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Geoff Gannon
Geoff Gannon
Articles 

Volatility Is the Value Investor’s Friend

What a value investor wants to see is lots of stocks moving on no news. A static 'earnings power' combined with a dynamic stock price is what lets a stock picker get to work

In recent days, the market has experienced some of its biggest point drops ever. The past couple trading days have been abnormal. But, the many months that led up to these last couple days were just as abnormal in a different way.

They weren’t volatile.

The market moved steadily upward. And when I say “market” I mean quite a lot of different stocks and even quite a lot of different markets. Obviously, the U.S. stock market has been getting progressively more expensive on valuation ratios like the Shiller P/E ratio since about mid-2009. There is nothing wrong with a stock market – or a single stock – getting suddenly a lot more expensive. Sometimes it is well-deserved. From the market bottom in early 2009, it wasn’t unusual for an investor’s portfolio to have gained about 50% over the next 12 months. And there was nothing wrong with that, because – after that 50% bounce off the bottom – stocks were priced much in line with the kind of normalized P/E ratios they had traded at in the past.

I’ve written before about how I believe we are in a bubble. I think it was on Dec. 19, 2017, that I did a blog post officially admitting that “yes, I think we’re in a bubble.” Since then stocks haven’t really changed much in price. That is, they’ve changed quite a bit. But, they went up a lot and then down a lot and have now ended up not far from where I wrote that post. So, we can safely say I still think we’re in a bubble.

I am also 100% invested. And it’s investing – not bubbles – that I’d like to talk to you about. It’s not worth spending time worrying about anything that isn’t going to change and potentially improve your own investment process. If it doesn’t help you pick better companies to buy, pick better times to buy them or pick better times to sell them – then it’s not worth worrying about. I’m not sitting here worrying about whether I should be 100% invested or 60% invested or 20% invested in stocks. Certainly, I would have been better off if I started February (but not any month before then) with a lot more cash and lot fewer stocks. It seems to me that kind of timing requires clairvoyance. After all, I said in December I thought we were in a bubble, but that didn’t mean I knew the market would drop 40% in the next year or go nowhere for the next eight years. Either path gets you to about the same outcome in terms of valuations.

So, let’s not fixate on the price level of the overall market. We’re value investors. We’re stock pickers. So, we will always focus on the price level of the individual stock we’re choosing to buy next. That’s enough. The market may be overvalued at a Shiller P/E of 32. But, if Starbucks (NASDAQ:SBUX) sounds good to you at an EV/EBITDA ratio of 11 or Wells Fargo (NYSE:WFC) sounds good to you at a P/E ratio of 14 – you should buy those stocks even if you wouldn’t buy the overall market. I might pick different stocks and I might not get especially excited about those exact price levels. But, I certainly can’t argue that it’s unreasonable to pay 11 times EBITDA for Starbucks or 14 times earnings for Wells Fargo. Those are reasonable prices to pay for well-entrenched businesses. It is, however, unreasonable to pay a Shiller P/E of 32 for the overall market.

So, what we are talking about here is being selective about price. Last year, someone asked if I thought Omnicom (NYSE:OMC) was a good stock to buy. And I said I thought it was an obviously good choice at $65 a share. Well, it’s at $73 a share right now. So, if you believed what I said made sense back then – you’d have to wait for another 10% decline in the stock price. You wouldn’t be able to buy it today. You would need to exercise selectivity when it comes to price.

Last year, investors had little chance to exercise selectivity when it came to prices. A lot of stocks kept rising month after month. The market didn’t give you even a 5% drop from top to bottom – much less a 10% drop like what I’m saying you should wait for in Omnicom. Of course, that’s an arbitrary number. I am saying Omnicom looks really obviously good to me as a buy-and-hold stock if you do the buying at $65 a share. It looks less obviously good at $75, $85 or $95. I think it’s worth more than $75, $85 or even $95. But, I wouldn’t buy it till it was selling for as little as $65. That is the margin of safety value investors are always talking about.

And that margin of safety comes from volatility. Over the truly long term, most stocks trade mostly in line with their intrinsic value if we average out the highs and the lows for the year. Omnicom and the other ad agency holding companies have – over the last 30-40 years – been perhaps a bit cheap on average. They’ve worked better as buy-and-hold investments than other industries. But, there have been long periods – sometimes an entire decade in the case of Omnicom – where you wouldn’t have gotten a market-beating type return if you bought the stock at its average price for the year.

But, stocks don’t trade at just one price all year long. Normally – not in a year like 2017, but in a “normal” year – there’s volatility. Mr. Market offers you different prices on different days.

And that’s what a value investor needs to do the day-to-day drudge work of picking stocks and actually buying them. He needs volatility. That is why the last couple days of trading should be exciting rather than frightening for value investors.

Stock are still – on average – far, far overpriced. If you asked me what the “right” price for the Dow Jones or something like that is right now – I’d have to say down 40% from here. But, that doesn’t mean I can’t find stocks to buy. As long as there is volatility, there will be stocks to buy.

Why?

Because there are so many stocks. And because volatility offers the same stocks at such different prices during the year. So, if you follow my advice for how to best become a better value investor – which is to read one 10-K a week and come up with your own “appraisal” of intrinsic value for that stock – you will find some stock during the year (out of the 52 stocks you study) that trips a level you find acceptable to buy at.

For me, it is 65% of my appraisal value. That’s the level that tells me it’s okay to buy. So, when you hear me say that Omnicom is obviously cheap enough to buy at $65 a share – that’s my way of saying Omnicom’s intrinsic value is at least $100 a share.

If I really believed Starbucks was a good buy at 11 times EBITDA, I’d need to believe Starbucks was worth at least 17 times EBITDA. If I really believed Wells Fargo is a good buy at 14 times earnings, I’d need to believe the intrinsic value of Wells Fargo would be reached when the stock hits a P/E of no less than 22.

I’m not sure I quite believe those things. But, I am sure that I’m not confident that Starbucks isn’t worth at least 17 times EBITDA and Wells Fargo isn’t worth at least 22 times earnings. I am, however, totally confident that the S&P 500 isn’t worth a Shiller P/E of 32.

So, I’ve just mentioned three stocks – Omnicom, Starbucks and Wells Fargo – that are cheaper than the market in the sense that I’m not sure they’re overpriced while I am sure the market is overpriced. Now, imagine if these stocks – stocks like Omnicom, Starbucks, and Wells Fargo – were to move down as much as 8% in just the next couple trading days. What if – pretty soon – you got the chance to buy these stocks at 10% or less from where they now trade?

In many years, in many stocks that’s often true. It’s pretty much taken for granted that you’d have a very good chance of seeing any stock you’re looking at trade for 10% less on no real news. There’s also a good chance you’d see it trade for 10% more on no real news.

But, in the very recent past – this changed. The market taught stock pickers like us that it wasn’t very likely at all that we’d get a chance to buy the stock we were looking at today at 10% less some time in the near future.

We have to re-learn this belief. I don’t know if the big drops of the last couple trading days are the beginning of a bubble popping or a blip that will be reversed within a day or a week or a month. But, I do know that stock prices will be more volatile in the future than they have been in the recent past.

And, more importantly, I know that’s great new for value investors. I recently did a podcast about a stock called NIC (NASDAQ:EGOV). The stock lost its biggest client, the Sate of Texas, and dropped 20% on the news. Texas accounted for about 20% of NIC’s revenues. This is the kind of stock drop that’s not helpful for value investors. There was some very big bad news. The stock’s price dropped big too.

Not very helpful.

Sure, we can try to work out the math of exactly how bad the loss of Texas will be to NIC. We can assume the profit drop will be a lot bigger than the 20% stock drop. But, what odds was the market putting on the loss of that contract. It wasn’t a secret that companies would get to bid on that Texas business and someone other than NIC might win it. So, what if the market was putting a 65% chance on NIC keeping the business and a 35% chance on NIC losing the business? You see how the math gets a little complicated. And it quickly becomes apparent that although the stock dropped a lot and earnings will drop a lot too – it’s not such a clear cut big buying opportunity or a clear cut big selling opportunity. That kind of event counts as volatility as far as people looking at that stock. They see the earnings release came out and the next day the stock was down 20%. They know that’s a volatile stock. But that was stock price volatility driven by underlying earning power volatility.

That kind of volatility isn’t real helpful. What kind of volatility is?

Well, this same stock – NIC – had declined 30% in price in the 12 months leading up to the loss of the Texas contract. During those 12 months, the U.S. passed a tax bill that would likely reduce NIC’s tax rate – including both state and federal taxes – from between 35% to 40% of operating profit (as it had been in most past years) to something close to 25%. So, you have an undeniably positive tax law development that probably increases the value of the EBIT in shareholder (rather than “government”) hands by at least 15% after-tax. And yet, during that same year, the market values the business at 30% less. This is equivalent to a 40% decline in the price of a stock with a static intrinsic value. And, of course, the business grew a little – maybe a bit better than the nation’s nominal GDP rate. So, really it’s more like the stock got 45% cheaper in a year.

That’s exciting. And that’s the sort of mindless – random walk looking – volatility that batters the average stock around in the average year. We haven’t had an “average” year of volatility for quite some time.

As you can see in the “disclosures” at the bottom of my articles, I own three stocks. I own NACCO (NYSE:NC), Frost (NYSE:CFR) and BWX Technologies (BWXT). You can look up these companies’ business descriptions here at GuruFocus for yourself. But, I’ll tell you right now – they don’t have much of anything in common. One depends on electricity demand at coal power plants. One depends on short-term interest rates. And one depends on U.S. government demand for nuclear powered ships. Nothing causes their “earnings power” to move in the same direction at the same time. Well, in the last two trading days the coal company is down 15%, the nuclear company is down 6% and the bank is down 4%.

Look at the stocks in your own portfolio. Why are they down? Right now: Most stocks are down because they are stocks. People are selling stocks indiscriminately. And no one is interested in buying stocks indiscriminately. That should make the discriminating value investor – the true stock picker – very excited.

Disclosure: Geoff owns NC, CFR and BWXT.

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Geoff Gannon



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