multiple on 2019 consensus S&P estimates to 14.4 times earnings, about 15% below its historical average.

What about interest rates going up, isn’t that bad for share prices? It is true that bond yields have risen, and we think they will go higher. Nevertheless, yields are nowhere near a level that should have any significant negative impact on the market. The yield on the 10-year Canada bond is currently 1.96%; the comparable US 10-year Treasury note yields 2.69%. The average yield of these bonds over the past 40 years was 6%, and throughout that period, average price-earnings ratios were much higher.

Historically, stocks have been the best performing asset, and from this low level, we expect stocks to provide better than historical returns.

One area where we expect significant returns is our financial holdings. About 30% of the portfolio is invested in financial companies. In Canada, that includes three banks, Toronto Dominion, the Bank of Nova Scotia and a smaller Equitable Group; two insurance companies Manulife and Sun Life; Onex Corporation and TMX Group. In the US, our financials include Citigroup, JP Morgan Chase, Blackstone, KKR, Lazard, and Morgan Stanley. These stocks all have a dividend yield of 3% or better, with some over 8%, they all sell for eight to ten times 2019 consensus estimates, and they are repurchasing a lot of their own stock. Investors appear worried that financials will act as poorly in the next recession as they did in the last one. They fail to recognize that these companies all strengthened their business. Since 2008, these companies use much less leverage, and specifically in the case of the banks they have tightened lending and mortgage underwriting standards. In essence, they have become safer and more solid than at any point in the last two decades. In each case, they are selling at a large discount to the market and to what they are worth.

We are also making new investments that should add to our returns. In the US, we recently added AMC Entertainment, the largest movie exhibitor in the world. AMC operates over 10,000 screens in the US and Europe. The low share price reflects the below normal box office of 2017. This happens periodically. It is important to look through the short-term annoyances and focus on the positive long term trends. While studios sometimes deliver a few flops, they have a long history of producing content that compels moviegoers to go to the movies. Movies remain one of the lowest cost out-of-home entertainment options. 

AMC is renovating its theatres to make this experience even better. In addition, the company is building its business by expanding into new geographies. It is paying down debt and buying back stock, providing owners an increasing share of the improving cash flows. When the market begins to reflect these strengths, we are looking for the share price to double. 

 “The only function of economic forecasting is to make astrology look respectable.” – John Kenneth Galbraith

We have been hearing a lot in the press, and in particular the talking heads on business television, explaining the decline in the stock market over the past three months, and then following it up with a forecast of impending doom for the North American economy by so-called “experts”. Are these predictions of any value? We don’t think so. It was the same people who were saying the upswing would never end.

The history of economic forecasts has been miserable and presumably that is why economics is called the “dismal” science. Forecasts based on the behaviour of the stock market are no better. Nobel Laureate economist Paul Samuelson correctly observed: “The stock market has forecast nine of the last five recessions.”

There are actual records of economic forecasts, and the one thing they tell you is that they tell you nothing. That is not surprising. “It is difficult to make predictions, especially about the future” -Nobel Laureate physicist Niels Bohr. Nevertheless the “experts” never miss an opportunity to tell us with great authority what lies ahead.

The Economist magazine has kept a record of 100,000 forecasts of economic growth by banks and consultants for the past 20 years. The record shows that forecasts a few months out fare pretty well, but over any longer time frame, not so much. The farther analysts peered into the future, the less accurate they are. In fact, the data shows that once the forecast goes over a few months, you might as well presume the previous year’s result will repeat. The results were just as accurate.

Like the rest of us, these “professional forecasters”, are prone to two behavioural errors, “anchoring” —over-weighting the most recent occurrences while ignoring powerful longer term trends, and  “herding” —  keeping their predictions near to everyone else’s. They just follow the crowd.

Worst of all, the “experts” were completely useless at predicting turning points in the economy; the time when a correct forecast is the most valuable.

Some must have been better than others, you say, we just need to follow the good ones. Unfortunately, this is not so. Top performers rarely repeat, so knowing who has been better tells us a lot about the past, nothing about the future.

If a recession lurks beyond 2019, economists are unlikely to foresee it.

The conclusion is clear. Do not waste your time listening to predictions about the future, and certainly do not risk your financial future on the opining of “experts”. They are rarely right.

What to do? As we said, one of the biggest mistakes forecasters make is anchoring —  overreacting to the most recent information and ignoring longer term trends.

In the stock market, the longer term trend is powerful. The stock market goes up over time. Companies make more money, not every year, but over a cycle. Higher economic earnings translate into higher stock prices. Over the past 50 years, the return in the stock market has been very good – about 10% per year compounded.

So the smart strategy is not to place our faith in astrology, not to try to outsmart what you cannot outsmart, but to allow the sweep of history to be our friend. Invest when prices are down to take advantage of the natural tendency of people to overreact. If you are invested correctly, have the fortitude and patience to stay with it. Follow this precept, and you will be much better off emotionally, and much better off financially.

When business fundamentals outperform stock prices as they have in the past few months, we find stocks become more attractive and our investment process takes these metrics into account. We look to buy stocks when they are selling at about 60% of our estimate of value. When these stocks rise above 90% of our estimate of business value, we begin to sell them. At any point in time, our portfolio is a mix of stocks priced below our estimate of value.

Today, the Value Gap of our portfolios is larger than at any time since the depth of the financial crisis: Canada 48.3%; US 45.3%. This means that the portfolio could almost double over the next few years. Importantly, these wide gaps mean the portfolio does not have a lot of risk. There is significant safety in buying a company that is selling at half of its worth.

Our view is that the historic pattern will repeat and that higher prices are ahead. The companies we own are both cheap and high quality. Each company has an excellent reason why it will be much more valuable a couple of years from now. We happily remain patiently invested while this plays out.