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How To Remain Solvent Longer Than The Market Is Irrational
I believe it is extremely important that investors focus on the value of what they own more than they do on the day-to-day machinations of price volatility. However, I also believe, and even recognize, that very few investors are capable of ignoring volatile stock price movements. When the price of a stock that they own is rising or falling, especially when the swings are large and/or violent, it is very difficult for people to maintain a steady head and hand. Instead, emotions take over reason which often cause otherwise rational investors to make irrational decisions.
My last article dealt with how to think about stock prices in today's volatile markets, and can be found here.
The above article was well received by readers, and generated many lively comments and questions. One comment/question in particular that attracted my attention was also the inspiration to offer this follow-up regarding how to think about stock prices. I have cleaned up the comment and paraphrased it as follows:
"In your Dividend Growth articles, it's always been highlighted that certain premium dividend stocks often seem to be fully or slightly overvalued, except in the case of a severe financial crisis. e.g. Kimberly Clark (KMB), Coca Cola (KO), Walmart (WMT) ,and then there are certain stocks which often seem to be chronically undervalued by the market, for years and years at a time--take Teva (TEVA), for instance. Is there a strategy to deal with buying these outliers that takes this mispricing into account? I'm wondering how to navigate chronic under and overvaluation..."
The above comment led me to realize that it's one thing to accept the idea that stock markets can be irrational at times and misprice companies, over or under, however, it's another thing altogether to develop and follow a strategy that allows an investor to exploit other people's folly. First of all, in order to do this successfully, investors have to be able to discern and differentiate between times when the market is behaving rationally and when it is not. My point being, that there are times when wild price swings are rational, and of course times when they are not. Therefore, it is implicit that the correct strategy be predicated on distinguishing between the times when price behavior is rational and when it is not.
To my way of thinking, that was the essence of the question that the reader was asking in the above comment/question. Therefore, I offer this article to illuminate upon the types of behavior and research required to ensure as best you can, that the proper strategy and actions are being implemented. At this point, I would like to interject that the correct strategy regarding navigating "chronic" overvaluation and/or undervaluation must be based on the proper determination and realization that overvaluation or undervaluation actually exists. This can only be accomplished when the investor is focused on the business first and foremost, and then, and only then, on stock price.
The point I'm driving at here is that stock prices are often, as I pointed out in my previous article, pathological liars. They can be misleading and often are deceiving, thereby generating extreme emotional responses. It's hard to have confidence in your company when its market price is falling precipitously. Moreover, and equally as dangerous, it is very easy to become complacent and overconfident about a business when stock price is on an upward tear.
On the other hand, I believe it is much easier to determine the intrinsic value of a business, than it is to attempt to forecast where its price may go in the short run. As I did in my previous article, I will turn to the wisdom of legendary investors to illustrate my points. The following quote by Martin J. Whitman supports my last statement:
"I remain impressed with how much easier it is for us, and everybody else who has a modicum of training, to determine what a business is worth, and what the dynamics of the business might be, compared with estimating the prices at which a non-arbitrage security will sell in near-term markets." Martin J. Whitman, Chairman of the Board, Third Avenue Value Fund
Procter & Gamble (PG) - A Quality Premium Form of Overvaluation
When dealing with overvaluation, there many types and degrees that can occur. For example, certain blue-chip companies can typically be awarded what I call a quality premium by the market. In many ways, I consider this type of overvaluation to be one of the most difficult to navigate. First of all, because the overvaluation is chronic, it is less obvious, and therefore, more difficult to ascertain or judge. But more importantly, it is up to each individual investor as to whether or not they would ever be willing to pay the premium the market typically is asking in order to own the security.
A classic case in point is the blue-chip dividend growth stock Procter & Gamble. Procter & Gamble has paid a dividend for 122 consecutive years since its incorporation in 1890, and has increased its dividend for 56 consecutive years. On this basis, it is easy to see why the market historically affords the company a premium valuation. Quality and consistency, the likes of which that Procter & Gamble has achieved and delivered for shareholders, is very rare.
The following FAST Graphs™ review Procter & Gamble for the years 1997 - 2007 in order to illustrate the quality premium that the market has typically applied as referenced in the above paragraph. I chose this time frame for two reasons. First of all, it clearly shows typical premium pricing by the market, and includes the infamous irrational exuberant period that ended in 2000. Therefore, it illustrates two types of overvaluation, the normal quality premium and a period where overvaluation becomes extreme. The second reason I chose this time frame was because it shows Procter & Gamble up to, but just before the great recession of 2008.
The orange line on the graph plots earnings-per-share and represents a PE ratio of 15 which would typically be applied to a company growing at approximately 10% per annum like Procter & Gamble has. The blue line on the graph represents the normal PE ratio of 22.2 (the quality premium valuation) that the market was typically capitalizing Procter & Gamble shares at. Therefore, it is clear from this graph that if you were ever to own Procter & Gamble during this time, you had to be willing to pay the premium valuation as the company's price never touched its theoretical fair value (the orange line).
When you review the performance associated with the above historical time frame where Procter & Gamble was always priced at a premium, you discover that the shareholder rewards were very attractive. Procter & Gamble delivered cumulative total dividends that would have exceeded the general market as measured by the S&P 500, and capital appreciation ($2729.02 for Procter & Gamble versus $1982.29 for the S&P 500) was also significantly above average.
Consequently, even though you were forced to pay this premium valuation in order to own this blue-chip, the rewards were clearly worth it. However, at the same time you should also have been aware that you were taking a greater risk than the company's valuation, based on its cash flows, warranted. In theory, the quality of the company compensated you for the extra risk you took. On the other hand, it is up to the individual investor's own judgment as to whether or not they were willing to take this overvaluation risk. Personally, I chose not to.
When evaluating overvaluation, the individual investor needs to always be aware that even though the market may not always be efficient, it always has a penchant for seeking efficiency. Therefore, the reality that a reversion to the mean could occur at any time should be at the forefront of their mind. It's one thing to be willing to pay a premium valuation for a quality blue-chip like Procter & Gamble; however, it's an entirely different matter to complacently believe that mispricing would never be corrected. It's much smarter and prudent to recognize that it could occur at any time, and therefore be prepared when, and if, it does.
This next earnings and price correlated graph that brings us up to current time on Procter & Gamble shows that a reversion to the mean did, in fact, occur during the great recession of 2008. Here we see that the price of Procter & Gamble shares did drop down to, and then slightly below, the orange earnings justified valuation line (orange circle on the graph). Interestingly, over the next three years or so, with investor sentiment negatively charged by the great recession, the quality premium for Procter & Gamble shares was gone. Instead, price tracked earnings very closely up to the spring of 2012, wherein the price has once again begun moving towards its typical premium valuation (the blue normal PE line).
The title of this article was written in reference to a popular quote about the market that states "the market can remain irrational, longer than you can remain solvent." However, I received a comment in my previous article from which I modified this quote to state as follows: "Mr. Market can be irrational longer than your patience threshold can endure."
As another reader pointed out, the original quote referred to those who were investing using leverage. When money is borrowed, it is quite possible that the market can be irrational longer than you can be solvent. In contrast, if you invest more prudently without leverage, I believe that market irrational behavior can be waited out. However, there must be an intelligent framework supporting your patience. I believe that intelligent framework would be an understanding of the intrinsic value of the business behind the stock.
Therefore, a strategy for dealing with overvaluation is to focus more on the business (the orange line on these graphs) and less on the stock, and make your investment decisions accordingly. In other words, if you must own Procter & Gamble, then you must be willing to accept the fact that the market likes to put a premium valuation on the stock. On the other hand, don't fall asleep believing that this can never change, as evidenced by the following graph.
The following performance graph associated with the above earnings and price correlated graph where Procter & Gamble's share price did revert to the mean provides an interesting perspective. As long as shareholders didn't panic and sell when the recession hit, their long-term performance would have still been intact. Moreover, for the wise and levelheaded dividend growth investor, they continued to receive a raise in pay each year to reward them for their patience.
Cisco Systems Inc. (CSCO) - Dealing with Extreme and Dangerous Overvaluation
The most insidious form of overvaluation is when Mr. Market is truly being totally irrational. In the case with Procter & Gamble above, Mr. Market was quasi-rationally applying a premium valuation to a blue-chip. However, during the infamous irrational exuberant period, Mr. Market brought us a quintessential example of a bubble in technology stocks. Great tech stocks, such as Cisco Systems Inc., became so irrationally overvalued as to be dangerous.
Dealing with this situation is a far cry different than dealing with a premium valuation on a blue-chip. For starters, the correction can be much swifter and severe due to the extreme nature of the mispricing. Moreover, the effect of the correction can last for a significantly longer time. Cisco Systems has never, and may never recover from its peak price in calendar year 2000.
Since a picture is worth 1000 words, let's look at how ridiculously overpriced Cisco really became during this time. Cisco's PE ratio became so astronomically high that common sense dictated that there could be no possible way that future earnings and cash flows could support it. Consequently, as quickly as the shares rose, their imminent fall was just as dramatic and swift.
Consequently, I believe that dealing with dangerous overvaluation must imply a different approach and behavior. First and foremost, an investor's first step should be to protect and preserve. Therefore, dangerous overvaluation implies a selling strategy. Depending on the investor's tolerance for risk and their emotional capacity, will determine whether an outright sale should occur, or perhaps a methodical unwinding of the position.
The following earnings and price correlated FAST Graphs™ on Cisco Systems Inc. is marked with a green dot representing a theoretical purchase when the company's shares were in value. The red dots represent various theoretical sells. This is presented to illustrate potential strategies that an investor could utilize when dealing with extreme overvaluation.
For example, a prudent, but perhaps more aggressive, investor could have sold one fourth of their original position as the stock went on its meteoric advance. Therefore, in the following example, they would have locked in a significant profit after the first sell. Consequently, each subsequent sell was made while playing with so-called house money (unrealized gains).
A second strategy would have been to simply sell out at the first level where the investor felt that the stock could become dangerously overvalued. Note in the example below that even if this occurred on the first red dot, a significant profit would have been harvested. Moreover, even though a lot of money would have been left on the table over the short run, this still represented a good long-term decision. However, the primary point is that strategies for dealing with even extreme overvaluation must ultimately be based on each individual investor's own judgment and risk tolerances.
Stock prices can be all over the place, and often for no good reason. On the other hand, the fundamentals underpinning a solid business are much easier and therefore reliable to gauge. Moreover, business results tend to be more consistent than the often whimsical up-and-down and jagged movements seen in the typical stock price chart. But as Marty Whitman points out in this next quote, the trick is to determine the difference between the destruction of the business model versus a temporary drop in its price:
"Unrealized Market Depreciation occurs when the market price of a publicly traded security declines. Permanent impairment of Capital occurs when the Fundamental values of a business are dissipated with the consequent long-term adverse consequences." Martin J. Whitman, Chairman of the Board, Third Avenue Value Fund"
I fervently believe that knowledge is power, and I further believe that knowledge is the greatest antidote against making foolish mistakes. For added color on this important principle, let's turn to Warren Buffett and see what he has to say about navigating the market's mispricing:
"Great investment opportunities come around when excellent companies are surrounded by unusual circumstances that cause the stock to be misappraised. It's only when the tide goes out that you learn who's been swimming naked." Warren Buffett"
In order to correctly ascertain undervaluation, the first step is recognizing that just because the price of a given stock drops, does not mean that the stock is undervalued. Some price drops are justified, and others are not. More simply stated, not all price drops are the same, and it's implicit that the prudent investor makes this distinction for them to expect their investments to be successful.
Once again, I will turn to earnings and price correlated graphs to illustrate the veracity of this point. My goal is to establish that if prices are dropping while business results are holding up, a bargain is created. On the other hand, if prices are dropping along with business results, then the price drop is not only justified but perhaps even permanent.
During the great recession of 2008, financial stocks were the most devastated sector in the market place. The following earnings and price correlated graph on Aflac (AFL) up through year-end 2009 shows that stock price fell significantly beyond the earnings drop. Therefore, Aflac's stock price recovered back to its earnings justified level rather quickly (red circle on the graph).
However, when we bring the Aflac graph back to current time (below), we see that price again became undervalued due to an earnings drop in 2011. This drop was primarily a function of the company de-risking their balance sheet in order to better prepare themselves for weak economic times. Nevertheless, the market reacted strongly once again, and Aflac shares have remained under their earnings justified valuation ever since.
The question that stimulated this article was essentially how long can, or should, an investor wait for an undervalued, and therefore, underperforming stock to regain its luster. My simple answer would be that as long as the company's earnings are justifying a higher price, then I would be willing to wait as long as it takes. Personally, I am confident that the stock will inevitably reach its fair value; it's only a matter of time. As I did in my last article, I will once again repeat one of my favorite Peter Lynch quotes:
"You can see the importance of earnings on any chart that has an earnings line running alongside the stock price. On chart after chart the two lines will move in tandem, or if the stock price strays away from the earnings line, sooner or later it will come back to the earnings." Peter Lynch - 'One Up On Wall Street"
In order to be as clear as I can on my position on undervaluation, the most critical step is determining that undervaluation does, in fact, exist. The only way I feel that can be done is when you measure stock price against its earnings justified valuation. In other words, if earnings justify a higher value, then one of the bargains that Warren Buffett talks about above is being manifest. On the other hand, if both stock price and earnings are falling, then I feel the appropriate action is to sell regardless of price. The following graphic on Citigroup (C) another famous financial stock, represents a clear example of what I'm referring to.
Contrast Citigroup with a regional bank such as the Bank of Marin (BMRC) below and we see a precipitous drop in stock price during the great recession while earnings held up nicely. Therefore, in this example the stock price recovered quickly and has continued achieving new highs.
Summary and Conclusion
The following graphic on Teva Pharmaceuticals (TEVA) represents an example of a company that I believe Mr. Market is currently mispricing. Since I believe that this company's earnings' future is well-defined and bright, I would be adding to my position as much as I could, as long as the market kept giving me the opportunity. I trust the orange line on the graph much more than I trust the black line. Warren Buffett taught me this when he said:
Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices." Warren Buffett"
Therefore, I submit that the simple answer to the question how you navigate overvaluation or undervaluation is fundamentally based on whether you trust fundamentals or not. I believe that as long as earnings are solid it makes sense to hold on, and perhaps even more sense to add to your position. I never let the market dictate my behavior, instead I take my cue from what I believe the intrinsic value of the business is, based on deep research. Once again I'll turn to Peter Lynch and share his sage words on this subject:
"What makes stocks valuable in the long run isn't the market. It's the profitability of the shares in the companies you own. As corporate profits increase, corporations become more valuable and sooner or later, their shares will sell for a higher price." Peter Lynch, Worth Magazine, September 1995"
I am interested in owning stable and growing businesses that can be purchased at sound and attractive valuations. I'm never one to be willing to pay more than I believe the stock is worth, but on the other hand, it's hard to argue with a quality premium valuation awared to Procter & Gamble, as was illustrated previously in this article. Personally, I did not invest in Procter & Gamble until the price came down to the orange line. This took well more than a decade to occur. However, it was worth the wait.
So at the end of the day, my advice is that investors can, and should, trust a solid business and always hold the day-to-day price volatility with a great deal of mistrust. With that said, the best strategy is to conduct comprehensive due diligence with the goal of recognizing anomalous pricing when it occurs. This is how you exploit others' folly and find bargains to buy and overpriced businesses to sell.
Disclosure: Long PG, CSCO, AFL, C & TEVA at the time of writing.