February 2019 Update

In a turbulent sea of irrational behavior, the few who act rationally may well be the only survivors. In fact, the only antidote to emotion-driven misjudgment is rationality, especially when applied over the long haul with patient perseverance. - Robert Hagstrom


Mr. Market’s job is to provide you with prices; your job is to decide whether it is to your advantage to act on them. You do not have to trade with him just because he constantly begs you to. - Ben Graham


January was a good month for our portfolios, with stock and bond prices moving higher. The long term growth and value characteristics of our portfolios have never been better, save for the low prices seen late December 2018. Now is a good time to selectively take advantage of cheap prices for future growth.

It is my opinion that the general market has just passed through the popping phase of a bubble. For the last two years investors have stopped paying attention to valuations and important things like company debt, cashflow, and profit margins, etc. Instead, investors have played an expensive game of follow the leader, buying stocks because they’ve gone up in price. History tells us this type of momentum chasing, although exciting, never reaches a favourable end. Even with stock prices lower today than they were two months ago, valuations remain near the extreme peaks seen before the 1929 stock market crash and the dotcom crash.

So during this period, I’ve chosen to play a different game. Instead of chasing the most expensive stocks like everyone else, I’ve been purchasing the cheapest stocks of the most durable companies I could find. I have been preparing for the aftermath of over-valuation, with the goal of giving my clients long term protection of their money.

I did this by buying companies at exceptionally low valuations (between 4 and 5x cashflow in most cases) over the past two years. But unfortunately over the past year these shares went down instead of up. So depending on your point of view, either I look like an idiot (it’s possible), or these stocks now offer an even better deal, and therefore even more protection, than when I first bought them. In total, our portfolios today are valued at about 4x the cashflow that our businesses earn.

Is that good? What does that mean in a tangible sense?

For example, if I offered you a two bedroom condo in downtown Toronto with $2000 per month in rent net of expenses and taxes, that’s $24k a year of cashflow. Would you buy that condo for $120k? That’s 5x cashflow. Would you buy it for $96k, or 4x cashflow? What about $60k, or 2.5x? Some of our companies are that cheap – 2.5x cashflow.

My research shows the top performing stocks of the past couple years trade at about 40x cash flow right now. The average stock trades at about 20x cashflow. If I look back over history, I see that over the long term that average stocks trade at about 12x cashflow. Such lofty valuations imply 60% downside for the best performers from here, and 40% downside for the average stock. In contrast, the low valuation of our current holdings implies around 50% upside.

Having purchased durable businesses so cheaply, I have no doubt that we will realize on the implied upside, making our companies tremendously valuable investments for us. The simple thing about buying businesses so cheaply is you don’t have to be too smart to do it. One just needs a good sense of the obvious, and some patience for sentiment to correct so prices can move higher.

So if these businesses are so cheap, and all one needs is patience, then why doesn’t everyone do this?

When stocks go down most people get worried. The nervous system’s wiring overrides rational thought, causing investors to sell what’s been going down. With little sense of irony, these same investors usually then re-invest their proceeds into whatever has been going up – effectively doubling down on their misjudgements. This behaviour is most responsible for the market activity over the last two years. And it is precisely this emotional response that makes value investing difficult for most people, and yet creates opportunity for dedicated value investors in the first place.

But over the last two months there has been a change in market behaviour. The leadership of the market is now rotating away from the overpriced towards the cheap. My best guess is this mirrors the early 2000s, when the tech bubble popped catching most investors off guard. At that time, value investors, who had previously suffered material underperformance (Warren Buffett included), shone as boring, cheap, and profitable businesses regained popularity. The tech stocks previously considered safe on the way up proved anything but on the way down. In much the same way, I believe today’s exceptionally large gap between expensive and cheap securities has become its own catalyst. It’s been said before that the cure for low prices is low prices. Today, many old, boring, and profitable businesses are on the cusp of outperforming the shiny and new.

In my January note I wrote that now is the time to add capital to our portfolios to take advantage of cheap prices. I continue to believe that. In the spirit of Warren Buffett, it’s the most rational thing to do.

Recommended reading

Life isn’t about the hand we are dealt, it’s about how we play it https://ofdollarsanddata.com/fickle-fortune/

Keep your head when others are losing theirs https://fs.blog/2019/01/billion-dollar-ego/

The growing use of leverage in Canada will shift from tailwind to headwind https://betterdwelling.com/canadians-using-real-estate-for-personal-loans-accelerates-for-a-5th-month/


Ben W. Kizemchuk
Portfolio Manager & Investment Advisor
Wellington-Altus Private Wealth