With the markets and the economy in disarray, the average p:e ratio of my portfolio has fallen to a level I haven’t seen since 2008.
Invest On Information, Not Speculation
The world is in desperate straits. We’re facing a deadly global pandemic, an economy that is shuddering to a halt and a stock market that has dropped like a stone. The worst of it all is the uncertainty. There is a lot we still don’t know about this virus. And on the investing front, we are in uncharted waters. We have never voluntarily shut down the world economy before and then tried to kickstart it back to life again a few months later.
If we’re not successful, a toppling chain of dominoes could plunge us into another Great Depression as businesses close, people lose their livelihoods and the banking system fails.
If we are successful, then we can halt this virus in its tracks. We can pick up the pieces, rebuild and move forward again. A mountain of liquidity and stimulus and a new-found optimism could feed directly back into the markets and even have them hitting new highs by year end.
With such an incredible range in possible outcomes ahead of us, what are we, as investors supposed to do?
For the most part, the answer is probably surprisingly little. I have a saying that I often repeat to myself at times like these and that is: “Invest on information, not speculation.” Right now, there is precious little real information to go on and an awful lot of rampant speculation. Not a good environment for making carefully reasoned and intelligent investment decisions in. Given that, doing nothing is probably going to be the best approach for most investors. If you had a portfolio and a risk weighting that you were happy with before this unwelcome turn of events, then you should probably not try to make any drastic changes now when the future is so uncertain. At the very least, wait a few months to see how this is all going to shake out.
I’ve had some friends asking me recently if now is a good time to jump into the markets. They’ve got some cash on the sidelines that they’ve been sitting on and with the market dropping, they’re wondering if they should be bold and step in to take advantage of the drop in prices.
Well… I definitely applaud the instinct, but I’ve been telling them no. I’m no nervous nelly. I’ve made a career of stepping up to the plate and buying up things that no-one else dares touch. And I continue to do so. But I’m very, very conscious of the risks I am taking. Most new investors aren’t. The uncomfortable fact is that the market is still not cheap even after some of those 50-75% declines we’ve been seeing. Yes, I believe there are scattered opportunities. I was able to buy a clothing retailer recently for the value of the cash on its balance sheet. I bought another company for less than 2 times last year’s earnings. The average long-term earnings yield on my whole portfolio is now hovering around the 15% mark. These are better prices and better values than I’ve seen in years.
But the market as a whole is not cheap. The S&P 500 still trades at 19 times last year’s earnings. During the Great Depression, the Spanish flu of 1918 and the runaway inflation of the 1970’s stocks traded down to an average p:e of 6 or 7. If this thing really gets out of hand, we could be headed right back down to those kinds of levels again. That means another 66% drop from where we are today. This is no time for neophyte investors to be plunging into the markets, in my opinion. Even if we manage to pull off this mass self-isolation experiment flawlessly and kickstart the markets right back up to their previous highs, then investors in the big-name stocks stand to make a mere 33% return on their money. The possibility of a 33% gain balanced by the chance of a 66% loss still seems uncomfortably skewed to the downside to me.
A More Hopeful Message
Having said that, if you understand the risks, and you know what you’re doing, I do believe there could be some awfully attractive opportunities out there. Over the last few weeks, I’ve been combing through the most beaten down sectors of the market, looking for companies that I think have a better than even chance of survival and that I can buy for vastly reduced prices. While the average p:e ratio of the large cap S&P 500 may still be close to 20, the average p:e ratio of the small cap segment of the market has fallen to 12 and the average p:e ratio of my portfolio (thanks to a 40% drop from the start of the year) is now down below 5. If these companies can pull through, they could offer big gains. But of course, there are no guarantees.
Despite my warnings of impending catastrophe, I am feeling cautiously optimistic at this point. The data I am seeing on the coronavirus suggests to me that we are gaining the upper hand. I have been amazed at how quickly everyone has responded to this crisis. As humans, we’re impressively adaptable. Even governments, not normally known for their speed or efficiency, have been remarkably responsive and have launched enough financial firepower at the economy to hopefully keep everyone afloat until the crisis has passed.
The portfolio, as it stands, I think is very well positioned for the more optimistic recovery scenario. I’m well exposed to some of the sectors that have been hit the hardest. If things continue to deteriorate, then obviously it is not as well positioned. I’ll no doubt continue to take a shellacking if markets keep dropping. As always, I try to seek out some of the more conservatively run companies in an otherwise decidedly risky corner of the market. I look for low debt levels or better yet, outright cash. I look for a history of profitability. And I try to plan for worst case scenarios. But as the past few weeks have amply demonstrated, when the s*!t hits the fan, my bargain priced, small cap value stocks are not the ones that investors flock to. Quite the opposite, they are more likely to abandon them to move their money to the safety of cash or the perceived stability of larger, more well-known stocks.
As we move beyond the peak of the virus outbreak, we’ll be faced with the daunting chore of trying to rebuild the economy. Perhaps this will be surprisingly easy. Maybe if we’re lucky we’ll be able to just pick up where we left off. But a longer, more painful recovery seems like the more likely scenario. It seems reasonable to expect that we’ll have a year or two of recessionary conditions once the coronavirus gets dealt with.
Don’t Marry Your Stocks
During recessions, small cap stocks often struggle. Many of them will be losing money or, at the very least, making considerably less than they did before the recession began. When making my investment decisions, I’ll often have to look back at how the company performed during the previous expansion and base my valuations on that. The implicit assumption is that when the recession ends, the company will pick up where it left off. Most of the time, this will be true. Sometimes it won’t. The leaders of one business cycle are often not the leaders of the next. So it is important to stay flexible. Circumstances change. I never get overly attached to any of my portfolio companies. If I see something cheaper or that offers better opportunities or if the business environment changes (as it just did, violently) then I won’t hesitate to ditch one stock and buy another. My goal is to always try to maintain a portfolio of the best, most undervalued stocks I can find. Especially during market downturns, this can mean selling existing holdings at a loss. As long as I am buying something new that I think offers even better value than the stock that I am selling, then the chances are good that I am going to come out ahead in the long run. It is always the overall health and value of the portfolio that I am concerned with, not the fate of any individual stock within it.
With that philosophy in mind, I’ve recently done a fair amount of portfolio re-shuffling. Obviously, things have changed dramatically in the last few weeks and I have struggled to fully digest the bewildering torrent of new information. I can’t be sure that any of the individual stocks I just bought will outperform any of the ones I have sold, but overall, I am always aiming to own a portfolio of the cheapest stocks I can find. To that end, I sold off my Yellow Pages, Medifast, Big Lots and Urban Outfitters. All good stocks and an argument could still be made for owning each of them. But I felt the arguments were even better for Tilly’s, Gildan Activewear, The Valens Company and G-III Apparel. I’m keen on all these new additions and looking forward to seeing how they perform.
Apart from those changes, I continue to hold the same stocks I did before the downturn started and I’ve got my money roughly evenly split between them all. I thought these were good values going into this downturn and I think they are even better values now. Some of them have dropped by 50% or more from where they were only a few weeks ago. I’m not sure there’s much point in commenting on them individually at this point because the future is so uncertain. As events unfold and as earnings reports are released over the next couple of quarters, I’ll have a much better idea of where these companies stand. Right now, I like them all, but if I see something I like even better or if conditions deteriorate even more than I am expecting them to, any of them could get the boot.
A Pair Of Long Shots
Essential Energy Services and Francescas probably deserve a special mention. Personally, I still own these companies and have no immediate plans to sell them. But they should both be considered long shots at this point. They were both losing a modest amount of money even before this crisis hit and their respective industries (oil and gas drilling and retail) are under heavy attack. The oil and gas industry in Canada is obviously on very shaky ground. Essential may just have to park its rigs in a field somewhere and hope for better times. Shopping malls across the US have shut their doors and Francescas can only hope that doors will re-open again at some point and that there will be enough traffic for them to continue implementing their turnaround plan. While the future looks somewhat bleak for both of these companies, they are both trading at a tenth of their tangible book value and far below their previous earnings potential. Both companies had fairly strong balance sheets with little in the way of debt heading into this, so they at least have that in their favour. Some of the most spectacular gains coming out of big market downturns can be in these kinds of borderline, low p:b stocks. I think they still make sense to own as part of a diversified, value-oriented portfolio.
As I mentioned before, the average p:e ratio of my portfolio, using trailing earnings where available and peak earnings where appropriate has fallen to just under 5. That’s as cheap as it got during the bottom of the downturn in 2008. Will the market do a quick about-face and roar back to life as it did in 2009? Or are we in for a much longer, more painful recovery? Could we even be facing a cataclysmic Great Depression style scenario?
I will have to wait to find out. Meanwhile, I have finished my review of year end results and the snow has almost melted off my lawn. I’m going to be paying less attention to the markets in the next few weeks and more attention to trying to evict the boisterous family of squirrels that have taken up residence in my roof.
Full Disclosure: Of the companies mentioned, I own shares in Essential Energy Services, Francescas Holdings, Tilly’s Inc., Gildan Activewear, The Valens Company and G-III Apparel. I do not own shares in Big Lots, Urban Outfitters, Yellow Pages or Medifast.