In one of Peter Lynch’s old interviews, he remarked that he loved volatility but he estimated that volatile markets were probably a disservice to the average investor. Specifically, he purchased shares of YUM Brands (then just Taco Bell stock) at a price of $7 after it had fallen from $14. The stock then fell to $1 per share before going on a multi-year tear that ultimately resulted in PepsiCo acquiring it for $42 per share.
Lynch remarked that he enjoyed the volatility from $7 to $1 per share because he knew the company was in great shape (no debt, no store closings, and in fact, same-store earnings growth) and he was able to enhance his compounding by purchasing shares as the price declined. In the same breath, he pointed out that the average investor would not be well-served by seeing his investment suffer a similar decline because the possibility of seeing a 40%, 50%, 60%, or 70% investment loss on paper was too great to bear and would result in great emotional harm.
Like Warren Buffett, Peter Lynch is on record saying that investors should limit themselves to buying stocks where they would respond to a 50% price decline by ecstastically purchasing more. If there is no such desire to purchase more shares, then maybe you don’t understand the company the way you thought or maybe you do understand it and that is the problem.
I would also note that time and dividend payments help one understand the nature of the volatility. I purchased shares of BP after its oil spill when it fell from the $50s into the $20s. My average cost basis for that particular lot of shares is $28.43. Over the following nine years, BP experienced extremely high litigation costs, settlement, and judgments, and experienced not one but two “bust” oil cycles. Guess what? With dividend reinvestment, it has paid out over $15 in dividends during that time. Nominally, the stock would have to fall to the $17 range for me to sustain a loss (and I was briefly down on the position in March).
By understanding the nature of the oil juggernaut, I have not worried as the price has fallen. It is part of the risk inherent with owning cyclical stocks, and many of the risks have materialized. But as Warren Buffett pointed out in his 2020 annual letter to shareholders, the stock actually represents an ownership share in a business and there is a tremendous benefit over time due to “retained earnings” that spur future growth, including dividend payouts to shareholders and earnings per share growth that results in a higher share price over time.
A day will come when BP will again trade in the $40s, the shares that I purchased in 2011 will have outperformed the market, and I will look back on the cash dividends reinvested during this time as a source of additional wealth that would not have existed but for the Coronavirus shutdown and the Saudi-Russian oil war. It doesn’t mean that I wanted any of these things to happen, but rather, it is an acknowledgement that very significant and beneficial future outcomes result when you start mixing distressed pricing and dividend reinvestment among businesses that are ultimately solvent and prosperous.
There are certain investment books that I find particularly useful during market declines. In particular, I appreciate Peter Lynch’s “One Up On Wall Street” because he discusses how volatility in particular benefits the individual investor over the institutional investor.
If you run a mutual fund, you are by definition dealing with people who are not actively managing their own money and part of the reason they may not be doing so is because they do not understand markets in general. So they see a 20% or 30% decline in their net wealth, turn on CNN and see Chris Cuomo scaring them, and then go to Wal-Mart and see everyone wearing masks. They respond by pulling their money from their professionally managed investments. As a result, even if the manager knows that certain stocks are tremendously undervalued, he has no choice but to sell because the investors are taking away their capital, whether he likes it or not.
That type of involuntary, forced sale is not pressed upon the ordinary investor. When you see Coca-Cola fall into the $30s, there is something to stop you from purchasing shares of the greatest performing wealth generator in the history of the United States at a 4% dividend yield point and then sitting back and collecting the cash while the world sorts itself out.
Regardless of our emotions, the rules of algebra continue to assert themselves. If you have any investment that you have held for a period of a few years or longer, take a moment to review some of your old statements regarding the dividend payouts. You will quickly notice how many more shares you were able to accumulate during the down periods, and how few shares you were able to acquire during the boom times. Coca-Cola shareholders acquired 45% more shares during 2008-2010 than they did through dividend reinvestment during 2005-2007. In five years, you will see that the reinvested cash dividends during March and April 2020 did more for your bottom line than any cash payouts during January or February 2020.
In the world of investing, the best protection for the long-term is a strong company. The second-best protection is a low buy-in price. Peter Lynch strongly benefited from his knowledge and balance sheet literacy by going on the offensive and adding more to his prized holdings during periods of market volatility. If you have the excess funds available, so can you.