By focusing more on the profits that I expect my portfolio companies to generate and less on their stock prices, big stock market drops become much less intimidating.
The speed and magnitude of the market drop over the last few weeks has been stunning. As of yesterday’s market close, the small cap Russell 2000 was down 32.5% from the start of the year. The Russell 2000 value index was down even more at -36%. My own portfolio has dropped by 35%. Despite these cringe-worthy numbers, I remain fairly sanguine about the effect this might have on my household finances and it’s because of the way I think about my portfolio.
I was on vacation last week in Arizona with my family, soaking up the sunshine and taking far too many pictures of cactuses and sunsets. This was just before the coronavirus had really started to make its appearance in North America. If I had been travelling a week later, I probably would have cancelled the trip. As it was, though, the virus was still half a world away and all I had to worry about was the fact that the value of my portfolio seemed to be evaporating before my eyes.
I was on the spectacular Seven Waterfalls hike near Tucson, talking with my daughter about the state of the markets. It was a long hike, so we had plenty of time to chat. I was telling her about the mayhem in the markets and our rapidly dwindling portfolio. She was confused about why I seemed to be more excited than apprehensive. So naturally, I proceeded to bore her to tears over the next 20 minutes trying to explain why.
Warren Buffett uses a term he calls “look-through” earnings when he talks about his portfolio. He tries to get people to focus on the accumulated earnings of his portfolio companies and not their stock prices. I look at my own portfolio in the exact same way.
To me, the true value of my portfolio is the sum of the profits that I expect my various companies to make in the future. I am reliant on my portfolio for my income, so this is more than just a theoretical exercise. I base the amount I am willing to withdraw from the portfolio every year to cover living expenses, roughly speaking, on the earnings that my companies generate.
This is why I generally steer clear of companies like Amazon which, last I checked, was trading at something like 100 times earnings. Yes, Amazon is an incredible success story and is eating everyone else’s lunch. And yes, it is very likely that those earnings will continue to grow and eventually, the profits the company generates may justify the share price. But right now, the company is only making 1 cent on every $1 you invest in it. If my whole portfolio was in Amazon, I’d only feel comfortable taking out 1% of the portfolio every year as income. There would be no more family trips to Arizona if my portfolio was only generating 1% a year.
Instead, I’ll go with a company like Urban Outfitters which is perhaps less sexy than Amazon but by my estimation has a p:e of around 7.5 at the current price. That gives it an earnings yield of 13%. (The earnings yield of a stock is a reflection of how much profit the underlying company is generating as a percentage of it’s share price. If the company paid out all of its earnings as a dividend then the earnings yield would equal the dividend yield. The earnings yield is simply the inverse of the p/e.) Given the choice between Amazon with an earnings yield of 1% and Urban Outfitters with an earnings yield of 13%, I’ll take Urban Outfitters every time.
My assumption here is that the earnings a company generates will eventually find their way into my portfolio one way or another. It could be directly through a nice, fat dividend or indirectly through share buybacks or reinvestment in the company’s future growth. One way or another, though, I believe strongly that the future value of my portfolio is intimately tied to the future stream of profits that my portfolio companies can generate.
Which is why sudden market drops like the one we’ve had over the last few weeks don’t have me hitting the panic button. While the share prices of the companies in my portfolio may have dropped precipitously, the future earnings power of those companies remains more or less intact. My own companies are often a mish mash of somewhat off-the-wall opportunities. Some are high growth, some are low growth, some are no growth and some are losing money, so I don’t necessarily look at the current earnings of my own portfolio as much as I do the earnings yield of the stock market as a whole. I trust that my process leads me to buy companies that are cheaper than the overall market, so if I use the earnings yield of the broader market as my gauge of the potential earnings power of my own portfolio, I’ll be erring on the side of caution.
Over time, the broader market has fluctuated widely between extremes of over and under valuation. At it’s peak, the average p:e of the market has been as high as 25. At it’s lows it has sunk as low as 5. This is quite the spread and explains why the market can be so volatile. It’s not so much that the underlying profits of the companies are fluctuating. Especially if you look at larger companies, in aggregate those earnings are pretty stable. Instead, it is the price the market is placing on those earnings (ie the p/e) that is changing.
We’re coming off of a long period of very high valuations. A few weeks ago, the trailing p/e ratio of the S&P 500 was sitting up around 25. That implies an earnings yield of 1/25 = 4%. If the earnings of those 500 companies were deposited directly into your brokerage account every year you’d be making 4% on your money. Importantly, these are trailing 12 month earnings at the end of a strong business cycle. If you looked at average earnings over a full business cycle, the earnings yield was even lower at around 3%. That’s moderately better than a high interest savings account would generate but it’s hard to get excited by a presumed 3% return. At those prices, it takes a lot of cheddar to feed the mice.
This is the kind of math I’ve been doing to determine how much money I can safely withdraw from the portfolio every year to pay for my family’s bloated grocery bill and other miscellaneous expenses. With stock prices as high as they’ve been, the conclusion is that I can’t afford to take out that much. The flipside of p/e ratios being as high as they’ve been is that earnings yields have been distressingly low.
But things are rapidly improving. As stock prices drop, so do the p/e’s and as p/e’s drop the earnings yields start to move up. Your same $1 of investment is suddenly buying a lot more earnings power. With the sudden market decline of the last few weeks, earnings yields have soared.
A few weeks ago, the typical small cap stock was trading at around 20 times earnings. But running yesterday’s closing stock prices through my spreadsheet, I come up with an average p:e of only 14 now. For me, that is fantastic news. It means that the expected earnings yield on my portfolio has jumped by a couple of percent. Which also means I can feel comfortable withdrawing more money on a percentage basis from the portfolio than I could a few weeks before. In fact, it’s an even wash. As the price of the portfolio drops, the percentage I can withdraw from it rises because the average earnings yield of the market is also rising. In the end, the family budget remains relatively unscathed.
Of course, it is not all wine and roses out there. The worldwide crisis we are facing will hit company profits in the short term. Longer term, there may be some lasting damage as well, but depending how bad things get, the long-term effects may not be as severe as one would think.
My point is that by focusing on the profit generating power of the companies I own and not on their stock prices, I avoid a lot for the angst that seems to plague many investors. As stock prices drop, the income generating power of the portfolio rises. My brokerage account might appear to be smaller, but the income that I think it can generate hasn’t changed.
Of course, this is all abstract and somewhat theoretical. If the portfolio drops 80%, as it would if p/e ratios fell all the way from the high end of their range to the low end (as they did in 1929), then yes, the earnings yield would be sky high (at a p/e of 5, the earnings yield would be 20%) and that would bode very well for future rates of return, but if you needed to take the money out tomorrow, those future earnings are not going to help. Which is why it is crucially important that you don’t put yourself in a position where you are forced to sell if you don’t want to. I’ve put aside some cash to fund future living expenses for a while in the event that this thing turns into a 1929 style catastrophe.
Longer term, though, I focus on the approximate earnings yield of my portfolio and that is what I base my concept of wealth on. The value of my portfolio may have dropped by 35% in the past few weeks, but I don’t feel that much poorer. For the most part, I still love the companies I hold in the portfolio and with each new down leg in the market, the earnings yield on those companies keeps ratcheting higher.
There are some great values to be had in the portfolio right now. I was reviewing Linamar’s most recent set of results yesterday and loved what I was seeing. Unsurprisingly, profits are down somewhat right now as the company has been facing a number of headwinds. But only last year the company was making $9 a share. At the current share price of $30 that’s a p:e of 3.3 and an earnings yield of 30%! Management is excited by all the new business they’ve been signing in both the electric, hybrid and regular internal combustion engine divisions, they are launching new products in their agricultural division, they are looking at expanding their scissor lift business more aggressively into China and have branched out into manufacturing high tech medical equipment.
There are starting to be some real honest-to-goodness bargains out there. Not just on a relative basis, but on an absolute basis. Using only moderately rose-coloured glasses, I can get to an earnings yield of 15% or more on many of the companies in the portfolio right now. I’m looking forward to combing over year end results next week as I self-isolate at home and try not to get too freaked out about the medical emergency that is unfolding around us. There is a lot to worry about right now. The price the market has put on my stocks is not one of them.
Full disclosure: I own shares in Linamar.