2018 Annual Letter excerpt - Contextualizing recent market volatility

2/15/2019

III. 2018 Annual Letter excerpt - Contextualizing recent market volatility:

Today Long Game Financial (“LGF”) is one-and-a-half years old and 2018 marked its first full year of operation. These are important successes, to be sure, but one can never cheer too loudly when it comes to investing because the “game” never concludes. There is always more to learn whether stock prices are high or low, rising or falling…and, as we all know, stock prices happened to decline considerably at the end of last year: the fourth quarter of 2018 was the worst returning quarter for the S&P 500 since 2011. As context, here are the S&P 500’s quarterly returns since 2009 (via Morningstar):

During large market declines it is natural to ask “why”—but unfortunately it is often difficult to attribute the change in any stock’s price to even a combination of factors with precision. This is, in part, due to “non-fundamental” buyers and sellers who transact for reasons unrelated to a stock’s intrinsic value (the present value of future cash flows across some hypothetical distribution of outcomes). This type of market participant tends to be more active in times of market stress, but they are ever-present…and in truth, most market participants—though perhaps not most dollars—are structurally non-fundamental because there are more savers than well-trained business analysts.

Put differently, at any given time a stock price can change “rightly” because of business developments that indeed affect our estimated value distribution for a stock (e.g., a business risk coming to pass), “wrongly” for reasons unrelated to a company’s actual prospects (e.g., liquidating ETF holders pressuring an illiquid stock), or, most likely, some combination of both. Every trading day, a chaotic web of motivations that no one can fully comprehend pushes share prices up and down, “rightly” or “wrongly”—and it all can be simultaneously rational: due to different goals and holding periods, or lack thereof, a rational transaction for one market participant can be irrational for another and vice versa.

Fortunately, we need not scrutinize others’ motivations to succeed. At LGF our strategy is to attempt to identify mismatches between today’s prices and our estimates of value, stock-by-stock, and then update our estimates as we learn relevant incremental information (e.g., new data relevant to future sales, profits, capital, and valuation). While we do care about macroeconomic forces that affect stock indices, we believe that understanding specific assets is more profitable in the long-term than dissecting the financial media’s macro worry du jour.

In fact, we suggest to our clients that the financial media’s worry du jour is frequently noise that is best ignored. Without exception, there are always legitimate-sounding worries about the economy and the stock market and the media always has an incentive to amplify discomfort. But particularly in today’s world of viral headlines and social media, repetition and perceived urgency are not the same thing as importance. What is important but far less urgent with respect to investing is the following unexciting statement, which should be printed underneath financial headlines as a public service: “stocks tend to generate a positive return over moderate to longer periods of time, but with difficult to anticipate price volatility.”

Popular worry persistently compels investors to transact against their long-term interest, as illustrated by the two graphs below. The first, sent by a friend of LGF, shows that the market has gone up more than 100-fold since 1950—though not in a straight line, of course—despite numerous human calamities that undoubtedly inspired selling along the way. The second shows that investors tend to sell stocks when trailing one-year returns are negative and buy stocks when trailing one-year returns are positive, even though lower prices often portend higher future returns. When worries rise and stock prices fall, sub-optimal long-term financial decision-making generally spikes.

(a) The US stock market since 1950, annotated by negative events (author unknown, note the graph’s log scale):

(b) Retail investors tend to sell low and buy high (source: the ICI’s 2016 Factbook):

We believe that one financial and emotional health-enhancing solution to this trap is to anchor on truths that are arguably durable over time rather than recent events or whatever else happens to be fashionable to discuss. Examples of LGF’s own durable truths with respect to the market include (1) the Four-Step Pattern, (2) our CAM investing framework, and (3) “stocks tend to generate a positive return over moderate to longer periods of time, but with difficult to anticipate price volatility.” (Related to this notion of guarding against biases, by the way, we recently read and thoroughly recommend the book Factfulness by Hans Rosling, the late Swedish medical doctor and public health professor.)

With respect to our Four-Step Pattern, CAM, and long-term stock market performance, we also note that stocks of well-positioned, growing companies can have an exceptional ability to power through over time, even if purchased at seemingly high prices (not that we seek to buy high). For example, Wharton Professor Jeremy Siegel calculated in 1998 that a portfolio of the infamous “Nifty Fifty” growth stocks purchased at their peak in the early seventies would have “nearly matched the S&P 500 over the next 26 years.” Although pundits will likely always associate the Nifty Fifty with market excess, Siegel showed that “market excess” over one timeframe may not appear so excessive over another.

Warren Buffett’s 1989 dictum that “time is the friend of the wonderful business, the enemy of the mediocre” dovetails with Siegel. Buffett’s point is that “wonderful businesses” grow in value over time and mediocre businesses do not—and a corollary of this is that a company that appears expensively-valued today may later prove to have been a downright bargain after future earnings growth. As an extreme hypothetical, suppose that Microsoft had purchased Google for $19.1 billion in 1999—or 1,000x Google’s actual year 2000 revenues of $19.1 million. At that time we would have labeled Microsoft the dunce of the millennium for paying 1,000x…but today, with the benefit of hindsight, we would laud Microsoft given Google’s dominant global businesses and >$750 billion market capitalization. Occasionally time reveals the actual dunce to have been popular opinion, convention, or an unthinking reliance on statistics (which are important but backward-looking) and the risk of popular misjudgment often increases when it comes to novel phenomena.

In some ways this hypothetical is actually less extreme than reality: in 2002 Yahoo! reportedly balked at the opportunity to purchase Google for not $19.1 billion but $5 billion, which must have seemed like too much for Google at the time but would not remain so for long. Even post-IPO Google stock bought at its December 2007 high—prior to the financial crisis—would have outperformed the S&P 500 over nearly any holding period, although it would also take Google’s share price nearly five years to exceed its December 2007 highs. Google demonstrates that with enough time, the increasing profits of a “wonderful business” can offset even major quotational loss caused by EPS multiple contraction. Over an investing lifetime, durable EPS growth truly can increase return and decrease risk; the difficult part, of course, is predicting durable EPS growth, not overpaying for it, and assigning portfolio weightings appropriately.

With this contextualization as preamble, in light of last quarter’s market decline we would like to frame our view of today’s macroeconomic environment for clients and specifically address four factors commonly cited as contributing to recent stock price volatility: (1) macroeconomic worry related to China, (2) weaker housing sentiment, due in part to strong home prices and a since-diminished rise in long-term interest rates during the second half of 2018, (3) December 2018 concerns that the Federal Reserve might raise short-term rates too much in 2019, depressing the economy, and (4) a self-reinforcing liquidation of stocks by institutional and retail investors.

As we will discuss, we do think it makes sense to be uneasy about China’s pace of economic growth but we are less concerned about (2), (3), and (4)—factors we regard as real but ephemeral. This means that LGF will continue to invest in US assets based on their individual merits and also minimize ownership of China-exposed assets. Although LGF weights company-specific considerations above others, macro does play a role in our investing process because we always consider whether the companies we own might currently be benefiting from, or hindered by, potential macroeconomic excesses that may mean-revert. US housing was an area of potential macroeconomic excess in the mid-2000s, for example, and we believe that China’s economic model qualifies today.