Investing Secrets: Four Ways To Overcome Fear
One of my general goals for writing finance articles, which I am going to focus on specifically in 2017, is to point out that fear arising from a stock price drop in a profitable business is one of the most self-destructive emotions that you can carry with you as you go through your investing life.
The good news is that there are four ways you can overrule those worst instincts that act as the devil sitting on your shoulder telling you to sell low. I discuss them below.
I. Liquidity
According to a recent white paper published by The Northern Trust, a risk assessment survey indicated that investment portfolios with 15% cash only has a one in ten chance of experiencing a 25% or greater decline in net worth between now and 2025. A back-test indicated that such an investor would have seen their net worth fall from $1,000,000 to $787,000 from the absolute highest price point prior to the financial crisis to the lowest point during the crisis. If you can’t handle that, you shouldn’t be in the stock market. I say that with no snarkiness, but rather, benign paternalism because stock markets do see sharp declines and people who are susceptible to an over-fixation on net worth may undo years of diligent savings in one moment of selling at a low.
Personally, I think the value of cash is that it permits you to play offense while everyone else if focusing on defense. A financially sophisticated investor will accept the trade-off of seeing current holdings diminish in value by X% if it means that they get to purchase Nike, Disney, Colgate-Palmolive, and Visa at X% off, too. As I profiled in the case of an investor buying General Electric stock during the financial crisis, it only takes one large investment in a significantly distressed security to sharply improve your economic future.
II. Diversification
I have written over 1,600 articles between my Seeking Alpha and The Conservative Income Investor contributions. You know what I find interesting? Only a few of them have had to deal with what I’d consider “material problems” to the business itself. BP had its oil spill and the aftermath. IBM and GlaxoSmithKline have struggled to grow revenues. Chipotle dealt with negative headlines after the E.Coli outbreaks which calcified distrust among its casual and loyal customers alike.
If you had 20% of your net worth in these names, it may have been difficult to remain rational while dealing with impairments to earnings and wildly fluctuating stock prices. If each of these investments constituted less than 5% of your net wealth, it is much easier to marshal the emotional gumption necessary to take the logical route that dictates “This, too, shall pass.” Even at a 5% point, a 50% drop in price from one such holding only takes down your overall net worth 2.5%. When you arrange your affairs in a way that limits the downside experienced, then you have positioned yourself to apply rationality to each individual problem that unfolds.
III. Fundamental Analysis
The distinction between a stock price and what a business really ought to be worth is the hallmark insight of Benjamin Graham’s career (and his “margin of safety” principle is his most useful call to action to arise from this insight.)
Using the stocks above, all four have pumped out multiple billions in net profits over the past five years. Most have paid out dividends which, over a few year holding period, softens and in some cases eliminates entirely the blow of Mr. Market. Chipotle doesn’t pay a dividend, but it maintained a debt-free balance sheet as it dealt with its crisis.
Thinking about your holdings as actual businesses that have some independence from the price other investors are willing to trade for an ownership positions is a great way to thrive during the harsh conditions that your investment encounters. A McDonald’s investor can point out that 84% of the 36,000 McDonald’s locations involve the payment of a four-figure monthly rent to the parent McDonald’s corporation. Every time a McDonald’s franchise sells a cheeseburger, the McDonald’s parent entity collects $0.08. There is this huge web of contracts that give McDonald’s a perpetual override on the food sold at its location, with hardly any risk to itself (the only franchise-specific risk is that a franchisee goes bankrupt or becomes distressed and McDonald’s has to pay the litigation risk and other transaction costs associated with the termination of the franchise agreement. A second emerging risk is related to the Labor Board’s seeming intent to widen the scope of vicarious liability for the parent corporation.)
Another way to maintain rationality is by just looking at the balance sheet. U.S. Bancorp (USB) saw its stock price fall from $45 to $8 during the financial crisis. But the profits only fell from $2.2 billion to a little over $1 billion. You could see right before your eyes that nonsense was taking place! There were only four months during the entire 2008-2009 period in which U.S. Bancorp failed to make at least $100 million in profit in a single month. The net profits remained there all along, even as the price of the stock disintegrated. This was a blessing for the fundamental analyst because you could point to the irrationality in real time—unlike the other companies that started losing money and force you to determine whether it would be short-lived or lead to permanent investment wipeout.
IV. Market History / Rise of Multinationals
Even if you have limitations that affect your ability to analyze an individual business during its moment of distress, you can also rely on general principles of stock market history to guide you towards rational decision-making.
Every recession in the history of the United States has led to more prosperous times ahead. Every stock market decline of the 20th century was followed by a subsequent rise in corporate earnings that led to ever-higher stock prices. Large-cap investments have a very long history of giving 6% returns net of inflation throughout the history of Western Civilization. Even Warren Buffett, in his 2015 shareholder letter, argued that the only thing that can stop America is nuclear holocaust—and by that point, we’d all be playing Metallica’s “Nothing Else Matters” anyway.
It should also be worth noting that companies aren’t what they used to be. When you bought Coca-Cola stock in 1927, you were buying a little southern distributor of syrup. When you bought it in 2015, you were buying a global behemoth that was earning profits in 210 countries. This diversified earnings base means that there are profits coming in from all over the globe, and while I’m not saying it’s impossible for a company to fail that operates in 50+ countries, it greatly narrows your causal risks of failure to technological obsolescence, leverage, or fraud.
V. Conclusion
Investing becomes simple when you think of it as the collection of a few discrete elements working in sync. You get a job. You generate a surplus by spending less than you earn. You put your surplus into a business that is profitable and will be around for a while. Every year, you repeat this process with a few new additions. You set the dividends to show up in your account regularly. You get it right in the first instance by selecting a company with a well-documented history of excellence, so that you can ride the storms out. Along the way, you only allocate about 0.85x of your surplus each year to individual investments. The rest builds up as cash to buffer against volatility during the bad times and go on the offensive for significant bargains when these moments arrive. When the storm does arrive, you pay attention to net profits and commit to riding the storm out, and look for price mismatches for companies that are selling for much lower than the profit engine suggests. To the extent your pre-existing holdings are affected, focus on market history and the diversified income streams of your own holdings and the business lines within the corporation itself.
Originally posted 2017-01-01 16:05:51.
