Show me the…cash flow!
April 20, 2016
Market Summary – 1st Quarter, 2016
“…volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong.”
– Warren Buffett
We’re in the midst of an investment environment defined by heightened volatility. Just when it appears that the next bear market is upon us, stocks rally. When it seems that markets are back on track, they take a slip backward again. We experienced a severe down-and-up scenario during the first quarter, with a fair amount of day-to-day fluctuation. Although this type of market volatility and short-term unpredictability is nothing new, too many investors react by following the same, tired script. With their fears inflamed by a volatile market, they shift money out of stocks and into the perceived safe-havens of cash, fixed income instruments, and bond proxies such as telecommunication and utility stocks.
Many investors have been mistakenly educated to believe, as Warren Buffett pointed out above, that avoiding volatility is a way to protect their portfolios. Unfortunately, the longer this logically-flawed trend persists, the greater validation it receives. Yet as we’ve noted in previous newsletters, risk-averse investors who follow this conventional path often become their own worst enemies. They sell equity positions as they are becoming more attractively priced. They then put that money into asset classes that have become very expensive, and thereby considerably riskier. These investors are leaving a cheap asset class and moving into an expensive asset class under the mistaken belief that they are reducing their risk.
Look at what are viewed as “safe” alternatives in today’s market. Cash continues to pay virtually nothing, and on an inflation-adjusted basis is losing value (purchasing power). Bonds remain a historically risky choice given that unsustainably low interest rates persist (and when rates inevitably rise, bond prices will drop). Bond proxies like utilities are currently trading at about a 25% premium (expensive) to their historical average, despite continuing to offer scant upside potential.
Not all investors have followed the masses into these falsely-perceived safe-havens. They ignored the ramblings of prognosticators who were calling for a sustained slump in stocks when 2016 kicked off. We applaud those who didn’t sell, but instead realized that markets in decline offer opportunity for those who understand how such events can work in their favor.
Playing defense in volatile markets
Volatility is the term that we use to define the up-and-down price movements that occur over a short span of time. It may result in headlines for the stock market (especially when markets go down), but it is does not have strong predictive power. Volatility is simply a measurement of what has happened, not what will happen in the future. Investors would be well suited to think of volatility as a rear-view mirror, not as a telescope.
Nevertheless, investors can’t be blamed for wanting to protect themselves from the uncertainties of the market. If the “safe-havens” of cash, bonds and bond-like proxies aren’t the solution to managing volatile markets, is there another way? We’ve often spoken of the importance of paying the right price for a stock as a savvy defensive strategy during volatile periods. As value investors, we emphasize price. By focusing on the appropriate valuation for a business (and endeavoring to pay even less than that for it), value investors avoid taking undue risks that become most evident during a market slide. After all, if you invest in a good business at a low enough price in relation to its assets, you limit your potential loss and lower your risk. Those who pay little attention to price, and instead focus on momentum investing, growth styles of investing, technical analysis, or who have overpaid for currently low-volatility stocks don’t have that same built-in cushion.
This isn’t to say that these other styles of investing don’t work from time-to-time. Over the market’s long history, several investing styles have had their 15 minutes of fame. The past five or so years have proven this point. But making a decision to invest in a stock based primarily on the confirmation bias of its recent price rise – a trend that feeds on itself during exuberant times – is how wealth destroying bubbles form. Just as volatility is not a predictor of the future, neither is price momentum. Ultimately, the market rewards businesses that demonstrate fundamental value.
How is that value measured? One of the most important and commonly overlooked measurements is a company’s cash flow. Discovering a business that produces extra cash flow after paying all of its expenses, taxes, and dividends to shareholders is an indication of a of a well-run business – one that is effectively positioned to weather the market’s inevitable fluctuations. If its stock price falters as part of an overall market correction, but the underlying cash flow generation of the company remains strong, there may be little reason to lose confidence in the stock’s long-term investment outlook. A temporarily declining stock price is not always an indication of the future prospects of a company. Just as the tortoise didn’t always lead the race against the hare, value stocks may, from time-to-time, lag growth stocks. But over time, the race is won by the business that has the fundamental underpinnings for success, which will inevitably be recognized by the market.
The more immediate rewards of positive cash flow Along with supporting long-term stock performance, cash flow has other benefits that investors may capitalize on from the outset. Companies with excess cash ultimately have to do something with that money. One option is to pay shareholders a dividend or raise the dividend if one is already paid. Another is to buy back some of its outstanding shares, a strategy that often provides a boost for the value of remaining shares outstanding. Forward-looking companies will invest in their future growth (i.e., new factories, expanded labor force). Others may use excess cash as a way to pay down debt, improving the firm’s balance sheet.
Companies generating significant cash also tend to become appealing acquisition targets for competitors seeking profitable expansion, or astute investors who recognize a profitable investment. Businesses with strong cash flow generating ability often become more attractive investments if their stock price declines. Ironically, stock price declines can actually serve as the catalyst for unlocking value in strong cash flow generating companies. In these cases, the price becomes too cheap to ignore, attracting interest from numerous value-seekers (such as competitors, suppliers, institutional investors, and private equity funds) who are willing to pay a premium to own the business outright.
A deeper dive into the numbers that matter
Cash flow is a number that does not receive many headlines. Much more attention is paid to earnings, which provide an accounting measure of the profit a company generates in a given period of time. This earnings per share number is important, but perhaps it gets too much credit given that it may be manipulated through creative accounting.
For example, the earnings number that drives opinion on Wall Street is referred to as “normalized” earnings per share. In this case, “normal” means ignoring unusual expenses or circumstances that are considered to be one-time costs. A shortcoming of this approach is that it ignores unusual expenses or events that occur more often than company management would like to admit (like a “100 year storm” that seems to come every few years). Who among us would not like to have our lives measured only by what was “supposed” to happen? We recognize that specific charges, such as a costly organizational restructuring, are often an unusual circumstance. What matters is that these “one-time” events still affect the actual bottom line, and frequently have an unmistakably negative impact on the value and cash flow generated by a company.
Why don’t more investors, both professional and amateur, pay attention to cash flow? Because it requires a deeper dive into a company’s financial statements. In today’s world of headline-driven trading, high-frequency trading, and index investing, the underlying fundamentals of a company are oftentimes at best a casual consideration for these market participants. There are fewer investors that are likely to peer deeply into these numbers. We are one of the few that do, because we believe that understanding a firm’s cash flow is an important part of determining a business’ worth. This process sometimes subjects us to the market’s short-term bouts of volatility, but we believe that it ultimately allows us to find businesses that offer our clients both meaningful upside potential and protection from permanent loss.
It may surprise some to learn how commonplace market volatility has been throughout recent history. Consider that from 1980 through 2014, the average intra-year price decline for the S&P 500 Index was nearly 15% per year, though the same index managed to deliver an annualized total return of over 11% during that same period. Short-term declines in a business’ stock price do not equal financial loss unless you sell. We believe that the key to successful, long-term investing is to accept this volatility, and recognize that if you own the right investments at the proper price, you stand not only to survive, but also to prosper.
Within our own portfolio
The following will demonstrate that we aren’t just a bunch of pretty faces (although follicly challenged), and that we practice what we preach. We added three positions to MPMG’s All-Cap Value Composite portfolio during market weakness in the first quarter of 2016 (Staples, Chevron, and Las Vegas Sands). These companies have both a proven history and bright future prospects of generating strong cash flow. Further, all three companies pay sizable dividends (averaging 5.5%1), and in our opinion, offer very attractive prospects for investors. They are among the many stocks in our portfolio we believe are well positioned to reward our clients over the long run . . . while at the same time have a wide margin of safety.
What can we expect from here?
Investors can be assured that volatility will continue to be a feature of stock investing as we go forward. The “back-and-forth” in the market is likely to continue in the months to come. Unforeseen dramatic events, a very unsettled domestic political environment, ongoing terrorism threats, and other factors are likely to add uncertainty to the market. And the market does not like uncertainty.
It is times like these that investors will appreciate owning businesses purchased at a reasonable price. These undervalued companies with strong cash flow generating abilities are in the unique position to provide security to investors even if the market prices decline. It means that good companies are available at even better prices. In a journey for investors that spans multiple decades, being able to buy a quality business on sale should be considered an opportunity. Investors who view the market through the value lens will appreciate that volatility is not about risk, but about opportunity.
1 Based on average acquisition price during first quarter of 2016.
Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted. Market returns discussed in this letter are total returns (including reinvestment of dividends) unless otherwise noted.
The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.