Published February 21st, 2018 by Nicholas Ward
The stock market has certainly been thought provoking thus far throughout February, to say the least. We started the month with one of the quickest double digit sell-offs of all time, only to watch it rebound back towards all-time highs at a similarly quick pace. In my previous piece here at Sure Dividend, I discussed some of the likely reasons for the recent downdraft, from a fear of inflation and the coinciding rising interest rates to the structural issues the market faced revolving around the volatility index and niche market products. In that piece I also mentioned how surprised I’ve been at how quickly my own sentiment regarding the market have changed. I’ve spent time during the last week or so analyzing my own reaction to the volatility in an attempt to stop myself from making mistakes in the future.
My personal fear/greed gauge has swung back and forth right alongside the volatile market moves. These initial reactions aren’t ideal; however, upon reflection, I’ve also realized that the direction of one of these swings is likely far more dangerous than the other. Fear can be a healthy thing but I’m having a hard time imaging greed in a positive, productive light.
Thankfully I’ve been at this game long enough to know that first reactions to market moves ought to be taken with a grain of salt until they’re validated with the data that only comes with proper due diligence and rational introspection. No matter how fast the market seems to be moving on a daily basis, haste is probably not in the retail investor’s best interest when it comes to decision making. First of all, you nor I will ever be able to keep up with the algorithms that drive market momentum in the short-term. Furthermore, this momentum is oftentimes fueled by technical analysis or simply key words in press releases triggering pre-determined responses; in hindsight we’ve seen that some of the mini-corrections or crashes that computers have caused in the markets aren’t based on fundamentals at all, which is a problem for traditional, conservative investors.
The problem is, there’s a lot of action and noise created in the market by forces that we’re taught to ignore. It’s always been difficult to determine whether or not company specific sell-offs are caused by isolated issues or systemic problems. The former oftentimes result in buying opportunities and the latter should typically be avoided. To me, it has always been more of an art than a science when it came to attempting to determine whether or not issues were going to be long lasting. This art/science conundrum is basically the case for all types of risk management. Speculation will always be involved when looking at disruptive forces in the market. It’s impossible to accurately measure the strength of any company’s moat over the long-term, but this is a big part of my analysis as I apply an appropriate margin of safety target on an investment.
In other words, I’m happy to pay a higher valuation premium for a company with high barriers to entry and a strong, defensive market position. Just to give a quick example, we’ll go no further than the largest individual holdings in my portfolio. Looking at a couple of my favorite companies to own, Apple (AAPL) and past Sure Dividend Newsletter recommendation Boeing (BA), I’ll discuss how valuation plays a role in my decision making and how this is coupled with a healthy fear in the market.
Apple is my largest position, making up nearly 7% of my holdings. This is a very overweight position for me. What’s more, I admit that Apple’s moat isn’t particularly wide. I don’t buy into the “one trick pony” argument that many like to make when it comes to Apple. I’ve always been impressed with the company’s ecosystem and I think the rise of service revenues clearly mark the strength of the overall brand that Apple has created. However, I’m not naive enough to believe that the iPhone will be king of the mountain forever.
Before there was the internet or smart phones I suspect there were very few individuals outside of the science fiction world who could have imagined the amount of power and knowledge that a company like Apple would bring to our fingertips today. It’s truly amazing to consider the fact that these devices, which play such a paramount role in the lives of billions of people across the world, didn’t even exist roughly 10 years ago (the first iPhone was released in late June of 2007). I don’t know what the next step will be in the consumer facing technological evolution will be but I’m sure that in another decade or so something else will exist that I could hardly imagine today.
This is a threat to Apple, though the company’s strong balance sheet and cash positions makes it seem likely to me that they will be able to keep up with their competition in the tech space. The company’s current cash cow of an ecosystem, combined with its strong balance sheet, and lastly, and more importantly, the company’s attractive valuation (Apple shares have traded below the market multiple for years now) have allowed me to conservatively build a large stake in the company. However, regardless of how much I like the brand, its products, and its balance sheet, if the valuation wasn’t right I wouldn’t have been interested because of the threats that the company faces.
Source: F.A.S.T. Graphs
Another one of my top holdings is Boeing (BA). In many respects, Boeing is similar to Apple. It operations in what is essentially a global duopoly with Airbus (Apple’s iOS also operations in what I deem to be a duopoly with the Android operating system). Boeing, like Apple, generates massive amounts of cash with its operations and in a way, they’re both hybrid cyclical companies (though admittedly, Boeing is to a much larger degree). What I mean is, both of their products have so much demand that companies/individuals are forced to own them, but they’re expensive, so we oftentimes see cyclical refresh cycles. However, I call them hybrid, because both companies have taken measured steps to even out cash flows along the cyclical curve with services that augment user experience and create higher switching costs.
Where these two companies become very different in my mind is the likelihood for disruptive competition. In the tech space, every major competitor that Apple has is exceedingly rich and striving to produce the next great attraction. There are a handful of names across the world that pose a tremendous threat to Apple in this regard because of the fast paced evolution of binary code. In my opinion, Boeing doesn’t face the same type of threats.
Sure, there are aerospace companies from emerging markets hoping to carve out a piece of the global air plane pie; however, there is a big difference between buying a phone that can easily be cast aside for a new one and spending hundreds of millions of dollars on an air plane that is responsible for the lives of its passengers. Chinese manufacturers pose a threat to Boeing, in my opinion, because I’m sure they will be backed by their nation state in local markets; however, on a global scale, I have a hard time seeing anyone knocking Boeing off its pedestal as a leader in one of the most reliable growth industries on the planet: aerospace.
Source: F.A.S.T. Graphs
The market has bid up Boeing to ~25x 2018 EPS estimates, while Apple trades at just 15x its forward looking P/E. Because of my confidence regarding Boeing’s moat within such an attractive industry, I associate less concern; less fear, with this company. This is why I am willing to hold my Boeing shares, which are trading for a 66% relative valuation premium to Apple’s (Boeing’s recent habit of rewarding me with ~20% annual dividend growth also helps). I went on this tangent to show why I don’t believe in hard and tight rules in the market pertaining to risk management. There are simply too many variables for such rules to work across the board. This is what I mean when I say that there is an art to portfolio management.
And getting back to my original thesis here, fear is one of the most prominent players in this art. It seems like I’m always talking about the perils associated with fear and greed in the markets. Traditionally, these have been the forces that drive markets and more often than not, the mistakes that investors make within them. However, in this piece, I’ll be singing a different, somewhat thankful tune. You know what? We’ll take that a step further. I’ll be singing a deferential tune. Today, I’ll be focusing on the benefits that fear can bring to the conservative, income oriented investor.
Fear in the markets is generally demonized, but that’s not because of the emotion itself, it’s because of the negative reactions that it oftentimes inspires. Fear is what causes investors to sell at bottoms and/or avoid buying attractive valuation during dips. I can’t tell you how many times I’ve heard investors say something like, “I’m waiting for a dip to buy,” only to because too fearful to take advantage of the next dip when it arrives. Buying low and selling high makes sense in principle but it’s a difficult plan to put to use practically because of the emotions that become involved with volatility perks up.
With that being said, as frustrating as fear can be sometimes with regard to unproductive inaction, it can be helpful as well. Fear is what helps us avoid dangerous situations that might be otherwise bad for our health. Fear has surely played a role in human evolution, allowing us to grow and prosper as a species into the dominant force on our planet today. Just like everything else in this world, it’s impossible to paint fear with an overarching brush. There is good and bad fear and investors must learn how to artfully deal with it.
Sometimes, it is best to throw caution to the wind. For possibly the first time ever in an investment article, I’m going to quote rapper Young Jeezy. In his song, “Scared Money” featuring Lil Wayne, Jeezy proclaims that “Scared money don’t make no money.”
I can’t be certain if Young Jeezy and Lil Wayne were talking about buying equities or not, but I’d be lying if I said that this phrase hasn’t helped me to pick up tremendous value in the market during times of high volatility.
A phrase along similar lines that is much more often quoted in the investment world, “Buy when there is blood in the streets.”
Many attribute this phrase to the Oracle of Omaha, Warren Buffett, but according to this Forbes article from 2009, the phrase was originally coined by Barron Rothschild, an 18th century British nobleman of the Rothschild banking family.
The Forbes piece goes on to say that the entire quote is actually, “”Buy when there’s blood in the streets, even if the blood is your own.”
Rothschild put his words to use, accumulating distressed assets throughout the early 19th century as Napoleon Bonaparte spread chaos across Europe during the Napoleonic Wars.
Rothschild certainly did well for himself, but I’m not saying that all investors should exude this sort of intestinal fortitude. There are certainly times when caution is merited and I suppose that living in war-torn times would be one of them. When one experiences genuine fear for his or her life, investing may not be the best idea. Although, I suspect that the very best deals are only available during such times of incredible distress, so with proper preparation regarding asset allocation and a very disciplined outlook pertaining to long-term goals, it is possible to play the contrarian role rationally.
Yet, there are other times when fear should not be ignored. The fear of missing out is a powerful force and a potentially destructive one to wealth. The fear of missing out is a very close counterpart to greed, especially during bright, sunny days when upward momentum in the market rules the day. As I said in the intro, greed is rarely a good thing for an investor. I suspect it can lead to profits for speculators, but I doubt that’s why anyone is here reading a piece on a website focused on conservative, reliable streams of passive income.
Sometimes fear works in conjunction with greed, but other times, it can be the only force that counteracts its pull. It is perfectly logical to be fearful of future returns when the market is running hot, overvalued, and sitting at all-time highs. It is also perfectly logical to be fearful of future returns when the economy is facing major changes, like the normalization of interest rates. I think it’s fine to be fearful of change, for a moment, at least, while you attempt to analyze new data sets.
However, it’s not rational to be scared of change itself; just because sometime is different doesn’t mean that it is dangerous. My point with this article, if there is one at all, is bring up questions about fear in an attempt to prove that it isn’t necessarily evil.
Fear is surely complicated and isn’t the most enjoyable aspect of portfolio management (or the human experience) to reflect upon, but it is something that all investors must come to terms with if they’re to be successful over the long-term.
Fear can be good and bad, it can make you money, lose you money, or prohibit you from doing either. Fear is an ever present force in the markets and one that investors must learn to dance with if they’re to elegantly navigate the dance floor that is the stock market…especially when it’s blood splattered.