Falling Markets: Are You Bottom Fishing or Buying Quality?
When markets fall precipitously it can be tantalizing to fill a portfolio with statistically ‘cheap’ stocks. During market routes it is not uncommon to see stocks in industries most impacted to have trailing P/E ratios fall into the mid-single digits. Value investing is often incorrectly conflated with only buying statistically cheap stocks – usually stocks with low P/E or P/B ratios. In reality, value investing is buying a business for a price that is cheap in relation to its intrinsic value (or the present value of its future cash flows), which doesn’t correlate to a specific P/E threshold.
While it is tempting to go “bottom fishing” and gather up as many of the cheapest names as possible in anticipation of a valuation bounce, we think there is usually a better way to approach “mini-panics” like we are seeing now.
Instead of buying groups of fair businesses at wonderful prices, we aim to use these opportunities to buy wonderful businesses at fair prices.
Two Ways to Exploit a Panic
Let’s compare two investment options right now – company A trading for 5.5x earnings and company B trading for 11x earnings. Both are not expensive by any measure, but one clearly appears to offer better value and margin of safety. Company A is a cyclical travel business that has been sold off significantly in recent weeks. Company B is a compounder that has also declined over the past month, though not nearly to the magnitude of company A.
On the surface, a value investor would clearly prefer company A given it’s valued at half of company B, right? Take a look below at what we believe a 10-year investment yields in each company if each ends up valued at about the long-term market average, or 15x earnings (also roughly where these two companies have historically traded).
Figure 1: Cyclical Business vs. Compounder
Contrary to what the valuations suggest, Company B offers better return prospects with a great deal more certainty. Let’s look at the key differences driving expected returns.
Company A is Carnival Cruise line. Carnival has been crushed recently and is about 65% off its 52-week high due to concerns over what the corona virus will do to demand. The company earns poor returns on invested capital (consistently below 10%), is very cyclical and capital intensive and carries a hefty debt burden. After the last recession, it took nearly 10 years for Carnival to return to its 2007 earnings per share level and the business only increased earnings per share by 2% annualized over that 10-year span. All that being said, the business is extremely cheap on an absolute basis, and clearly offers the potential for an attractive outcome.
Company B is American Express, a business that we know and follow closely and that has declined by about 30% since its recent high. American Express will undoubtedly be impacted to some degree by reduced consumption and spending due to COVID-19 and the related economic ramifications. These may even matter materially to earnings over the next 6 months or 1 year. However, we don’t think any of this will impact the business in any noticeable way over the next 5 or 10 years.
Short term headwinds aside, there is a lot to like about American Express. The company earns excellent returns on capital (40%+), does not need to reinvest hefty sums into the business to consistently grow, and returns excess profits to shareholders. Further, the business maintains a world class premium brand, and benefits from the long-term tailwinds of increasing prosperity and spending across the world and a continuing shift to cashless payment methods.
Uncertainty Should Command a Risk Premium
We think it’s very probable that at these prices American Express will compound intrinsic value per share (through earnings growth and share count reduction) at a low-teens rate and also benefit from a modest valuation re-rating over the next decade. This compares with an investment in Carnival that is predicated on a one-time event - a valuation multiple re-rating. That could happen in one year, ten years, or not at all.
Part of the difficulty is investors need to be right about multiple variables for Carnival to outperform. There’s no guarantee that Carnival ends up trading at 15x earnings - most automotive businesses still haven’t returned to their pre-recession valuation multiples and who’s to say the cruise lines won’t follow the same pattern. Also, earnings are volatile in this industry compared to the payments space. Predicting the ultimate valuation multiple is immaterial to returns in American Express, and the future is much more predictable compared to Carnival.
Also, once Carnival rises to a fairer value, the investment will have to be sold with the hopes that another statistically cheap business can replace it in the portfolio. If and when this occurs, there is no telling what valuations will look like in other industries and if there will be a similarly attractive place to deploy the capital, creating a substantial reinvestment risk. Additionally, holding American Express and allowing it to compound is much more tax efficient compared to buying Carnival, selling it when it re-rates and attempting to repeat the process with another stock.
The uncertainty associated with investing in a below-average business predicated on a multiple re-rating should require significantly higher expected return than buying a great business like American Express. We can substitute most airlines, cruise ship operators, and oil companies for Carnival and will arrive at a similar conclusion. Because high-quality compounders have also come down in price, the risk premium for investing in below-average companies does not appear to exist in most cases right now.
Takeaway
This comparison is not meant to suggest Carnival Cruise, or an airline, or an out of favor automotive or oil business, or any other cyclical business being impacted by COVID-19 won’t deliver satisfactory returns due to multiple re-rating. In fact, Carnival may well prove to be the better investment over the next year or two if it re-rates quickly (while creating a tax drag and reinvestment risk). However, we aren’t investing to maximize returns for the next one or two years but instead for the next 5, 10, and 20 years. The longer your investment timeline, the better a business like American Express should prove for overall returns. The aim here is to demonstrate there is more than one way to earn outsized returns in a volatile market and given the choice we prefer the American Expresses vs. the Carnival Cruises of the world.
Over the long-term, the fundamentals of a business trounce a change in valuation multiple. Of course, valuation still matters greatly to us, which is why it’s important to wait for periods of undue pessimism to purchase a great business at a discount. Great businesses don’t become cheap compared to intrinsic value very often, but it does happen with some regularity. These opportunities often coincide with sharp overall market corrections when the proverbial baby is thrown out with the bath water. Thanks to these short-term dynamics we are recently proud owners of American Express.
As usual, Warren Buffett’s right-hand man, Charlie Munger, said it best to illustrate this point. During an interview Charlie reminded us:
“Over the long-term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.”
We think there are several opportunities to execute this approach right now which we’ll discuss in more detail in our upcoming spring portfolio update.
Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.