CNN’s Fear & Greed Index confirms what it is pretty obvious from price action and the narrative financial news has spun – people are scared right now. The fears are understandable even if not necessarily logical – a contested election and rising COVID cases will lead to more uncertainty of future cash flows for the world’s best companies. As long as this uncertainty exists, in my mind the market is likely to have a steeper discount rate, meaning future cash flows are worth less. Said another way:
In normal (and boring) times, the market puts a low denominator on future cash flows, meaning expected returns are higher.
In bad (and exciting) times, the market puts a high denominator on future cash flows, meaning expected returns are lower.
If you tell me there’s a 90% chance I’ll make $10 next year and will sell me the chance for $8, I’ll buy it every time (Expected Value (EV) = $9, 10 * 0.9, $1 of value – 9 – 8). Lower that to 70%, and I’m out (EV – 0.7 * 10 = $7, negative value of 1, 7 – 8).
I actually think this little example is part of what’s going on with the market. There is a perception that future lockdowns or higher taxes from a blue wave or no stimulus for months is going to put cash flow at risk. For some companies, there might even be truth to this idea (ex. think Caterpillar, who benefits massively from an infrastructure bill and more reopening). For other companies, I don’t think even a draconian scenario of lockdowns or moderately higher taxes in two years or delayed stimulus will lower the EV enough to stop me from buying stock (think Nintendo, Shopify, Crox, FAANG, etc.) *at current prices*.
The real kicker here is that lower prices in a real crisis discount too heavily even the worst scenarios. Check out this column from March from Diligent Dollar on C19 and cruise lines. The whole thing is worth a read, but the cash flows and quick math in the screenshot below stand out a ton:
Worth restating – in this example case, a 50% haircut on earnings and a return to earnings power in year 2 and beyond only has a 4% impact on the intrinsic value of the business. We know now that saying Year 2 (2021) is the same as Year 0 (2019 + some growth) levels is probably too optimistic – I expect most of 2021 to still have a COVID overhang, albeit one that I think for the most vulnerable industries has a 20-30% EPS decline impact – but let’s do the math and weaken Year 2 so it’s a 40% haircut from 2019, with a back to even level the next year (see spreadsheet here for those interested):
A 10% decline is deserved based on my math. We saw some stocks decline that in single days this past week (CHEF is a holding of mine that sold off 17%+).
Importantly, this math is for only the most COVID impacted stocks. Check out my posts on CROX and TRTN for examples of names that are increasing sales and raising guidance either because of or in spite of COVID. NOW is another one that raised guidance this part quarter with record earnings.
One more point I’d make here is I think 40% declines in EPS in the “model” above is way too bearish. I don’t think 40% will happen on the top line and on the bottom line, companies are realizing savings through aggressively trimming costs, work-from-home and cuts they were forced to make because of COVID. An example on why I think 40% is too bearish – Bank of America reported a “full restoration” of customer spending in Q3 and even more spending for Sept. 2020 versus 2019 – yet, the stock is over 30% off pre COVID highs. If you use XLF as a proxy for banks, the whole financial sector is down 22.5%. Energy is down 47%.
You have to believe in a permanent impairment of earnings power if you think the market got this right. If the coming weeks bring the market down an additional 10%+, you have to believe something unique about COVID and/or election controversy further reduced the ability of companies to produce cash flow in the out years of a DCF. Is COVID or the election going to be impacting the market in 2025+? What about 2023? And how much in 2022?
The fact of the matter is if you’re taking a 5 year view, you need to think about government + COVID past 2021. I have conviction in the belief that the next few weeks and months make zero difference as it pertains to company cash flows past 2021. Sure, a butterfly flapping its wings can eventually cause a hurricane, but that’s not the same as saying Crox’s equivalent butterfly is the same as the macro.
I have my “bazooka” ready that I wrote about in a previous edition of Stock Talking. I’m going to look to deploy it slowly through November if the market continues to decline and be more aggressive if / when all assets move down together (I think when you see all assets move together (gold, bonds, stocks, etc), it means people are selling indiscriminately).
What assets to deploy to? I think during times like these it helps to rank your 3-10 best opportunities and concentrate on your highest conviction bets. Writing a sentence or two on why you like the company often is helpful. What stocks do you want to own forever? My top 3 right now looks like:
1. $NTDOY – Nintendo is wrongly valued by the market as a console maker when it’s clear it is moving towards a subscription model with backwards compatible hardware. New-ish management team (current CEO took over in June 2018) mentions Apple on calls and seems to be taking pages from Apple / Disney playbooks. Trades at teens forward earnings which discounts forever franchises (Mario, Zelda, Animal Crossing, Pokemon, Donkey Kong to name a few) coupled with moves to cloud memberships (ex. Nintendo Switch Online), AR (Pokemon Go, Mario Kart Live: Home Segment) and movies (Mario movie on deck). Should thrive with (more gaming) or without COVID (movies, theme parks, stores, etc.).
2. $IAC – InteractiveCorp. has a stellar track record of monetizing online activity (travel with Expedia, dating with Match Group, now home services through Angi’s List). They bought 12% of MGM during COVID because they thought market was discounting the online sportsbook / gaming segment. They own Vimeo ($250mm+ 2020 revenue, growing at 30-40%, top Shopify video app and big partnerships with GoDaddy and others, video provider staple of e-comm), which should IPO in the next few years and is arguably worth twice the <$2bn the market is valuing IAC’s private companies at (IAC also owns Care.com, Ask.com, Investopedia and more). IAC specializes in monetizing what you do online – we’re going to do more things online with or without COVID.
3. $LADR – Ladder Capital is a mortgage REIT with a super management team that is shareholder friendly to the max. The company trades at about 60% of book despite having most of its loans maturing in two years and being downside protected 30%+ on many of those loans through overcollateralization. The maturing in <2 years is important because soon this company’s loan book will be entirely originated AFTER COVID – it shouldn’t trade like a REIT with a borrower problem. On their Q3 earnings call, they announced they bought back stock this quarter and intend to repurchase debt and stock as long as the market discounts either (stock was bought in low 7s, company trades at 7.50 as of Friday’s close). CEO said on last call smart holders of stock don’t buy for dividend (which is 10%+), but because they know it can double on the strength of its earnings power. Unlike my (1) and (2), this doesn’t benefit from prolonged COVID, although it has its market cap in cash and management is renowned for buying low-priced assets – they did amazing cherry-picking opportunities in 2009-10. That said, I think they can easily weather through two more years of COVID due to having a truck load of cash and low leverage relative to peers. You also get paid 10% a year to wait through the divvy.
All three of these I want to lower my cost basis on. If the market gets worse, I can confidently buy knowing I’ve thought about the downside.
The weeks to come if they materialize the way the bears think are the weeks I think you can change the destiny of your portfolio.