This article is authored by Christopher Tsai, president and chief investment officer of Tsai Capital Corporation. It was originally shared with Tsai Capital investors and interested parties on March 10, 2020.
I would like to reiterate our investment approach with you and talk about the recent market sell-off, which according to Deutsche Bank Global Research, was the fastest in recorded history.
The sell-off in equities was partially triggered by the outbreak of the novel coronavirus, which has tragically claimed about 4,300 lives worldwide, to date.
While the number of deaths related to the coronavirus is just a fraction of the number of deaths caused by the common flu each year, after millions of years of human evolution and living on treacherous terrain (the Savanna), we are genetically hardwired to hate uncertainty and novelty. And the virus is both uncertain and new. In the type of environment that we are in, investors often sell first and ask questions later. And they sell fast.
Less spoken about is the fact that the market downturn was exacerbated by Russia’s refusal to accept oil production cuts while worldwide economic activity is being disrupted by the virus. One ramification of the standoff between Moscow and the Organization of the Petroleum Exporting Countries (OPEC) was a collapse in the price of oil, which led to an even more dramatic sell-off in equities and a stampede into U.S. Government bonds.
Since many investors have rushed into government bonds, the 10-year U.S. Government bond rate is now under 1% – that is, at about 0.70%. What does this mean?
Since bond investors who hold their bonds to maturity receive no more than the interest rate at the time of purchase, a buyer of U.S. Government bonds is paying more than 140 times earnings at the current market yield. Put differently, it would take more than 140 years to double your money at present rates, and that’s in nominal (as opposed to real) terms. The rate of return on high-quality bonds looks just terrible in relation to the U.S. stock market, as measured by the S&P 500 Index.
Even with the disruption from the virus, we expect operating earnings for the S&P 500 to be more than $170 per share over the next 12-months, which equates to around 16.5 times earnings (as compared with more than 140 times for U.S. Government bonds). Put differently, if the profits of U.S. companies never grew over the coming years, an investor in the S&P 500 Index would likely double her money in around 17 years (as compared with more than 140 years in U.S. Government bonds). As Warren Buffett recently said, the choice between equities and bonds is a no-brainer for the long-term investor in the current interest rate environment.
I think those who are not long-term oriented and not invested in equities are likely to experience financial hardship over the decades to come. That’s because of inflation and the tendency for the dollar to lose purchasing power over time. After all, prices for goods and services tend to rise over time.
I’m reading a fascinating book right now called Common Stocks as Long Term Investments by Edgar Lawrence Smith. It was published in 1924. This book, which has largely been forgotten by now and is only read by the nerdy types, like me, really changed the way people thought about bonds and stocks. Mr. Smith provides fascinating commentary about markets during the Civil War. He also points out (almost a century ago at this point) that all governments want the value of the dollar to decrease over time. A decreasing dollar lifts asset prices and creates the illusion of prosperity, which keeps governments in power. But a declining dollar also raises the cost of living.
I figure that the purchasing power of the dollar (read cash) falls by about 50% every 17 years. So in 17 years, what you have now will buy half as much as what it buys today. In the past, people were somewhat able to offset the effects of inflation by earning some interest on their savings. But today, with rates at less than one percent, that’s simply not the case. Long-term holders of cash and bonds beware…
In 1924, Mr. Smith points out that common stocks are an inflation hedge. That remains generally true today, especially when it comes to companies that have pricing power.
At Tsai Capital, we spend a lot of time figuring out what high-quality businesses we want to own for long-term capital appreciation. We also spend a lot of time figuring out what price to pay so that we can build into each purchase a margin of safety. Margin of safety, or a discount to what we think a business is worth, not only helps to provide downside protection, but also can lead to a higher rate of return.
What we don’t do is obsess about the market’s day-to-day gyrations because we believe stock prices are ultimately driven by business values. Put differently, we focus on the fundamentals of a business and not ticker symbols and day-to-day quotations.
While stock prices bounce around all day long, especially during periods of exceptional uncertainty, the value of a business does not change that much on a day to day basis. That’s because the value of a business is the present value of its discounted cash flows. The outbreak of the coronavirus may impact negatively (or positively) the current cash flows of the businesses that we own, but the math is such that most of the value of a company, especially a growth company, comes from the cash flows many years out. One just can’t ignore math.
Unfortunately, the vast majority of investors are driven by emotions of fear and greed and wind up buying high and selling low. That’s not my idea of fun!
Countless investors also foolishly try to time the market and make assumptions about where the market is heading; what might seem so obvious at the time (even to me) often just doesn’t happen. As U.S. Army General George S. Patton said, “If everyone is thinking alike, then someone isn’t thinking.”
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