Sogo Shosha

Not quite a whale, and pretty small investment, but interesting nonetheless. As usual, people are trying to read all sorts of things into this investment, from bullishness on Japan, bearishness on the U.S., the U.S. dollar, inflation hedge / exposure to natural resources etc. It almost feels like nobody ever reads anything Buffett writes. He doesn't base investments on themes like inflation or economic views or views on foreign currency exchange rates. 

But anyway, one can only assume that Buffett feels that these Japanese trading companies are decent businesses with decent managements trading at attractive prices.

Foreign Investments 

This investment really reminds me of his Korean stock trade a while back. He said he was flipping through a Korean company handbook and noticed that a lot of stocks were trading at very low valuations. It seemed like he didn't need to dig into the details of every company to know that they were cheap enough and buying a basket would be profitable. This shosha investment kind of feels like that.

 

I remember noticing a while back in a photo or video of Buffett in his office that the Japan Company Handbook was sitting on his desk. So you knew he was flipping through that thing one company at a time looking for bargains. This may have been how he found this group. I would not be surprised if he has been reading all the annual reports of the big Japanese companies for years. Why wouldn't he, with so much capital to allocate?

First of all, I won't go into too much detail about the Japanese trading companies. They all have English annual reports on their websites, and you can just read about them on Wikipedia etc.

But I have to say my first reaction was not positive. I think many of us who are familiar with the Japanese market were a bit surprised. One pro said he was "disappointed". 

What does he see?!

Anyway, first, let's see what Buffett may be seeing. Since he bought five stocks, this is clearly not about any individual company or management. 

Let's just look at the big picture on these names. This table below is current as of early September 2020.

 

Since he has been accumulating these stocks for the past year or so, the most recent annual report he would have seen last year would have been for the year-ended in March, 2019 or more likely 2018 (as English versions of annual reports come out late). I have highlighted the March 2019 year figures, but he may have evaluated things based on 2018 figures too.

 

Prices haven't moved much (except Itochu), they are within sort of the range they have been for the past couple of years. So the table just compares everything to current prices.

 

In short, what he was seeing was a group of companies earning double-digit ROEs with single-digit P/Es and P/Bs below 1 (except Itochu).  Where can you get that combination? Maybe in some emerging markets. These are blue-chip companies with solid reputations, at least socially (banks and shosha were the two industries that parents traditionally wanted their fresh college grads to join). 

Initial Reaction

So just by the numbers, this makes total sense. No mystery here. It is exactly the sort of thing Buffett would jump into.

What about the reputation of incompetent Japanese management? That's what I would worry about most. Japanese management is and has been improving over the past few years, but I can't say I would be completely comfortable with management there, particularly in the big companies.

There are many cultural reasons why management in Japan has been so inept over the years. Things like seniority, lifetime employment, constant annual rotations of staff and the short put nature of employee positions have been really detrimental to companies there. I do have first-hand experience with this. It is getting better, I hear, but if you remember how a Korean airlines flight went down because it was culturally unacceptable for a co-pilot to point out an error to the pilot, cultural factors can be quite destructive. 

In Japan, one of the big ones is the notion of seniority. Meritocracy is increasing over there, but there is still a notion that older people know better so must be respected and not challenged. A lot of this gets mixed in with the natural tendency to defend your own turf. This combination may make it difficult for energetic, creative, competent young people to move up to benefit the company. Also, the lifetime employment 'promise' makes it difficult to make room for more competent employees. This combination of lifetime employment and seniority can be lethal in a fast changing, dynamic world.

The other big problem is that a lot of large companies tended to want to rotate people every three years to give them a broad experience to prepare them for senior positions at HQ. I remember dealing with some of these employees in NY and was shocked at how things worked. They come over to NY knowing nothing about finance, for example, and they speculate using firm capital not knowing what they are doing. Of course, by the time they start to understand what is happening, they are 'rotated' out to London or somewhere else. So they barely get to understand anything before moving on and they eventually end up at the head office, not really knowing much.

 

There were some trading companies that were close to blowing up or had to merge because they were on the verge of bankruptcy, and given my first-hand observations, that was no surprise at all. Did I tell you about one of the trading companies that would call our swap desk every day and ask for anything above a certain LIBOR spread? And they were indifferent to the risk; they didn't care. They mechanically just bought anything above a certain hurdle rate. I used to get invited sometimes to client dinners and I heard it directly too; they don't care about the risk, just give them something with this yield. They are willing to take whatever risk is implied in that given yield. Why this rate? Oh, that's our funding rate. Oh. Well, you have to take some risk, then. That's OK. Do you care what kind of risk you take? No, we just need to clear our funding rate. But structured products can be very risky. That's OK, we like structured products. etc...  You get the point. It was crazy.

 

This is one reason, by the way, why I thought a lot of the criticism against the banks during the financial crisis was baloney; a lot of these clients knew what they were doing, knew the risk they were taking. Or they simply didn't want to hear anything. They just wanted certain things regardless of the risk. Of course, I was never a salesman so would simply state facts, and they were like, OK. That's fine with us. Scary stuff. I'm sure things are better now (but I wonder. I just finished the GE book, and Immelt sounds very much like a clueless salaryman! Frightening. Except GE may have been worse; how is all of that stuff not fraud?!).

Of course, I am making all these sweeping, generalized statements, but here's another thing that you may have noticed. Some Japanese corporations do really well globally, particularly the manufacturers. If you look at Toyota, Canon, Sharp and many others, they have tended to do well in the past (although a lot of them are now under pressure from Korean / Chinese competitors). They succeeded because they mastered their craft in Japan and exported around the world and eventually built plants around the world implementing their techniques. 

But if you look at the businesses that tried to expand globally through acquisitions and / or the financial/service companies, they have failed miserably. The Japanese tend not to be great acquirers. Well, data show that this is true everywhere and anywhere; M&A tends not to work out well. But I always had the sense that it was worse for the Japanese when they venture overseas. 

As I mentioned above, I just finished the GE book, and it's funny how Immelt sort of acted like a Japanese salaryman; they just want to get the deal done no matter the price, and people are afraid to challenge the 'senior' person. In big companies, so often, things are decided by politics, so you can't afford to upset people. If you think a deal is bad, why would you risk your own career and point it out? 

This goes on to the next part of the problem in Japanese companies, and that's the short-put aspect of the employment contract. Again, there has been some change, but in general, Japanese companies are not known for paying outsized bonuses for success (well, you can argue that the Americans are very good at paying outsized bonuses for failure), so this discourages risk-taking. Why bother? If you step up and try to do something big and it succeeds, you get a nice pat on the back and maybe a small bonus. But if you fail, this can be detrimental. They may transfer you out of your job and send you to corporate Siberia. We've all read about the madogiwazoku. They can be like those empty rooms with no windows that we read about, but more often it is probably some transfer to some branch somewhere that nobody wants to go to. 

 

Although the long-call nature of U.S. business can create problems, the short-put structure of Japanese employment can be troublesome too.

Anyway, enough of this. Things have probably changed a bit. The above problems usually manifested itself in low profits, low margins and low ROE in Japan, as businesses pursued market share at all costs, spent money building facilities for their employees, created companies where the main company can dump unnecessary workers etc. 

But at least in the above table, we can see that ROE has been decent in these trading companies in the recent past. 

BPS Growth

OK, so we see that the stocks are cheap on a P/B basis. If we are going to evaluate something on a P/B basis, unless we are expecting liquidation, we have to look at how BPS has grown. So here is a quick table that shows the BPS of these companies; most recent, 2015 and 2010 figures, so we can see how BPS has grown for these companies in the past 5 and 10 years. I also added stock prices for the same time frame so we can compare.

BPS Growth of Buffett's Shoshas

 

Itochu is pretty good; they have grown BPS 11.2%/year over the past decade and 5.5%/year over the past five. This may even be better than BRK! (I didn't look). Stock price returns are not bad either. The other ones? Not so impressive, but including dividends, most of them look decent on a 10-year BPS growth basis, actually.  (Stock price change excludes dividends).

 

Anyway, moving on...

Itochu

I will spend some time over the next few weeks reading the annual reports of these companies, so maybe I will post more about them if I find anything interesting. 

But first, I took a quick look at Itochu. Itochu has been one of the top trading companies for years, and has a reputation of being a little more modern and 'hip' than some of the others which were part of a zaibatsu. Shosha as part of a zaibatsu makes you wonder where their real interests are; are they trying to make money for the shareholders? Or do they have a specific role to fill as part of the industrial group which would force them to do things that might not be economically rational? They also might seem a little more traditional / conventional, which is not a complement when it comes to Japanese business.

 

 

This is a great chart from the 2020 annual report. But this is illegible, so I cut it up below so you can see the tables below. 

 

It's hard to see, but the below tables are what's at the bottom of the above table. They show the stock price and valuation of the stock every year from 2011 through 2020. And you can see that the stock has always been really cheap; single digit P/E's and trading at around BPS. 

Despite this, their historical returns are pretty decent.

A cheap stock that has grown nicely over time is sort of a no-brainer, if you believe in the quality of the earnings and accounting values of book.

 

Trading companies are hard to analyze. I have spent time on them in the past, and they were usually just big, black boxes. They have evolved over the years from a purely import / export business to more of an investment business. A lot of investments, though, are related to their client businesses. For example, a company might buy a farm that produces products to export to Japan, or may invest in an oil field that will export oil to Japan etc.

There was a little block in the 2020 annual report explaining how they differ from private equity funds.

 

Here's another snip showing the ROE of Itochu going back to 2011. This is very unJapan-like, with double-digit ROEs for the whole period.

...and here's a nice snip showing labor productivity. But I am not so sure how relevant this is as they are investing more. Investments will increase profits and may not necessarily increase number of employees. Kind of like Berkshire Hathaway; not all employees are directly related to the revenues the holdings produce. 

...and here is a snip of all the medium-term plan targets and results in the recent past. They have achieved most of their goals. 

As Buffett explained about his IBM and Petrochina investments, he likes it when managements say they will do something and they accomplish it. IBM used to succeed in hitting all their goals too, which was one reason Buffett was attracted to the stock (which didn't work out in that case).

 

 

 

 

So Itochu looks very interesting. This doesn't count as much of an analysis, though, as you would have to go and dig into the balance sheet and see what's in there and how they're valued. Buffett said the accounting is good, but I think he means that many of these companies report under IFRS or GAAP standards and are audited by major accounting firms (well, this was true with GE and Enron too, not to say shosha are either of those). 

Marubeni took a big writedown in 2020, so you never know when these things will happen. I don't think we have enough information to make our own estimate of what these things are worth. So you have to just look at and use what we have. And I guess that would be cash flows and dividends. You can't really fudge those.

 

Conclusion

This is kind of interesting, and as I said, I will spend some time looking at these companies. But I am not at this point jumping with excitement about buying these names. If any, Itochu is certainly interesting. The others? Not sure.

A lot of these companies talk about wanting to invest for the future, but you can't just wake up one day and decide that you are now suddenly a venture capitalist. Marubeni has a fixed amount they said they want to invest in new businesses, which is kind of frightening. When you say you want to invest X in a certain sector, it makes management want to fulfill that regardless of the opportunity. Why would you want to do that? Maybe 0 is the best course of action. 

 

I probably told you guys about a supplier in Japan who told me that certain period-ends, they get a big influx of new orders. Why? Clients say they have money left over in their budgets and if they don't use them up, it will be cut next year. Nobody wants their budgets to be cut! Makes sense for the division, but a nightmare for shareholders!

Some of these annual reports eerily resemble Immelt's nonsensical ramblings about investing in the future and technology too. Scary.

Shosha investments in the past have been related to their clients; buying a factory that manufactured goods for them or a client, buying mines, oil fields, refiners, processors or farms that exported supplies to Japan etc. So there was this expertise and some proprietary knowledge behind those investments. 

But venture capital?  I'm not sure how that would work. It might work!  But it might not. Who knows. 

Anyway, I will probably follow up with more posts because this is sort of interesting. 

Is Buffett Really Bearish?!

So, with Buffett dumping airlines, JPM and not jumping into the markets in March, is he really all that bearish? His cash keeps piling up to the frustration of long time Buffett fans.

March Decline

First, I would have to say that the March decline was pretty quick. It crashed, and the market bounced back pretty quickly. Plus, what crashed are the stocks that are going to have a lot of problems. What rallied are beneficiaries. I would have loved to buy MSFT, GOOG, AMZN or whatever, but those didn't really tank all that much. 

 

Plus, for a company like BRK, you would want to take advantage of any distress to get involved, but as Buffett said, with the stimulus package, the phone wasn't ringing all that much. There may be opportunities within each of the private holdings too, and we know there is a lot of pain in just about every wholly owned business at BRK.

 

Buffett Bearish? 

A while back, I argued that this increase in cash does not necessarily reflect a bearish view on Buffett's part. OK, maybe it's not super-bullish. But it's not outright bearish, either. 

 

First, I said the accumulated cash pretty much corresponds to the rise in float; since the mid-1990s, cash and fixed income investments always approximated the amount of float. Also, just because Buffett doesn't buy stocks doesn't mean BRK is not fully exposed; some of his former stock holdings are now wholly-owned subsidiaries. Just because they are no longer publicly listed equities doesn't mean we can't participate in intrinsic value growth of the business. We still own the equity. Same with outright purchases of other listed and unlisted businesses.

 

To show this, a while ago I posted how BRK is fully exposed despite the high cash balance. First, I added up the stock holdings, and then to that, I added the net worth of our subsidiaries; the railroads, utilities, and manufacturing, services and retail, and it all added up the the full value of BRK's shareholders' equity.

 

I showed that the high cash holdings of BRK is not a drag on future potential returns as it would be in a mutual fund. If a mutual fund had a high cash holding, yes, then it would lag in a bull market. Not so BRK. 

 

Since manufacturing, services and retail is no longer itemized on the balance sheet, I can't do this, but if you net out the cash, cash equivalents and fixed income securities with float, you will see that what you have left is still equity ownership in the various businesses; the cash is not necessarily a drag on returns on this basis. Of course, if the cash was invested in higher returning securities, future returns would be higher.

 

But it's still fair to say BRK has 100% equity exposure.

 

Here are a couple of tables to illustrate this. 

Liquid Assets = Float

First, check out the liquid assets (cash and cash equivalents plus fixed income investments) against float. This is just an approximation of float using the 2 or 3 items shown on the consolidated balance sheet so may not match what Buffett calls float, but it is close enough.

This ratio is on the far right of the below table labelled, "Liquid / float". Since 1999 or so, it's been remarkably stable at around 1. Someone asked about this at a recent annual meeting and Buffett said there is no relationship. It is a head-scratcher because it seems to match perfectly over time.

By the way, the cash and cash equivalents include only what is at the top of the balance sheet and excludes cash held in railroad / utilities (for simplicity, and most cash is in the insurance segment anyway).

 

Stocks to Total Shareholders Equity

Some insurance companies like MKL and Y use their equity portfolio to shareholders' equity ratio to show how much stock market exposure they have. This, for BRK, is in the column labelled "Stocks to sheq". It is amazing to think it was above 100% before the Gen Re merger. BRK back then was a leveraged play on Buffett's stock-picking skills, and any investment in bonds offered free incremental points on ROE above all that. No wonder why returns were so high back then. 

 

Since then, the stock portfolio (including equity method investments) has averaged 52% of BRK's total shareholders equity.  Despite the huge cash holdings, note that the year-end figure was 62%, and at the end of the 2Q2020, it was 56% despite the portfolio taking a big hit this year. This is higher than the 52% average since 1998. I use the average since 1998 because the beast was a different animal pre-Gen Re. 

So, this piece of evidence doesn't really show any bearishness on Buffett's part, or at least compared to the last 20+ years.

 

BRK Balance Sheet Stuff

 

This next table shows some other ratios. Investment leverage is used by insurance companies too, total investments versus total shareholders equity. This is not really all that relevant for BRK because insurance is only one part of the business. 

 

Investment Portfolio

But let's look at the portfolio in a conventional way. We will add the cash, cash equivalents and stock portfolio and see how that breaks down. 

 

The column labelled "equity %" shows how many percent of total investments was invested in stocks (including equity method). 

 

And, check it out! This also averaged 52% since 1998, and at year-end 2019, this was 65%, and was 58% at the end of 2Q2020.  

Buffett bearish? Well, according to this piece of evidence, not really. Or, at least, not all that much more than in the past 20 years.

Maybe this is a little tautological but liquid assets as a percent of total investments is also below historicals, and also liquid assets vs. total shareholders equity is also lower: 51% average since 1998, but 34% and 41% at year-end 2019 and 2Q2020, respectively.

 

 

 

AAPL

By the way, for those who say Buffett has lost his touch, what do we call AAPL? At $470/share, the gain to BRK on this buy is $83 billion! This is not how much it's worth now, but how much BRK has gained on the position of around 250 million shares. That's as much as the total shareholders equity BRK had as recently as 2004, and also as much as the gains on all of the other holdings as of the end of 2019 (so before the recent decline in most of these holdings). 

This is the table from the annual report, excluding AAPL.

I admit I have been an AAPL naysayer for years. Part of this multiple expansion is probably due to a shift in the business model from a hardware, consumer electronics business to more services. I have no idea how this will pan out over the years, but I do notice more and more people living their lives in a very Apple-centric way.

Conclusion

People are frustrated that Buffett continues to accumulate cash. The cash just gets bigger and bigger and it makes Buffett seem more and more bearish. But as you can see from the above, the cash balance may grow, but so does BRK. So on a relative basis, the cash balance hasn't really been growing all that much. Judging from this analysis, you can't really conclude that Buffett is any more or less bearish than he has been in the last 20 years. But that won't stop people and the press from obsessing over this 'nominal' figure. Oh well... 

Tsunami etc.

Yes, it's a tsunami. Tsunami of liquidity. A fiscal tsunami. Both at the same time. People seem baffled at the strength of the stock market; they keep saying the market is 'divorced from economic reality' and things like that. Others say this is a big bubble waiting to implode. 

I don't mean to argue that the market is always right or anything like that, but the market is reacting to some massive, massive stimulus and liquidity injection. Some of that is bound to leak into the stock market. As I said earlier about  Covid-19, this is forcing governments around the world to try to offset the negative effects of the virus. And as usual, they are going to overdo it. And this, in turn, will lead potentially to a really massive bubble. 

As of now, with S&P 500 forward P/E of 23, or whatever they say, it doesn't really seem all that bubblish. Too, the median P/E ratio of S&P 500 companies on a forward basis is around 18.5x vs. a 15.2x average since 1982, I think. So that is not that crazy looking either, given much lower interest rates now than most of this time period. 

 

People say the S&P 500 forward P/E is as high as it was back in 1999/2000, but don't forget, interest rates were a lot higher back then. Also, the median P/E is much lower than that, which is again, just like 1999/2000. And if you remember 1999/2000, if you didn't own the bubble stocks, you actually did really well throughout the 2000-2002 bear market. It is very possible that this will happen again. Many of the frothy names can have large declines, maybe the S&P 500 index even goes down 50% or more, and people who didn't own the most expensive stocks might actually still do well. So, don't let people scare you out of the market with this talk of market P/E's. If you are happy with what you own and how they are valued, hold on and things should be fine (like it was in 1999/2000). 

This rickety house can symbolize a highly levered equity fund vulnerable to a bear market, but when I saw this picture, the first thing I thought of was all the shorts being steam-rolled by this tsunami (or simultaneous tsunamis). 

Greenblatt and Marks

Anyway, I wouldn't necessarily put this in a category of good news; some would say this is really bad news. But a recent Howard Marks note talked about all the reasons why current market valuations might be reasonable; that the current tech companies leading the market actually has really good, strong business models. Also, Joel Greenblatt was on Bloomberg TV the other day saying we are not in a bubble like 1999/2000 for the same reason; that the recent market leaders have real business models and are really good businesses that might actually deserve high valuations.

 

While not pointing to any individual names, I have been thinking the same thing over the years.

Buffett, Gold and JPM

So, as usual, the financial media is going crazy over the fact that Buffett bought ABX. Most of them didn't even mention that this could be a Ted or Todd pick and not a Buffett pick. Also, he dumped a bunch of JPM, which is actually kind of surprising. Not sure what is going on there. Maybe it's a valuation play as BAC is cheaper. I think Dimon is a much better CEO than Moynihan (who hasn't really been tested yet, whereas Dimon has been through many crises). Maybe BAC has a longer runway as Dimon has health issues. I don't know. Maybe he is a lot more worried about this pandemic than most of us. 

 

Market

Anyway, back to the market. So yes, it's kind of acting contrary to the expectations of many, but not really. If you look at the market leaders, they are really doing well earnings-wise. Sure, this may be a one-time bump for some of these names, but for the most part, Covid-19 is only accelerating what was going to happen anyway (move to cloud, retailers dying off etc...). So there is nothing wrong with being in companies who have been enjoying a tailwind for years and then suddenly gets a big gust from behind. 

As for consumption, as Dimon said, some unemployed, I think he said 60%+, were making even more money from the $600/week assistance than they were making when employed. So that explains the consumption figures. Of course, this is not sustainable forever (new plan hasn't been passed yet as of now). 

I have been spending more time recently looking at things to do due to the extraordinary nature of the what is happening, but I have to say nothing is really jumping out at me. 

I am tempted, of course, to jump into airlines, hotels, real estate, energy, anything travel-related and some other areas hit hard, but nothing is really jumping out at me. If you like any of these businesses and believe in them for the long term and are fairly sure they will survive this crisis without too much dilution, then it's a great idea to buy. 

But the problem is that most of the above businesses are not in areas I would have been interested in pre-crisis. So if I got into any of them now, they would just be 'trades'. I would get in, hold until normalization, and then get out. They would not be situations where I would want to buy and hold forever. So that makes me a little hesitant. 

 

 

Election Stuff

There is a lot of uncertainty about the elections. But as usual, I would say, look back at all the other times we were worried about something. We should never forget 2016 election day. What about the fiscal cliff? All sorts of problems, uncertainties over the years. 

 

So, as usual, I would just say ignore it all. I don't want to talk about politics here as there is plenty of other places to talk about it, and I don't think I have anything to add to what everybody is saying anyway. 

 

But I would say that whatever people worry about, I wouldn't worry too much about it. Whether it's pharmaceutical stocks when Clinton got elected, insurance companies with Obama, financial stocks when Elizabeth Warren was looking good etc. Whenever you have big moves on those worries, as traders, it's actually probably a good idea to trade against it. 

 

Books

I am reading this new book about GE, Lights Out, and it is terrifying. I'm only 1/3 way through it but it sort of confirms what we suspected all along, but at least for me, it's a lot worse than I thought.  

If you always wondered why Buffett always spoke so highly of Immelt and GE but never bought stock (other than emergency financial crisis financing), this would help explain it. I've always wanted to love GE, and it was always on my to-do list to do a detailed analysis of GE and even buy some shares at some point, but it never got to that point because of Immelt. He came across to me as this rah-rah cheerleading type; the kind of manager I would not want to put money with. And his denials and lies throughout the crisis was worrisome too (I didn't realize how much he was lying, though...)

And Immelt apparently still blames Welch, but jeez, the guy ran the place (into the ground) over 16 years; that's enough time to fix things, and many of the big moves / mistakes were his own. It's like a 40 year old man blaming his parents for his behavior.

I am still looking at it and wanting to jump in, but it is quite scary.

Long Book Excerpt

So, during this pandemic, I have been reading a lot as usual, and I started reading an old book that I am embarrassed to say I've never read before. 

Paths to Wealth Through Common Stocks

This is a Philip Fisher book. I think Philip Fisher is sort of underrated compared to Benjamin Graham. Everyone (including me) always talks about Security Analysis and Intelligent Investor, but not everyone talks about Common Stocks and Uncommon Profits or this book. 

That's probably for a good reason. First of all, Graham was the first in setting the ground rules of value investing so comprehensively. But on the other hand, I feel that Fisher has had more of an impact on Buffett (and he admits it) than even many Buffett followers realize. Buffett is still referred to as a 'value' investor, and 'value' is still viewed as things with low P/E ratios and P/B ratios. But Buffett has for decades been saying that he would much rather pay a fair price for a decent business than a good price for a mediocre business (OK, I totally butchered that one, but I'm a little rusty, you see...). 

Anyway, I was reading it and this whole section made me jump out of my seat as I immediately thought of quite a few people I would need to send this book to:

The Economists Go out -- The Psychologists Come In

    I have already commented on the strange tendency of the supposedly forward-looking financial community so often to fail to recognize a changed set of circumstances until the new influence has been in existence for years. I believe this is why the man who attempted to forecast the course of general business was regarded as so important a factor in the making of investment decisions during all of the 1940's and much of the 1950's. Even today, a surprising number of both investors and professional investment men still believe that the heart of a wise investment policy is to obtain the best business forecast you can. If the outlook is one of expanding business, then buy. If the outlook is for a decline, sell.

    Many years ago there was probably considerably more merit to such a policy than there could possibly be today. The banking structure was weaker. There was no assurance it would be shored up by the government in times of real trouble -- a process bound to produce a massive dose of inflation. There was no tax system of a type that can hardly fail to produce strong inflationary spending whenever business (and therefore federal tax revenues) are at abnormally low levels. No public opinion had crystallized to assure that whenever business levels dipped sharply, the government would take strong countermeasures to stem the tide. Finally, the industrial base was much more narrow. The large number of industries in today's complex economy that bear little relationship to each other in their basic characteristics probably assures that even without the actions of government, modern business recession would be somewhat less severe than its former counterpart. Some industries would be enjoying unusual background conditions enabling them to expand, while the majority might be in a declining phase. This tends somewhat to stabilize the economy as a whole.

    All this means that a depression is of less significance to the investor than it was many years ago. It does not mean knowing what business is going to do would not be quite useful information to have. But having such information is not vital for obtaining magnificent results from common stock investments. Simple arithmetic should show this. When a stock market decline coincides with a fairly sizable economic slump as happened in 1937 to 1938 or 1957 to 1958, most stocks sell off from 35 to 50 percent. The better ones then recover when the slump ends and usually go on to new high levels. Even in the greatest slump of all time, only a small percentage of all companies failed, that is, went down 100 per cent. Most of these companies were companies which had had fantastic amounts of debt and senior securities placed ahead of their common. After one of the wildest speculative booms ever known, much of it financed by borrowed money, the average stock slumped 80 or 90 per cent. In contrast, when stocks rise over a period of years, even the most casual study of stock market history shows many figures of a very much greater order of magnitude. Compared to the temporary declines, usually of 35 to 50 per cent, that frequently accompany depressions, the outstanding stocks (those of the unusually well-run companies that have maneuvered themselves into growth fields) go up several hundred per cent, stay at these levels, and then go still higher. Many can be found for which a decade's progress can be measured in multiples of 1000 per cent rather than 100 per cent. 

...

    From the standpoint of obtaining results, I have noticed that investors who place heavy emphasis on economic forecasts in the making of investment decisions usually fall into one of two main groups. Those who are inclined to be cautious by nature can nearly always find an impressive sounding forecast that for quite plausible and persuasive reasons makes it appear that important economic difficulties lie ahead for the business community. Therefore, they seldom take advantage of opportunities when they present themselves and, on balance, these missed opportunities mean the economic forecasts have done them considerable harm. The other group are the perpetual optimists who can always find a favorable forecast to satisfy them. Since they always decide to go ahead with whatever action they are considering, it is hard to see how all the time they spend on business forecasting does much good. 

    More and more investors are coming to recognize the wisdom of making their decisions about common stocks largely on the basis of such outright business factors as appraisal of the quality of the management and the growth potential of the individual company's product line. These things both can be measured with a fair degree of preciseness and have a far greater influence on how good a long-range investment will be... 

This book was published in 1960, and it is amazing as it still applies to this day; there are still people who think that predicting the economy accurately will lead to superior investment results. 

So...
Anyway, this is a fascinating time to be living in. This pandemic is really terrible and I hope we at least find some sort of treatment to take death off the table. I feel this is the key to normalization rather than vaccines. Of course, a vaccine would be great, but it is probably unrealistic to expect one to come within a year. If we can figure out how to treat the worst cases, and this treatment becomes widely available, this would sort of turn Covid-19 into something like the flu.

But who knows, really. 

As for stocks, there is certainly a lot of trading opportunities, but for us long term investors, I would stick to things that have secular growth potential. I don't really feel that excited about buying the dip on something in a long term downtrend. Not to say those can't be great trades. I would rather buy the dip on things in long term uptrends. If things are in secular downtrends but got a bump up due to this, then that's probably a great time to sell.

As for the market, it may seem like it's crazy, but keep in mind the amount of stimulus and liquidity injected into the system. It's not just lower interest rates. Also, people keep talking about overoptimism about the virus, but if you look at hotels, airlines etc., the market is clearly not all that optimistic about anything returning to normal any time soon.

Also, keep in mind that a lot of the big winners this year are making a lot of money; revenues are growing at incredible rates, profits etc. Other than the cloud players, look at COST, WMT, TGT etc. What is happening is that the smaller operators are suffering. Fast food is taking share away from the independent restaurants. As those are closed, if you want to eat out, you have fewer choices so you end up at CMG or QSR (Popeye's). A lot of the eating out money is moving to eating at home (groceries, again, COST, WMT, TGT etc...). 

 

If airline and hotel stocks were making new highs, then I would think the market is nuts. But that's not what's happening. You have to sort of look under the hood to see what's going on, but of course, that's too much work for most! I get it. 

Also, a lot of the revenues / profits that were not listed (small, mom-and-pop restaurants / stores) are moving to listed companies; as independents go under, the only ones left standing are the big ones, and often those are listed companies.

So there is a lot about this market that does make sense. This is not to say the market is always right, or that the valuations of each of these businesses at this point is correct. I am just pointing out that it may not be as crazy as some suggest. Airlines and hotels, REITS are down, and they are down big. Cloud players, stay-at-home beneficiaries are up big. What is so crazy about that? I don't know. 

Also, I think there has been a lot of tech adoption from the never-adopters. I see all these posts about kids teaching their grandparents how to use a tablet, how to get on a Zoom call with family, how to chat on FB, Line, or how to use email. People (many of them seniors) who only used land-line phones and didn't know how to turn on their TV (well, I have trouble with that too with so many remotes and buttons...) are chatting with their kids / grandkids on Skype on their tablets. They are learning how to order things online. 

A lot of this will be permanent. When things clear, many of these newbies will keep using their new devices and will continue to shop in their new ways. Not all of them, of course, and maybe not as often as right now. But this has caused an increase in this market for sure.

 

As for all the talk about how things will never go back to the way it was, that people will never go to conventions ever again, and that client visits will never happen again as Zoom calls work just as well, and offices will decline as people get used to working from home, I think, is rubbish. People always extrapolate what they see. Sure, it may take some time to get back to normal, but things will get back to normal, eventually. 

 

Surely there will be some permanent changes for the better, utilizing things we have learned during this time, and that's great. But I wouldn't expect a lot of this stuff to be permanent by any means. 

 

Wow!

It's been quite a few weeks since my last post. I haven't really changed my thoughts since then, but maybe the economic impact of this will have more than a blip on the long term charts after all.

So far, the economy seems to be doing much worse (or will soon) than the stock market. The initial decline was shocking, but not at all unexpected. The recovery rally is kind of incredible too.

As I watch all these commentators, I realize nobody really has any idea. The commentators / pundits that survive a long time are masters at saying things that will make them look 'correct' in hindsight later on. You make enough calls and predictions, you will at least be able to pick one and say you were right. Also, they are very careful to word their comments so that they can't be called out for being wrong. 'If this happens, then this will happen, if that happens, then that might happen...' etc. You say enough of that, and you will be right about something, eventually... It's kind of a joke, but whatever.

Buffett and Airlines

A lot of things have happened since my last post, including the virtual BRK annual meeting. Nothing really new or unexpected, as usual, but one thing that may have shocked people was how Buffett dumped all his airline stocks. We are supposed to be long term investors, and are not supposed to be reacting to headlines, however scary.

But if you look at their income statements and realize that their revenues are down 90% and may be down for a year or more, it's hard to imagine them surviving. Most of them will be out of business by the end of the year or long before that. The government will have to bail them out, but that will be costly. Either they will have to take on a lot of debt that will take years to pay off, or they will have to issue a lot of equity, basically wiping out current shareholders.

Many businesses will not survive this, and even if they do, there will be big losses to equity investors.

A lot of restaurants will go out of business too, but mostly the independent ones. Major chains, especially fast food and fast casual should be fine.

Retailers are out too, for the most part. A lot of retailers should probably not even exist, and this pandemic is just accelerating what is going to happen anyway. The Micrsoft CEO, Nadella, said that there was two years worth of virtualization in two months since the pandemic. I think that's the case with retailers. This will just accelerate the demise of retailers with flawed (or out of date) business models.

No Bargains?

One thing Buffett said was that he didn't really see any bargains during the decline in March. We know from the 2008-2009 crisis that Buffett is not really a trader, so he is not going to be buying the lows on big down days, necessarily. So on fast declines with quick rebounds, he is not going to get much done.

If you look at what's going on, the stocks that were really hit are the ones that you don't really want to own, necessarily. Airlines, real estate, retail, travel-related stocks etc. And the ones you want to own didn't really get cheap. I can see Buffett piling into things like Amazon or Google if they were dumped with the bath water, but they weren't, really. Neither was Microsoft. Not sure what he thinks of Netflix, but that wasn't dumped either.

So crappy stocks got cheap, but as Buffett said, the way to succeed in the stock market (or at least not lose money) is "don't buy crummy businesses". And there are a lot of them out there now.

People also view Buffett as being 'bearish' because he sold stocks, and he is still sitting on a growing cash balance. He did mention during the meeting that he has a lot of cash, but he has a lot of equity exposure too. I wrote about it a while back, but his equity exposure is not limited to his listed equity portfolio. Kraft is not included in his list of stock holdings, but he still owns it. Same with Burlington Northern, and his many other operating companies (some of which were listed until recently).  If you add it all up, BRK is still fully exposed and is not as conservative as it seems if one were to look only at his listed equity portfolio and cash balance.

Which leads to the next thing being talked about a lot these days (as it has been for the last few years).

Value Investing is Dead?

One thing people need to keep in mind about value investing is that the way the general press talks about it and the way investors talk about it are completely different. The press just looks at nominal valuation and that's it. There is no concept of what something should be worth, and whether it is trading above or below that. They don't understand the concept of intrinsic value. Indexes split between growth and value don't help either.

Value investing used to be about low P/E's and things like that, I suppose, but the more modern approach is what something is trading at versus intrinsic value. This is not that modern, actually, as Buffett has been saying that for many decades.

Here is something from the second edition of Graham's Securities Analysis. This is in the section where he discusses the difference between investment and speculation.

It may be helpful to elaborate our definition from a somewhat different angle, which will stress the fact that investment must always consider the price as well as the quality of the security. Strictly speaking, there can be no such thing as an “investment issue” in the absolute sense, i.e., implying that it remains an investment regardless of price. In the case of high-grade bonds, this point may not be important, for it is rare that their prices are so inflated as to introduce serious risk of loss of principal. But in the common-stock field this risk may frequently be created by an undue advance in price—so much so, indeed, that in our opinion the great majority of common stocks of strong companies must be considered speculative during most of the time, simply because their price is too high to warrant safety of principal in any intelligible sense of the phrase. We must warn the reader that prevailing Wall Street opinion does not agree with us on this point; and he must make up his own mind which of us is wrong.

Nevertheless, we shall embody our principle in the following additional criterion of investment:

An investment operation is one that can be justified on both qualitative and quantitative grounds

I would look at the opposite of this example and say that many cheap stocks may not necessarily be safe. Would you buy junk bonds just on yield? Nope. Someone showed me years ago a quantitative report basically showing that the valuation of a stock is pretty much determined by it's credit quality (I don't know if there was an adjustment for long-term growth or returns on capital), but it made sense to me. The industrial cyclicals were always 'cheap', like steel, auto manufacturing etc. And consumer stocks were always expensive.

Anyway, today, I think a lot of this gap between value and growth just may be reflecting huge secular changes in the economy. You can say AMZN is overpriced and BBBY is cheap. But really, who would short AMZN and go long BBBY?

MKL Dumping Stocks

On the 1Q earnings call, MKL said they dumped a few stocks they thought would be hugely affected by Covid-19. Here are the stocks they dumped:

Anheuser-Busch Inbev ADR	0	0.00%	13,000	-13,000	-100%
CDK Global Inc	0	0.00%	176,897	-176,897	-100%
Discovery Communications	0	0.00%	117,000	-117,000	-100%
Dollar Tree Inc	0	0.00%	123,100	-123,100	-100%
Hasbro, Inc	0	0.00%	364,000	-364,000	-100%
Kraft Heinz Co	0	0.00%	68,000	-68,000	-100%
Rockwell Automation Inc	0	0.00%	140,100	-140,100	-100%
Scotts Miracle-Gro Co	0	0.00%	422,000	-422,000	-100%
Unilever PLC ADR	0	0.00%	1,527,600	-1,527,600	-100%
United Health Group Inc	0	0.00%	599,000	-599,000	-100%

This is as of end the March, and they may have dumped more things in April. Buffett dumped airline stocks in April, so that dumpage doesn't show up on his 13-F, which is here, by the way:

BERKSHIRE HATHAWAY INC

Filing Date: 2020-05-15

Name	dollar amt	%port	#shares	change	%chg
APPLE INC	62,340,609	35.52%	245,155,566
BANK AMER CORP	19,637,932	11.19%	925,008,600
COCA COLA CO	17,700,001	10.09%	400,000,000
AMERICAN EXPRESS CO	12,979,391	7.40%	151,610,700
WELLS FARGO & CO NEW	9,276,210	5.29%	323,212,918
KRAFT HEINZ CO	8,056,205	4.59%	325,634,818
MOODYS CORP	5,217,658	2.97%	24,669,778
JPMORGAN CHASE & CO	5,196,030	2.96%	57,714,433	-1,800,499	-3%
US BANCORP DEL	4,563,233	2.60%	132,459,618
DAVITA HEALTHCARE PARTNERS I	2,897,549	1.65%	38,095,570	-470,000	-1%
BANK OF NEW YORK MELLON CORP	2,686,487	1.53%	79,765,057
CHARTER COMMUNICATIONS INC N	2,367,684	1.35%	5,426,609
VERISIGN INC	2,307,964	1.32%	12,815,613	-137,132	-1%
DELTA AIR LINES INC DEL	2,050,935	1.17%	71,886,963	976,507	1%
SOUTHWEST AIRLS CO	1,910,218	1.09%	53,642,713	-6,500	0%
VISA INC	1,701,823	0.97%	10,562,460
GENERAL MTRS CO	1,551,872	0.88%	74,681,000	-319,000	0%
LIBERTY MEDIA CORP DELAWARE	1,446,433	0.82%	45,711,345	-240,000	-1%
COSTCO WHSL CORP NEW	1,235,572	0.70%	4,333,363
MASTERCARD INC	1,192,040	0.68%	4,934,756
AMAZON COM INC	1,039,786	0.59%	533,300	-4,000	-1%
PNC FINL SVCS GROUP INC	880,431	0.50%	9,197,984	526,930	6%
UNITED CONTL HLDGS INC	699,073	0.40%	22,157,608	218,966	1%
SIRIUS XM HLDGS INC	654,149	0.37%	132,418,729	-3,857,000	-3%
KROGER CO	570,475	0.33%	18,940,079
M & T BK CORP	556,665	0.32%	5,382,040
AMERICAN AIRLS GROUP INC	510,871	0.29%	41,909,000	-591,000	-1%
GLOBE LIFE INC	457,278	0.26%	6,353,727
LIBERTY GLOBAL PLC	434,229	0.25%	26,656,968	-481,000	-2%
AXALTA COATING SYS LTD	415,689	0.24%	24,070,000	-194,000	-1%
TEVA PHARMACEUTICAL INDS LTD	384,248	0.22%	42,789,295	-460,000	-1%
RESTAURANT BRANDS INTL INC	337,782	0.19%	8,438,225
STORE CAP CORP	337,425	0.19%	18,621,674
SYNCHRONY FINL	323,860	0.18%	20,128,000	-675,000	-3%
STONECO LTD	308,410	0.18%	14,166,748
GOLDMAN SACHS GROUP INC	296,841	0.17%	1,920,180	-10,084,571	-84%
SUNCOR ENERGY INC NEW	236,195	0.13%	14,949,031	-70,000	0%
OCCIDENTAL PETE CORP	219,245	0.12%	18,933,054
BIOGEN INC	203,440	0.12%	643,022	-5,425	-1%
RH	171,638	0.10%	1,708,348
JOHNSON & JOHNSON	42,893	0.02%	327,100
PROCTER & GAMBLE CO	34,694	0.02%	315,400
MONDELEZ INTL INC	28,946	0.02%	578,000
VANGUARD INDEX FDS	10,183	0.01%	43,000
SPDR S&P 500 ETF TR	10,155	0.01%	39,400
UNITED PARCEL SERVICE INC	5,549	0.00%	59,400
PHILLIPS 66	0	0.00%	227,436	-227,436	-100%
TRAVELERS COMPANIES INC	0	0.00%	312,379	-312,379	-100%
Total	175,485,996

Insurance Companies

By the way, insurance companies are going to hurt for a while. People keep saying that business disruption doesn't cover pandemics, or that it requires physical damage etc. But the way things work in this country, that doesn't matter. We have enough lawyers with a poorly structured incentive system so insurance companies can get bogged down in years and years of lawsuits. Even if insurance companies win, who knows how much all of that is going to cost.

Plus, interest rates are now 0% all the way out to 5 years, and 1% to 20 years. That's going to be painful, and makes BRK's float basically worthless. Yes, this may be temporary, but we have been saying that for more than 10 years now. I have always suspected we will follow Japan in terms of interest rates. I didn't expect a pandemic to cause rates to go to zero, though.

I still think BRK, MKL and others are great investments for the long haul, but there are serious issues for them out there for sure.

Banks
JPM and other banks are going to take some huge credit losses. There is no way around that. One rule of thumb is that credit card losses will follow the unemployment rate. Unemployment got up to 10% during the financial crisis, and sure enough, JPM's credit card charge-offs peaked at 10% or so. Total charge offs were 5%, I think, back then.

Unemployment is now over 15%, and headed to 20%. JPM has $160 billion in credit card loans, so credit card charge-offs can get over $30 billion. Total credit losses may get to 10% and they have around $1 trillion in loans outstanding. Who knows, really.

JPM is still the best managed big bank and they will get through this for sure, but they face some very serious problems. I think the view expressed during the 1Q conference call (expecting rebound in second half of the year) is way too optimistic.

Even if we start to reopen the economy, we can't really have a real recovery as a lot of events won't come back, and restaurant / bars / retailers will run at 30-50% capacity.

An interesting thing to look at is Sweden. They didn't have a hard lockdown like the U.S. and European countries, but their economy is taking a hit anyway. Reopening the economy doesn't mean we are all going to go back to the way we were right away. Many people tell me that they won't change anything even if the economy reopens until they get a vaccine. This could be years away.

I tend to believe things will normalize when we get a treatment that makes Covid-19 far less fatal. If we take that off the table, people will start to get back to normal.

I have no idea about these things, but I tend to think the odds of us finding a treatment is far higher than us finding a vaccine (there is a chance we may never find a vaccine).

Anyway, the mitigating factor to the above bank credit disaster is the amount of money being injected into the economy. I don't know if people are going to use their stimulus / Covid-19 help checks to pay off their credit card (they seem not to be paying their rent), but it will have some positive impact on bank credit, I assume (and hope).  Well, but don't assume because...

Is the Market Being Rational?

So, people are saying that the market is being too optimistic about a return to normal, but it's hard to tell. The market is full of stocks with different exposure. If the airline stocks got back to their highs, I would agree that the market is being too optimistic. But that hasn't happened; not even close. Same with retailers. And restaurant stocks.  OK, Amazon, Netflix, and others are going to new highs, but I doubt that is reflective of the market's optimism about a return to normal.

So when the markets move, I think we have to look by sector, and by stock, to see what they're expecting. It makes no sense to look at the index itself.

What to do?

When this started, I told people the same thing I always told them. Ignore the headlines and just think 3-5 years ahead. This works, though, for people with diversified portfolios. I wouldn't know what to say if they owned a lot of airlines, hotel and other travel related businesses, or other areas that may not recover so quickly. I have no idea.

I haven't owned any retail stocks in a long time (except BRK, which is the closest thing to a retailer I own), and the only restaurant stocks I own are CMG, QSR and SHAK.  Well, SHAK was never cheap so it's a token position that is not significant; it's more of a moral support, I like this company, kind of position. CMG was a large position that I scaled back and had to do again as it went over $1,000. It's not a cheap stock, and I have no idea why it's above $1,000; maybe they are going to take market share after many of their competitors go out of business within a few months). Oops, after writing this, I just realized I do own Costco. So I lied. I own Costco and have no problem with it. I will hold on to it. Yes, it's expensive, but I really like the business for all the reasons we've all heard already a gazillion times.

If you own the S&P 500 index, it doesn't really matter. Many companies will go bust, but that happens all the time. Some big banks, AIG and FNM went bust (or was massively diluted) during the financial crisis and yet the S&P 500 index was fine. It should be fine over the long term this time too, but many of the components won't be.

As usual, just don't invest based on the headlines. OK, evaluating your holdings on long term potential incorporating Covid-19 might not be a bad idea (like Buffett's dumping of airlines), but I would be careful about that too.

One thing is for sure. You really don't want to go chase Covid-19 stocks. You can buy AMZN, NFLX, MSFT thinking these are the pandemic-proof stocks, but the worst time to buy stocks is when everyone piles into them for the same reason (I wouldn't short them either!). For example, I wouldn't touch Zoom stock, of course.

Things are Interesting

I have to admit I have sort of been lazy about my investments over the past few years, kind of just let it go... Looking for things to do wasn't all that interesting as things got expensive.

But things are getting interesting again. I haven't read through so many conference calls and 10-Q's in a long time, and it's been fun. I have to say, though, that the 10-Q's only reflect a small portion of what's happening as the 1Q included the relatively healthy January and February. NYC shut down in mid-March. So there was only 2 weeks of really bad data included in 1Q. The 2Q reports are going to be really scary, but I can't wait to sift through that stuff.

Maybe this will lead to more blog posts. That would be fun, as I do enjoy this process. Until now, though, things are more interesting, but nothing really stands out to me. The really devastated industries are just 'too hard' for now, like cruise lines, airlines, casinos, and the solid businesses that you want to own are not cheap (AMZN, MSFT, COST etc...).

So to those who feel that ETFs and the indexing bubble has lead to a lack of differentiation in the evaluation of individual stocks, it is quite obvious that this is not the case at all. I've always maintained that this is not the case. Sure, there may be excess valuation in some large cap index stocks where index funds are 'forced' to buy regardless. I think overall, crummy stocks are cheap and higher quality stocks are expensive.

OK, banks and insurance companies are cheap now, and not all of them are crummy. But there are massive uncertainties they are facing now. The market is probably wrong and these stocks are probably too cheap.

Who Cares What Mr. Market Thinks!

So, the market has gone crazy. People ask me about the market and the impact of the COVID-19 and I keep saying it doesn't matter. But with the market acting like this, it's hard for people to agree with me. The markets make the news, the market creates the sentiment etc.  and I can't fight that. That's OK, as it doesn't really matter to me.

But I had a really interesting conversation recently, and I did some illustrative work and thought it was interesting so decided to make a post about it.

Every time people worry about these things, whether it's a trade war, Brexit, 9/11, fiscal cliff, coming recession/depression, war or whatever, I say the same thing. If something is not going to have a long term impact on the intrinsic value of businesses, it doesn't matter.

If you own a restaurant on a beach and the weather forecast shows a hurricane approaching, are you going to rush to sell the restaurant before the hurricane hits? Are you going to lower the selling price because you know the hurricane is going to hit and you are going to lose a few days or possibly weeks of business? Of course not! So why would you do the same with stocks?

I think most will agree that COVID-19 is temporary. We just don't know how bad it's going to get before we get it under control (I still think there is way more COVID-19 even here in NYC than anyone thinks, because frankly, people are just not being tested. Plus I don't think the government is going to be truthful about this; I was living in Battery Park City during and after 9/11 and the EPA lied to us about the safety of the air. Christy Whitman admitted she lied to us about the safety of the air (she denies knowing the truth at the time, but I don't believe that at all). Forgot who, but someone said that the government had to balance the risk of causing a panic and the abandonment of downtown NYC (to the detriment of real estate prices downtown) with the 'minor' risk of people getting sick from inhaling toxic fumes. This is especially true when the known risks were also known to be far off into the future, long after elected politicians are out of office (so won't need to take any of the heat). So this was not really about public safety but more about social control.  Not that different from China, are we?)

But in my recent discussion, I had trouble getting across that the intrinsic value of the restaurant is not going to be impacted by the coming hurricane. Yes, they will lose business, and will probably have to repair some damage (even though that should be insured).  Of course, in the hurricane example, there is a possibility that it wipes out the whole beachside town and it takes years to rebuild. But most market exogenous events in the past ten or twenty years weren't of the magnitude to destroy everything (in aggregate) for years.

Current P/E
So when I say it doesn't matter about COVID-19, I don't mean to say there will be no impact. I just mean that there is no impact on the intrinsic value of businesses in general 5, 10 or 20 years out.

If people value stocks on current P/E ratios, then yes, there will be an impact on stock prices. If you value a stock at 10x P/E and think it's going to earn $1 this year, but COVID-19 will cause it to earn $0.50 instead, then you might think the stock is only worth $5.00 instead of $10.00. But if you think this dip in earnings is temporary, you would still think the stock is worth $10.00.

P/E ratios are just a short-cut to calculating future discounted cash flows, so it sort of makes no sense to price a stock on current year estimates if there is a one-time factor involved.

Intrinsic Value
So this is the part I had a hard time describing. I guess non-financial people (unfortunately including many in the financial press) have a hard time grasping the idea that intrinsic value of a business is the discounted present value of all future cash flows. This person argued that the market looks only at earnings over the next year or two, but not fifty years out. Yes, this is true. But intrinsic value has nothing to do with what the market is looking at. Intrinsic value is a mathematical truth as long as the inputs are correct (or reasonable enough). Intrinsic value is 100% independent of Mr. Market's opinion. Well, Mr. Market does set the discount rate to some extent.

When people slap a P/E ratio on a stock, they are basically discounting all future cash flows back into the price of the stock; they may just not know it or understand it. The P/E ratio is just a shortcut valuation method.

If you value a stock at 10x earnings, you are basically pricing in a 10% earnings yield going out into perpetuity.

So first of all, we have to understand that regardless of what the 'market' is looking at, or what the pundits say on TV, a business is simply worth the present value of all future cash flows. We can argue whether that's earnings, dividends, free cash flows or whatever. But the idea remains the same.

Here's the thing I did to try to illustrate how non-eventful recessions and exogenous events are to the intrinsic value of businesses in general (but alas, this illustration failed to get the point across in this case even though the person is a highly trained engineer! No wonder why Mr. Market is so irrational!).

Simple Model
So, here's the illustrative model. Let's say the market has an EPS of $10/year, and the discount rate is 4%. In this table, I just took the earnings for the next 10 years and discounted it back to the present at 4%, and then added a residual value at year 10 based on a 25x P/E ratio (or 4% discount rate), and discounted that back to the present and added them together. Of course, this would give the market a present value of 250.

I think most of you have no problem with any of this. For illustrative purposes, the details don't really matter, and I have no earnings growth built in here either.

Now, let's say COVID-19 causes the global economy to stop for 3 months, and companies earn no money at all for three months. Of course, many businesses will lose money (retailers, hotels, airlines), but others will continue at a lower rate but may not lose money in aggregate. Remember, the S&P 500 (and predecessors) has shown a profit every single year since the 1800s, and that includes the great depression, world wars, great recession etc. So this is not a stretch.

Plugging in $7.50 for year one earnings instead of $10.00 would negatively impact intrinsic value of the market for sure. There is no doubt about it.

Let's quantify that. I copied the above table into another one so we can look at it side-by-side.

If the above scenario holds, the intrinsic value of the market would go down less than 1%.

First Year Earnings $7.50 Instead of $10.00

Way too optimistic you say? OK, so let's say the S&P companies make no money for six whole months. What does that do to intrinsic value?

Let's take a look!

 First Year Earnings $5.00 Instead of $10.00

This scenario would dent intrinsic value by less than 2%.

OK, screw that. Too optimistic. Let's say that the economy is wiped out for a whole year, and the S&P companies make no money for a whole year. Remember, this didn't happen even during the great depression or great recession (or during the 1918 flu etc.).

First Year Earnings $0.00 Instead of $10.00

Still too optimistic? OK. Zero earnings for two years, then.

Zero Earnings for First Two Years

Ah, now we are starting to hurt the market. With zero earnings for the first two years, intrinsic value is knocked down by 7.5%. Ouch. That hurts.

Here are some more:

Zero Earnings for First Three Years

Zero Earnings for First Four Years

So, with the market down more than 12%, it is like the market is discounting no earnings for the next four years!  Nuts!
When the pundits say that the market is or isn't done discounting the risk of COVID-19 or a coming recession, you can see how that sort of comment is total nonsense. It is based on Keynes' beauty contest. They are just saying that people didn't expect a recession or negative event earlier this year, and now these things are here so the market therefore must go lower as the market lowers their expectations.

But this has nothing, really, to do with intrinsic value or expectations thereof. It is just based on pundits guessing what Mr. Market would do based on the headlines.

Of course, I would be the first to admit that if an event did occur that would cause the S&P500 companies to not earn any money for a whole year, two years or three years, it would cause a drop in the market far in excess of the decline in intrinsic value. That would have to be quite a scary event!

Again, this is just a simple illustrative model. There are other reasons why the market can be down. The market may simply have been overly optimistic / overvalued, and this has triggered a 'normalization' of valuations. Maybe the market needs to increase the discount rate to account for the increasing risks that were not considered in the past. Maybe this will actually cause some sort of permanent reduction in the profitability of corporations in general going forward.

But remember, we all had the same thoughts every time something happens. We all see some permanent negative change that explains a lower stock market. For example, after 9/11, the thought was that the world would never be the same, and that increased security measures will permanently reduce global growth potential and profitability.

Again, the market makes the news, and the market creates the explanations, not the other way around. We all try to model the facts to explain what is going on in the market to maintain the two illusions that 1. the market is always right, and 2. that we know what's going on. We wrap the market volatility tightly into these rational-sounding wrappers, pleased at having figured it out, secure in the knowledge that we know what's going on.

Conclusion
OK, so I lied. The above tables clearly show that there is a negative impact on intrinsic value by even temporary business interruptions. But the magnitude is not nearly as much as the market usually moves.

Index arbitrage traders make money because the futures contract fluctuates much more widely than the fair value of the contract. Debt / credit traders make money because credit spreads fluctuate (or at least used to) much more widely than the credit quality of companies. And value investors make money because stock prices fluctuate much more widely than intrinsic value of the underlying businesses.

Of course, I am not calling a bottom in the market, or trying to say that markets won't or shouldn't fluctuate based on the headlines. We can be pretty sure there will be more wild days to come. Markets can be up or down 1000, 2000 points on news. I still expect photos of empty streets in NYC at some point before this is over with the market down a lot on those images. NYC is only starting to test this week, so when more cases are found, subways will be empty too, and of course the market will be down on that.

But I have no idea, actually. It's sort of what I expect (and have been expecting since early February).

On the other hand, check out the VIX index. In my trader days, this was my favorite indicator. As Munger says, always invert. You don't usually make money being short in a market with the VIX at a high level, and it's as high as it's been in the past few decades. This is no guarantee that the market can't go lower, of course.

But anyway, who cares what Mr. Market thinks!