Stocks Get Cheap on Christmas Eve

The typical United States stock lost approximately 20% of its value in December 2018. Technically, we have to go back to the Great Depression to find another example of a December in which stock prices have declined by such a substantial amount, but on an annual basis, we are looking at a 10% or so decline, which is something that U.S. Stocks have done about 4-5 times out of every 20 years since the Civil War.

I wasn’t planning on writing about investments during the heart of the Christmas season, but I am reminded of a client I once represented at trial who had to call and make arrangements for neighbors to take care of the farm during the week-long trial, saying that “the cows don’t know it’s a trial week.” So, too, seems to be the case with the sequence of this year’s returns, with no real December event that one could cite in order to justify a 20% decline, such as may be the case after some type of military/terrorist event.

Nevertheless, I’ll take opportunities as they come, and I often come back to two lessons I consider often: the first, from Benjamin Graham, who pointed out that owning a share of stock represents an ownership position that entitles a shareholder to a pro-rata share of all profits distributed and all value created from now until kingdom come, and the second from Peter Lynch, who pointed out that stock market declines do not just reflect a stock price going from fairly valued to undervalued but overvalued to undervalued and thus a stock price decline often encompasses some portion of speculative froth being burned away as well as some portion of a business selling for less than it is worth.

Both of these lessons come to mind during any meaningful negative market event.

Regarding the Graham insight, I am reminded of the data reports that came out of the 1987 stock market decline that pointed out massive declines in Coca-Cola, Exxon, Johnson & Johnson, Procter & Gamble, Colgate, and Hershey stocks. Guess what? Thirty-one years later, a supermajority of those businesses that existed in 1987, and experienced a major stock market decline then, survive to this day (perhaps there is a merger or two that must be adjusted for) and have paid out enormous dividends and risen in price over the same time frame.

The profitable monoliths roll on. They go up over the long term because they become more efficient, sell more of the products, acquire competitors, and repurchase shares in order to give each remaining owner a higher proportionate claim on the business. Why would someone relinquish an ownership in a business that is going to be around 31 years from now, at a much higher price?

I went through the Fortune 100 in 1987. There were only six wipeout events from that class. When people say “Only 32 firms remain”, it is because they are trying to make an apples-to-apples comparison and are not making the proper adjustment for spin-offs and acquisitions. “ConocoPhillips” may not exist anymore, but so what? Ownership positions in Conoco and Phillips 66 do. Dairy Queen may not be around anymore, but who cares–they got an enormous cash payout to become part of Berkshire Hathaway. It is the bankruptcies and insolvencies that you have to worry about.

And what about those six that failed? Well, one of them was Eastman Kodak, which still exists in some form through its spinoff of Eastman Chemicals, which has compounded at a high enough rate that you’d still have a positive return even accounting for the Kodak bankruptcy. So long as you purchased your shares before 1992, purchasing shares of Eastman Kodak would have been a “wealth-creating event” due to the eventual success of Eastman Chemical.

As for the other five bankruptcies. Well, they did go bankrupt, but the magnitude of the success from the 94.5 components that did not go bankrupt was so superior that the failures could be absorbed. Someone who put $100 into each of the 100 largest companies in the United States at the start of 1987 would have $161,000 today, even though 5.5 of those initial $100 investments were reduced to zero. I use the .5 to represent Eastman Chemicals’ survival from Eastman Kodak.

That is why I do not worry about market events as they relate to the largest global businesses. Decades from now, these declines will be a blip–a moment that could destroy wealth for those entering the sell orders, a moment that will turbo-charge the wealth creation process for those on the buy side. Those same companies will be here 31 years from now. To the extent that’s not true, the degree of gain from those that survive will dramatically eclipse what is lost from those that do not.  

It is privilege of investing that your ownership position is set for perpetual duration, and once you realize that each dollar of stock you own has a proportionate claim on all the dollars, quarters, nickels, dimes, and pennies that are thrown off each year, these events can be processed with high-minded aplomb.

Secondly, I am reminded of Peter Lynch’s advice concerning the nature of stock market corrections, namely that a correction includes some portion of excess being removed from valuations. I don’t know about you and what you own, but for nearly every stock I have owned over, say, the past five years or so, the amount of the price increase in the stock exceeded the earnings per share growth of the firm. The P/E ratio was rising, often to points that were decade highs.

I don’t look at the most recent high, compare it to the current point, and lament. A totality analysis has to include the years when a stock rose in price more than it merited. If your favorite restaurant has a four-piece a la carte chicken dinner, and half the time they give you five pieces, and the other half, you get three, are you getting screwed? No. On the whole, I expect to get returns that match the growth rate per share of what I own, and I try to imbue the process with a bit of conservatism by focusing on out-of-favor undervalued stocks so there is a chance I might get more than I deserve anyway.

My formula for success remains the same. Take care of your health, forge meaningful social bonds, acquiring better specialized skills and integrate them into sought-after tasks, keep cash on hand, and own for the long run businesses that churn out enormous chunks of cash over 10-20 year periods and buy more when the price is in your favor.

I recently posted a Patreon update on a stock that has gotten quite cheap in particular during the December route, which is arguably one of the top twenty dividend stocks in the world. You can subscribe here.

Originally posted 2018-12-25 00:40:41.

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