Investment Moats

I gotta say, I have never been so poorly positioned before. And I have possibly made some really schoolboy mistakes.

But I am no guru who is selling a top list of stocks to buy with a Covid-19 contagion or top list that I will be looking to buy, so that is OK.

So I just hope everyone stays safe.

Some General Indices Data Points

I would just wish to capture some data points for blog history’s sake. I remember back in the days, my fellow blogger La Papillion from Bully the Bear used to capture these when we were bully by the bear instead.

Everything is down and down by a lot. Even Bitcoin is down which is befuddling but I think it will be recovering soon with the event upcoming.

Some of the older readers would know I ran this Dividend Stock Tracker where I keep track of some high yield dividend-yielding stocks in Singapore.

The fall yesterday was crazy. Some really enticing deals out there, but not sure if there is a liquidity event on the horizon.

How Rare Are These Huge Daily Gyrations?

A lot of investors who started investing in the 2010s are not used to seeing this kind of volatility, even in the indexes.

This is new to them. Even for someone like myself who went through it, this IS a bit crazy. Even in 2008, I seldom see 9% down days on the indexes!

CFA Institute has a good table showing the standard deviation distribution of the SP500 from 1950 to 2012. This is interesting in that it bypasses the 1920s to 1930s which is very volatile.

The majority of the fluctuation in prices is within +1 and -1%. You get rare events like this. 3-4% is basically… a 3-4 standard deviation event already.

A 1 standard deviation means that there is a 68% chance the price movement is capture within -1% to +1%. If we invert this, there is a 32% probability that your daily return is not captured in this range.

In a 3 standard deviation event, we have a probability of 0.13% that it will not be captured in the -3% and 3% range.

How Are are These Huge Monthly Gyrations?

Thus, today’s -9.51% move in the S&P 500, this event almost should never happen. It is like a TOTO event.

We are basically nearly -25% from the highs on the index, which means that we are in bear market territory.

Going back to 1926, the average monthly return on the S&P 500 is 0.95%. The standard deviation is 5.37%.

S&P 500 hit a new high in February 2020 but closed off sharply lower. This is a rare situation.

• FEB 2020 returns: -9.4%
• Mar MTD returns: -16.28%

Feb returns are almost a 2 standard deviation event and Mar is almost 3 standard deviation. In the grand scheme of things, these are important buying days or important days to avert because it is rare.

Out of what I experienced, this is the monthly returns. We can see that this drawdown looks pretty similar to the mid or tail end of a bear market.

2008’s price movement is a brutal 3.8 standard deviation event. It is a rare return.

If you were to ask me what felt different for this one was that… 2008 was a difficult event for shorting because anytime a certain stimulus package was announced, there will be huge counter-rally.

Some of those look rather tame but a lot of them look like they are going to turn. They get your hopes up high until the end where you just give up believing it.

It makes shorting pretty difficult.

This time around, whatever Trump tried to say, the market got even angrier.

I guess this is the main difference.

Past Greater than 10% Drawdowns and Returns Over Time if you stayed invested

Some data may not see the light of the day at Providend because it might unnecessarily scare the daylights out of some clients.

But here it is.

There are about 25 instances where the S&P 500 fell by more than 10% in 1 month.

I took a look at the returns if you have stayed invested.

You can see how brutal the 1920s and 1930s were. There are 10 instances out of the 25 instances that the monthly return is less than 16%.

If you take out eh 1920s and 1930s, after 2 to 3 years, you would not be red anymore.

I also took a look that if we prudently be in a 60% SP500 and 40% US-Treasury, whether that helped the situation:

I think you won’t recover faster, but looking at the magnitude of the fall, it is much more livable. 6 months after the fall, if we take out the 1920s and 1930s, the largest fall is -16% on your portfolio and the recovery happens after 1 year.

If you invest after such a large drawdown month

Some of your money would have been invested, and some of your money is going to be invested.

So what if you invest after a greater than 10% monthly fall?

The 1920s and 1930s are damn brutal. I really hope we do not return to those scenarios.

Even if you are 100% cash and invested 1 month after such a fall, 3 years from now your results would still be shit.

But aside from that, the data looks compelling to put more money to work.

When you tranch or dollar cost average into the market, you will capture all these good and poor sequences. If the market goes up over time, then your returns should be alright.

If you are in a balanced portfolio, your returns are not too bad. With a lower volatility, in 6 months’ time, most months you are green while the largest negative month is about 21%.

Duration to Deepest Point

This isn’t rocket science but there are some that rebounded in 3 months and some that took nearly 3 years. On average, it took 19 months to go to the bottom.

So you can use this to pace yourself.

How Long it Takes to Recover

A recovery is a period where prices go down, then comes back up to the original point.

There are about 121 falls from the peak sequences since 1926.

Where we are now, there are again 6 instances where the drawdown is greater than this. The length of time it takes to recover ranges from 2 to 4 years to as long as 15 years (pray that it is not the 15 years)

The difficulty with market timing is that 88% of the time, the fall is less than 10%. If you sit out of them, you missed out on the returns.

Yet each of those 10% to 20% falls feel like the start of a great fall we are seeing now. But they turn right back up and you could not all in.

This is why we always say… stay invested.

Summary

Ok, this took longer than expected. Lack of sleep. Not in a good mood now.

For those who are accumulating your wealth, look upon periods like this as an opportunity to get at a good price.

The math here is that if returns suck in the first 10 years, the returns next 10 years tend to be better. Your time horizon is long. Keep your job and be frugal and put away money regularly.

For those who are invested, there are silver linings based on the data that I have shown. These things are a cycle. Even doggy European countries can do OK.

Some of you might have your risk profile re-calibrated by this event. You think you could take volatility but in actual case, this might be a little harder.

There is a reason we have a portfolio made up of less correlated assets (even though in times like this, you realize they are all correlated!) such as bonds. They act as a cushion to your portfolio.

If you are near retirement, your adviser should have structured your net wealth such that great negative volatility like this should not derail your retirement.

If you are not sure if you are well structured for it, get some help.

The toughest would be the 35 to 50 who are halfway in your journey. You have invested and are still getting there. Stay strong people. (I would probably break this out to another post)

Stay away from crowds and wash your hands.

Do Like Me on Facebook. I share some tidbits that is not on the blog post there often. You can also choose to subscribe to my content via email below.

I break down my resources according to these topics:

1. Building Your Wealth Foundation – If you know and apply these simple financial concepts, your long term wealth should be pretty well managed. Find out what they are
2. Active Investing – For the active stock investors. My deeper thoughts from my stock investing experience
3. Learning about REITs – My Free “Course” on REIT Investing for Beginners and Seasoned Investors
4. Dividend Stock Tracker – Track all the common 4-10% yielding dividend stocks in SG
5. Free Stock Portfolio Tracking Google Sheets that many love
6. Retirement Planning, Financial Independence and Spending down money – My deep dive into how much you need to achieve these, and the different ways you can be financially free
7. Providend – Where I work doing research. Fee-Only Advisory. No Commissions. Financial Independence Advisers and Retirement Specialists. No charge for the first meeting to understand how it works

I think for newbie investors, these 2 weeks have been a bit surreal. For as long as I could remember, we seldom have days of 2-3% daily up moves and 2-3% daily down moves since the financial crisis.

On usual markets, we should have the odd 2-3% moves but they should be over pretty fast.

A possible sign of a bear market is when you have many of these 2 to 4% daily moves clustering together.

Today’s post consists of some of the data that I see out there. It might be useful or might not be useful.

The chart above shows the 1-month yield change for Singapore’s 10-year government bond yield.

The 10-year government bond yield indicates a few things for me:

1. It is the rate where corporate bonds take reference from when pricing their debts
2. It generally indicates the GDP growth of a country
3. Inflation expectations
4. It shows the tug-of-war between stocks and bonds. A falling long term yield sometimes indicates that despite good economic times, the demand for bonds is increasing. This indicates cautiousness

The 10-year rate has fallen, even before the United States Federal Reserve decide to make an emergency rate cut of 50 basis points. This might indicate a mixture of lower GDP growth expected, lower inflation expectation and greater cautiousness.

In the past week, the yield has tumbled from 1.4% to 1.20%.

This is good news for interest rate sensitive assets such as REITs and Bonds. Their prices have shot up. This indicates that borrowing costs may be lower by as much as 1%.

The chart above shows the yield movement of the 10-year USA government bond. The 10-year in its long history has never been below 1%. Until this week.

When we were with Manulife US REIT’s results brief on the 5th of Feb, we were discussing their upcoming debt refinancing. The rate was 1.64% then. Management indicated in the market back then they should be able to refinance at slightly below 3%.

Today, at 0.77%, they might save 0.6% in interest cost. If the interest rate remains at this range, it would be conducive to the REITs.

Be Wary of the Magnitude Interest Rate Could Change

Interest rate matters to a lot of our lives since many readers own private property or leveraged endowment plans.

The loans are likely priced with some of these interest rate swap rates in mind.

Not too long ago, there was this fear that rates are rising and it is better to lock in the rates.

Now there is no fear anymore.

I always wonder whether you realize how much interest rate can change. In 1 month’s time, the USA 10-year yield dropped 53%.

The implication for you is that if you are risk managing your loans, instead of factoring in a 5% to 10% interest rate sensitivity, perhaps the better metric is 25%, 50%, and 75%.

If you use these sensitivity tests, you might realize that maybe these leverage endowment plans do not have much margin of safety and could be cash flow negative.

A Possible Liquidity Crisis?

If the interest rate goes down, then interest-rate sensitive assets such as REITs, MLPs should benefit in these bear markets.

But why aren’t this always the case?

Because in bear markets, it is usually accompanied by a recession which is not good for business. So income is affected (which brings me to the point that REITs is not always interest rate sensitive only)

A second reason is that in these bear, the sentiments towards debt lending shifts from easy to stringent. If your REIT is poorer in quality, you might not be able to refinance. There is generally less money out there to be borrowed.

Howard Marks, in his book, Mastering the Market Cycle, he talks about the credit cycle:

1. At the start, appropriately risk-averse investors apply stringent credit standards to the issuance of high yield bonds
2. The same healthy economic environment that facilitates bond issuance makes it easy for companies to service their existing debt (meaning default is scarce)
3. Thus high yielding bonds – with their generous interset coupons and little damage from defaults – provide solid realized returns
4. Those returns convince investors that high yield bond investing is safe, attracting increased capital to the market.
5. Increased capital for investment translates into increased demand for bonds. Since Wall Street never allows demand to go unmet, this results in increased bond issuance.
6. The same condition that allows larger amounts of bonds to be issued – strong investor demand – invariably also allows bonds of lesser creditworthiness to be issued

Usually, the credit cycle turns when the economy turns (not always):

1. A slower economy makes it harder for companies to service their debts.
2. With the credit market closed, refinancing can’t be accomplished, meaning defaults rise.
3. Rising defaults damage investor psychology
4. Investors who were risk-tolerant when things were going well now become risk-averse
5. Advancing capital to financially distressed companies – which seemed like a good idea just a short time earlier – now goes out of favor
6. Potential debt buyers back away, refusing to “catch a falling knife” and saying they’ll wait until the uncertainty has been resolved
7. Capital that is mobile flees from the market. Buyers become scarce, and sellers predominate
8. Selling of bonds increases; bond prices cascade downward; funds that receive withdrawals become forced sellers, and eventually, bonds are available for sale at any prices

This is how textbook knowledge is thrown out of the window. I realize that you can rename companies in the above two lists into ourselves and it will explain some of our behavior.

What I learn is that the irrationality affects lenders and spenders as well. The whole mood is just cautious. Cautious mood makes everything cautious.

A liquidity crisis is something the Fed is always trying to prevent. But what could cause one?

Daffodilistic from our Telegram chat brought my attention to the distressed in the Banking Repo Market. The repo market is a black box market where banks can put up their debts (loans to clients, businesses) in a market so that they can get short term cash.

With this market, they can alleviate short term liquidity with the debts on their balance sheet. In Aug to Sep last year, I started hearing that the Treasury had to step in to offer liquidity because… the Repo rate went up to 10%. For some reason, there is a real shortage of liquidity.

If you go down this rabbit hole, it might lead you to some doomsday subprime kind of crisis. Is it possible? I think it is possible but we are not sure about the magnitude of all the things.

I believe this is possible because we are getting some crazy historical high/low data points. When markets are so connected you get the feeling it is not out of the question there is a flaw not many see it coming in the system.

Modeling a 1 Year Lost in Earnings

The Covid-19 Virus is going to cause some very ugly numbers for a lot of companies. The market is currently adjusting to price in this scenario. The adjustment is usually mixed with the psychology of the investors as a collective.

So the price in the short term might not equal to the value.

Brooklyn Investor(BI) has a nice post in which he tries to explain how to model the impact of the Covid-19 virus.

One way of valuing a business/stock/company is to do a discounted cash flow analysis on the stream of cash flow of the company.

BI uses the case of a business that we do not expect the earnings per share (EPS) to grow over time. Suppose for this company we demand a discount rate for taking a risk of investing in this business of 4%.

Suppose we expect that this Covid-19 has a 6-month impact on the earnings of a particular company:

The image above shows the present value for an infinite stream of earnings from the company, discounted at 4%. In investing-speak, we say the intrinsic value of the company, based on discounted cash flow methodology, is 250.

If we reduce the 1st year EPS by 50% (deduct 6 months of earnings), the present value of the business is 1.92% less.

That looks quite ok because…. the value of the business is not just on the first year of earnings. The value of the business is in its future stream of earnings.

BI simulated the intrinsic value if the company did not receive income for 1 year:

And 2 years:

And 3 to 4 years:

Even a 14% fall in valuation looks OK. The future is uncertain and I don’t really wish for this to be stuck 4 years.

I do however like to caution that EPS can be negative. I think if cash flow is negative, it is difficult to do a DCF, and thus putting it as 0 makes sense.

How low valuation can get also depends on the discount rate and growth rate. BI didn’t use a growth rate (which is conservative) and he used a discount rate pricing the business as PE 25 times.

Some of your business might not be like this. The business might be riskier such that you would demand a 10% discount rate (which is a discount rate I used by default for a lot of uncertain businesses). However, I do think the discount rate does not matter.

This is because we are comparing the same company. If you are using a 10% discount rate before the ordeal and comparing it against the company after the ordeal, the difference in valuation due to having 1 year less of earnings should be similar (I have verified the math).

If we are realistic, let me modify BI’s case study to bed in a 5% a year growth for 3 years, 3% growth for 6 years and a 0.5% a year terminal growth rate after year 10:

The difference is 7.28% versus 3.8% if there is no growth (as illustrated by BI). But it is rather assuring that the intrinsic value is just a few percentage difference.

But what if the growth rate is 15% for the first 3 years instead of 5%?

The loss of 1 year of earnings matters much more to valuation.

This is because base on the time value of money concept, the cash flow in the earlier years is much more valuable than the future years. By “losing” 1 year of earnings, the impact is greater if you are expecting great growth rates.

A good example would be that if you like this high growth stock. It trades at 30 times of last year’s earnings. However, you are expecting a growth rate of 20% at least for the next 2 years.

The impact due to lower-income is going to affect the valuation of the company more.

However, these are theoretical and one reason I seldom use DCF so much in my valuation nowadays is because it is so hard to judge the stream of income going forward. Nevertheless, we can all learn from this exercise. It shows how important would it be to miss that 1 year of cash flow for the business.

My thinking: the earnings the company lost are just deferred to a later date. If the business is not a going concern, this is a good opportunity to pick up these stocks.

The businesses that will struggle to emerge with things intact are the businesses that have slim resources, have very tight working capital, those that do not have buffers.

I would normally ask you to have an emergency cash, and businesses need to have their own version of this as well.

I would see if I got some more posting tomorrow. Back to work.

Do Like Me on Facebook. I share some tidbits that is not on the blog post there often. You can also choose to subscribe to my content via email below.

I break down my resources according to these topics:

1. Building Your Wealth Foundation – If you know and apply these simple financial concepts, your long term wealth should be pretty well managed. Find out what they are
2. Active Investing – For the active stock investors. My deeper thoughts from my stock investing experience
3. Learning about REITs – My Free “Course” on REIT Investing for Beginners and Seasoned Investors
4. Dividend Stock Tracker – Track all the common 4-10% yielding dividend stocks in SG
5. Free Stock Portfolio Tracking Google Sheets that many love
6. Retirement Planning, Financial Independence and Spending down money – My deep dive into how much you need to achieve these, and the different ways you can be financially free
7. Providend – Where I work doing research. Fee-Only Advisory. No Commissions. Financial Independence Advisers and Retirement Specialists. No charge for the first meeting to understand how it works