Picking Up A New Skill For The Next Stock Market Recession

One of the general truisms for investors during a sharp market decline of 20% or more like we saw in 2008-2009 is that, as long as you are a net buyer of solvent companies, you are bound to do well. The only type of scenario in which that wouldn’t be true is if you had a late 1990s type of situation where some companies became so expensive that even a 20-30% price decline didn’t make those companies cheap, but rather, took them from grossly expensive to slightly expensive.

Anyway, the question I’ve set out to answer is this: When there is a significant stock market decline, what is the most intelligent course of action that should follow?

First of all, I should note that if you avoid selling during market declines, you’re already ahead of the curve. And if your impulse is to buy more shares when you see the prices of profitable enterprises fall, you’re already destined for lifelong success.

Actively rooting for lower prices of companies that are simultaneously growing profits is a place most people will never reach—Buffett addressed it well when he discussed why he actually desires for IBM’s stock price to fall, given its extensive commitment to share buybacks that lead to higher earnings per share growth than would otherwise occur if the price of the stock happened to be higher. It’s a very counterintuitive notion that doesn’t become clear until you review years of records denoting reinvested dividends. I know that at least a few of you reading this have been dripping Procter & Gamble for decades—pull out your old statements, and compare the shares added to your account in 2007 compared to 2009.

If you owned 1,000 shares in 2007, you received $1,280 in income that got reinvested around $67 per share, such that you ended up with about 19 new shares. Not only would they be worth 19 x $83= $1,577 today, but they would have been generating their own quarterly dividends as well. If, instead, that $1,280 got reinvested at the $50 per share price that was typical for P&G during 2009, then you would have picked up 25 new shares instead. Not only would those shares be worth $2,075 today, but that would give you 6 additional shares would have received 28 dividends from the 2008-2014 stretch, which would still be continuing well into the future.

The most scholarly work discussing this phenomenon came from Dr. Jeremy Siegel’s Stocks For The Long Run in which the Wharton Professor pointed out that the former Philip Morris compounded at a rate of 17% from 1956 through 2006, despite only growing profits at a rate of 11% annually. Why? Because the stock was perpetually cheap as investors concluded that growth would moderate in response to perpetually declining volume shipments, and this false expectation created perpetually cheap reinvestment opportunities that turned a $250 investment into a million-dollar fortune over the course of four-plus decades. It’s an investment story unlike quite any other.

All those things being said, the question still remains: Once you reach a point where you conclude that you will be a net buyer during broad market declines of 20% or more, what is that you should specifically be buying?

Well, the bulk should probably go to the typical blue-chip companies that I discuss here—Procter & Gamble, Colgate-Palmolive, PepsiCo, Chevron, Exxon, and so on, because once you buy those shares, the permanent compounding starts to take place without you having to put in any additional legwork. Take Nestle, for example. The food and beverage giant has increased its dividend 5,000% over the past thirty years. If you were generating $1,000 in annual Nestle income in 1984, and said, “I’m going to spend every dollar in dividend income I ever receive from this stock and never again reinvest a penny”, you would now be collecting $50,000 each year from Nestle. The growth in the payments alone, from that single investment, would have brought you up to what the average American household generates per year.

It’s hard to go wrong investing in quality during market selloffs.

But I also think there is a place for cyclical companies that tend to get hit especially hard during selloffs because their profits temporarily dip, and this leads to them trading at much lower profits than they deserve.

Take Emerson Electric and Illinois Tool Works, for example. Illinois Tool Works saw its profits dip from $3.05 in 2008 to $1.93 in 2009, and this caused extreme panic selling. The price of the stock fell from $60 to $25. By the next year, profits rebounded to $3.03, and by that point, the price of the stock was back above $50 (and it now trades at over $83 today). As an added bonus, the dividend increased throughout this period, and so you got nice little kickers if you reinvested when the price of the stock was in the $20s and $30s.

In the case of Emerson Electric, profits went from $3.11 per share in 2008 to $2.27 in 2009, and didn’t fully rebound until 2011 when the earnings were $3.24. The price action of Emerson was remarkably similar to what Illinois Tool Works did: the stock went from $59 to $24, and the rebounded into the $50s in 2010. Like Illinois Tool Works, Emerson raised its dividend throughout this period (in fact, it’s been raising its dividend every year since the 1950s. It’s one of those hidden gem companies that doesn’t get much attention).

For those of you who want to be especially opportunistic during the next market selloff, you should find a place for high-quality cyclical companies. The price volatility is more extreme—and this is why it’s an art that’s hard to get right—you see a $25,000 investment turning into $14,000 which is simultaneously being accompanied by steep drops in profit, and not everyone has the stomach to work through it (especially if you buy early in the decline).

But you do receive something extra for putting up with that—the price gains are much more substantial, and can be predicted if you limit yourself to high-quality cyclicals with long-term dividend streaks, strong product backlogs, and a decent gap between the amount of money they pay out as dividends and the amount of cash flow they generate during the good times (intelligently managed cyclicals rarely have payout ratios above 60% during ordinary or booming economic conditions). If I had to put into an allocation percentage, I would think it wise to dedicate 75% of investable funds during a market decline to the highest quality non-cyclical companies that you can own for the rest of your life without requiring much monitoring or thinking, and the other 25% to more opportunistic investments that are trying to take advantage of companies that are unfairly beaten down. The rewards for getting it right are so great that it’s worth studying and developing a strategy ahead of time for how to approach the role of opportunistic investing during the next significant market selloff, whether that means you buy cyclical companies, real estate investment trusts, or energy MLPs with a portion of your cash.

Originally posted 2014-10-01 09:02:33.

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