January 27, 2021

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!


Just Published: "Highlights Issue" of the Oddball Stocks Newsletter

We've recently had some new subscribers join the Oddball Stocks Newsletter community. Several of them have said that they had been reading the OddballStocks.com blog for years (it has been around for more than a decade) but they did not know what to expect if they subscribed to the Newsletter.

It's understandable. The truth is that there is nothing quite like the Newsletter – especially as we have expanded it over the past two years – and so we have put together a collection of sample pieces from the back catalog to demonstrate what the Newsletter is, or what it hopes to be: topical, philosophical, talking about companies that the market ignores, pounding the table for value investing while grappling with problems like rapacious managements that are consuming value.

The "Highlights Issue" is available here for purchase as a single Issue. If you have been curious about the Newsletter, this is the perfect opportunity to try about two Issues worth of content (much of which is still topical and interesting) at a low cost.

This is a "highlight reel," but it is not a victory lap or a tout of what we have written about. A lot of these highlights are our thinkpieces: on shareholder rights, on banking as a business model, on value investing. There are pieces about companies that got taken out at a premium but also about ones that are trading lower now some years later... of course, those may be the most interesting to pay attention to now. There are two companies – Scheid Vineyards and Enterprise Diversified (formerly known as Sitestar) – where we warned about significant risks that ended up materializing.

If you are a subscriber, the Highlights Issue should be in your inbox right now. (If you are not a subscriber yet, you can sign up right here.) Remember that we have made some back Issues of the Newsletter available à la carte, so you can try those before you sign up for a subscription: Issues 19, 20, 21, 22, 23, 24, 25, 26, and 27.

Some comments from happy subscribers:
  • "You need to raise the price!"
  • "I think you guys are selling yourself short on your company visits. Saying that you are visiting or reporting from a company in your marketing, doesn’t give justice to the insight and analysis you are providing."
  • "The quality of the writing (even including your new contributors) is really top-drawer."
  • "Great newsletter! - you guys are either providing too much info or not charging enough..."
We have also posted some excerpts over the past year to give a taste of the Oddball writing and coverage style - but just remember that the most interesting content is for subscribers only.

The excerpts were on The Coal Creek Company, Tower Properties, Bank of Utica, small banks, Avalon Holdings, Boston Sand and Gravel, Conrad Industries, and Sitestar / Enterprise Diversified.

Don't miss the recent Oddball Stocks blog posts on: Pico Holdings and the Bank of Utica Annual Report (and investors' reactions to it).

New Hedge Fund Newsletter Just Released

The new Q4 issue of our hedge fund newsletter is now available.  It reveals the latest portfolios of 25 top hedge funds and also features summaries of 2 stocks that Dr. Michael Burry (of The Big Short fame) has been buying.

Subscribers please login at www.hedgefundwisdom.com to download it.



Featured in the New Q4 Issue

- Investment thesis summaries of 2 stocks that value investor Dr. Michael Burry (of The Big Short fame) has been buying.  Quickly get up to speed on the situations

- Reveals the latest portfolios of 25 top hedge funds (full list here);  Now also includes Sequoia Fund

- Commentary on each fund's moves: Excerpts from hedge fund letters, 2019 year-end performance numbers, European short positions, and more.

- New consensus buy / sell lists of the most popular hedge fund trades in Q4



33% Discount

Take advantage of the savings while you still can.  After signing up, you'll get immediate access to the new issue & the full archive of past issues.

1-year Subscription (4 issues): Normal Price $299.99 Discount Price $199.99 per year







Quarterly Subscription: Normal Price $89.99 Discount Price $59.99 per quarter







Want to pay by check or soft dollar account?  Please email us: info (at) hedgefundwisdom (dot) com


Small Bank Investors React to the Bank of Utica Annual Report $BKUT $BKUTK

We posted the Bank of Utica annual report for 2019 yesterday. Here are some investors' reactions:

Bank of Utica – 2019 Annual Report

Most Oddball investors will know about Bank of Utica. We've talked about it before on the blog and in the Newsletter.

We just received their 2019 annual report in the mail, included below. More detailed analysis and commentary will be in the March Issue of the Oddball Stocks Newsletter.

Coronavirus, Munger etc.

Munger
Munger is looking and sounding great at the DJ annual meeting (I wasn't there; just watched the video). His 'wretched excess' seems to be more about private equity and venture capital than the public stock market. In fact, he said that tech stocks now are not like the Nifty Fifty stocks (he mentioned Home Sewing (?) trading for 50x earnings, and said that the current big tech companies are better businesses).

TSLA
Munger also said he would never buy or short TSLA. As I wrote in a response somewhere on this blog, I can't believe how many people got caught in a short squeeze on this stock. If people don't care about the valuation of a company, then obviously, a really expensive stock can get much more expensive. Trying to short that is like trying to short soybeans during a drought. You know with 100% confidence that the price will mean revert at some point, but there is no way to tell when it will revert and how high it can get before reverting. I saw this in Japan in the 1980s, in the U.S. in the late 1990s etc.

Bubble
I've said this here many times before, but for the stock market to be in a real bubble, at these interest rates, the P/E ratio would have to get up to 50x or some such. Who knows, this might even happen. One of the greatest traders of all time recently said that this might happen; the NASDAQ could double from here if we have another late 1990s-type bubble, which is possible with the current, ongoing massive stimulation combining low rates and huge budget deficits. How can this massive stimulation on a historical scale not be matched by an equivalently massive bubble?

Of course, I would not invest with that expectation, but if it happened, it would not surprise me at all. Remember, from my previous analysis, I would find it completely normal and not at all out of line if the market P/E averaged 25x over the next 10 years... and that may include times the market trades at 50x P/E, and times it trades at 10x P/E. But we just can't know when these levels are reached; only that it is probable that they will be reached.

Again, this is not my prediction at all; I would not invest expecting such an outcome. I am just making a single statement that seems reasonable from the data I've seen.

Coronavirus
The market seems to fluctuate with each breaking news about the coronavirus, but I view it as a non-event. As value investors, we care about what a business is going to be worth five, ten years out, so it doesn't matter how bad this coronavirus gets. Well, unless it gets really, really bad. I didn't take any action, but my instinct during SARS was to just buy all the Asian stocks that were hit hard, especially airlines (Cathay etc.).

I feel the same way now. If the market tanks further on coronavirus (well, I know we are at highs recently but...), just stay sane and buy what becomes cheap and available. As Munger says, keep your head as others lose theirs (well, he was quoting Kipling).

But wait, I am no expert, so let's just say this does get really bad, like the 1918 Spanish Flu.  That was bad. 50 million people died around the world back then including 675,000 Americans.  Quick googling shows that the world population at the time was around 2 billion, and the U.S. population was around 100 million. So the flu killed 2.5% of the world population and 0.7% of the U.S. population. A similar event now would kill 193 million people around the world, and 2.3 million Americans. 

That would be quite a shocking event.  By the way, did you know that the flu has killed 12,000-61,000 per year since 2010 in the U.S.? Between 291,000 - 646,000 people die of the flu around the world each year. I don't mean to trivialize the coronavirus. We have to do what we can to stop it, of course.

Anyway, let's take a look at the economic impact of such a worst case scenario (well, I know, there can be worst cases than 1918, of course. I am a big fan of The Walking Dead, 28 Days Later, World War Z, Shaun of the Dead etc... )

This is the chart of deaths from the 1918 flu from the CDC website. Not easy to read, but I think the deaths peaked in the 4th quarter of 1918.

Deaths from the 1918 Flu

Now, hold this image in your head while you look at the next chart. I couldn't find anything to take a close-up view of this, but if you look at GDP from 1915-1920, there is no real visible blip.




Same with the stock market. Close-up views of the market between 1915-1920 also doesn't really show much worth responding to in terms of stock market activity.  There really is no visible or actionable blip as far as I can see. Again, you can google for a close-up and you won't really find anything, I don't think.


Of course, coronavirus is a terrible thing and it is disrupting a lot of people's lives. There is no doubt there is a huge impact to many people all over the place.

But as investors, we have to keep our cool and not freak out over every new data point. There is no doubt that the numbers will rise over time, and I honestly don't believe at all that there is no coronavirus in NYC, for example. I think the odds of that are ZERO. There is no way that there is no coronavirus here. It's just that we don't know yet how many we have, as apparently, NYC still doesn't have a test for it so has to send samples down to Atlanta. Plus, most people I know do NOT go to the hospital for a fever and a cough. I certainly don't, unless there is a reason to do so, or else I am told to.

So honestly, nobody knows how much is already here in NYC, and how much it is spreading. We won't know for a long time, and we may never know.

This can get worse, may peak out soon, or they may come up with a vaccine soon too. Who knows.

Many argue that the globalized supply chain will make the impact of this flu worse than previous cases, but there are positives about globalization too, like communication and technology, that might make responding to the virus much more effective. But again, who really knows.

I just don't think it's worth spending too much time on.

Bullish
Well, actually, I am not bullish or bearish. I just am. But if I had to guess, I tend to think these 'events' are hugely bullish. This is sort of true for most exogenous events. Why? Because governments / central banks tend to overreact. We are so afraid of negative economic impacts that they will overcompensate. This often leads to bubbles, which is usually not good.

Think about the bubble in Japan in the 1980s; much of that was a response to the yen-shock (Plaza accord of 1985); the fear that the strong yen will destroy the Japanese economy contributed to the bubble in the late 1980s there. In fact, the same sort of FX bickering between the US and the UK contributed to the 1920s bubble. Greenspan's fear of Ravi Batra's Great Depression contributed a lot to the bubble in the late 1990s (and the various meltdowns from Russia, Turkey, Asia, LTCM etc. all of these contributed to the bubble as the Central Bank(s) overcompensated).

This happened again after the Great Recession, and will now happen again due to fears that the coronavirus will plunge us into a recession (and was sort of happening due to fears that the trade wars will kill the economy).

So every time something bad happens, it has just been enormously bullish, every time. Of course, this can't go on. At some point, we will start pushing on a string, and the old tricks will stop working. That is also a certainty. And bubbles will pop every now and then, but only after a bubble becomes a real bubble, usually.

But, we can't really know when this (the end) will happen. Unless you are sure that we have reached the end of the line, you have to asssume that these negative events will just be hugely and incorrectly overcompensated for resulting in huge rallies everywhere.

Anyway, this is not really a bullish proclamation on my part. I will remain neutral (but invested), but just an observation.

PICO Holdings, Inc.

In Issue 14 of the Oddball Stocks Newsletter, we had a writeup by Nick Bodnar about an Oddball company called PICO Holdings. There was an activist campaign, a special dividend, and the board of directors of the company is now in much stronger hands - and it is in liquidation mode.

In the past, we have described PICO as a "rare Oddball that combines a sum-of-the-parts cheapness, a catalyst, appropriate management incentivization (bonus formula of a time value of money charge against invested capital), and even ongoing share repurchases." As they have disclosed,
Any significant additional monetization proceeds [are] anticipated to be returned to shareholders through tender offer, and/or open market repurchases, and/or special dividends depending on facts and circumstances existing at the time of monetization
The executives of the company are incentivized to wind down the company with a bonus formula that provides for a time value of money charge against invested capital. Yesterday (January 31st), PICO put out a press release with an update on its share repurchase program:
PICO Holdings, Inc. (Nasdaq: PICO) announced today that its Board of Directors has approved the repurchase of up to an aggregate of $100 million of its common stock which would be made from time to time on the open market at prevailing market prices or in negotiated transactions off the market, as capital becomes available.

The Company's Board of Directors had previously authorized in November 2015 an aggregate of $50 million for its stock repurchase program and to date the Company has repurchased 3,494,443 shares for approximately $38.9 million.
We also saw an interesting (provocative) comment on this announcement on the Corner of Berkshire and Fairfax message board:
Lost amongst the pandemonium Friday after the close PICO announced and expansion of its share repurchase program. PICO is a bad investment and basically a slow liquidation play at best, but they've been remarkably consistent repurchasing their shares at prices averaging mid 10s and even 11s. With firepower authorization equal to basically half of the current market cap and ~$60M remaining plus a lot of bag holders with no interest selling shares around here, buying at/around/under $10 seems like a pretty reasonable and safe trade, even if its only for a few percent back to this mid 10s. This has no correlation to all the current hysteria either, and really only relies on the continuance of the status quo in Vidlers core markets.
We do not know what makes this particular commenter believe that PICO is a bad investment, although there are certainly risk factors. The biggest concern with PICO would seem to be that its investment in the 35 mile long water pipeline from Fish Springs Ranch to Reno, Nevada needs new home development there in order to be monetized, and as they say: "To date, we have sold only a small amount of the water credits, and we cannot provide any assurance that the sales prices we may obtain in the future will provide an adequate economic return, if at all."

In Oddball Stocks Newsletter Issue 24, we published an extensive piece on PICO Holdings, and have written other updates subsequently. If you are curious about PICO Holdings and you are not already an Oddball Stocks Newsletter subscriber, a back issue of Issue 24 would be a research starting point. (Don't miss our most recent Issue 28 and other back Issues, either!)

Oddball Stocks Newsletter Excerpt: The Coal Creek Company

Here is another sample piece from the Oddball Stocks Newsletter. This is an excerpt from Issue 25, published in June 2019, about The Coal Creek Company (CCRK).

Coal Creek shares have declined and are currently trading at the same level they were in the summer of 2006.
You can subscribe here to the Oddball Stocks Newsletter, and we also have some a la carte samples of back issues available.