What To Do When The Stock Market Falls by Ben Reynolds
The stock market is down over 8% so far in 2016.
Baupost's investment process involves "never-ending" gleaning of facts to help support investment ideas Seth Klarman writes in his end-of-year letter to investors. In the letter, a copy of which ValueWalk has been able to review, the value investor describes the Baupost Group's process to identify ideas and answer the most critical questions about its potential Read More
Source: Google Finance
Price declines have sparked widespread fear in financial markets that 2016 will be ‘the year of the bear’.
There are a myriad of reasons why the market has fallen in 2016:
- Fears of Federal Reserve interest rate increases
- Growth slowdown in China
- Plummeting oil prices
If you focus on negative short-term events the market looks bleak. The picture looks very different if you step back.
Notice the scale on the left-hand side of the image above is not linear. The stock market has exhibited exponential growth over long time periods.
“In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.” – Warren Buffett
To take advantage of exponential growth you cannot sell when the market dips down.
There are steps to take when the market falls. This article examines what to do when the stock market falls. It also gives 3 examples of high quality dividend growth stocks that are currently trading at a discount to fair value.
What To Do When The Stock Market Falls
There is a fantastic story that beautifully sums up what to do when the market falls.
“A broker who kept a brick on his desk would tell his new clients, ‘one of these days the market will go down and you’ll be upset – maybe so upset you’ll want to throw this brick through my window. Before you decide to throw this brick through my window I want you to do one thing I want you to write a check to your mutual fund company and tie it to this brick, because when the market falls, you should be thinking about buying more shares.’”
Source: Storyselling for Financial Advisors, page 225
The story above is very clear. You should be buying, not selling, when market fall.
As a side note, replace ‘mutual fund’ with ‘high quality dividend growth stock’ in the story above. Mutual funds tend to have high fees which hurt individual investor returns over time.
Warren Buffett On What Do To During Market Declines
Warren Buffett has 3 cornerstones of sound investing. All 3 are concepts Buffett finds to be critical to investment returns.
His second cornerstone is to look at market fluctuations as your friend rather than your enemy. Click here to see Buffett’s other 2 cornerstones of sound investing.
When markets are falling people tend to panic.
Most investors (including many professionals) see market fluctuations as their enemy. It’s easy to understand why. The quoted value of your investments has gone down. You have lost money (at least on paper).
Two facts take all the sting out of market falls:
- You don’t have to sell because the market is down
- You do get the chance to buy great businesses at bargain prices
Since you don’t have to sell when market prices fall, why would you?
If someone offered to buy your car one day for $20,000 and you didn’t sell then why would you sell if they came back a month later and offered you $10,000?
When the stock market falls we treat our assets differently. We want to sell our shares in great businesses because people will pay us less. That doesn’t make any sense.
As a seller you want a higher price. When prices get low, just don’t sell – even if other people are.
On the flip side, being a buyer is great during market falls. You get the opportunity to buy high quality businesses at a discount.
Think of market falls as coupons for 10%, 20%, 50%, or even more on ownership in great businesses.
“Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down” – Warren Buffett
Market falls give you the opportunity to buy ‘high quality merchandise’ (high quality dividend growth stocks) at reduced prices. What could be better for compounding your long term wealth than that?
You have the opportunity to benefit from market fluctuations by purchasing great businesses when they go on sale, and only selling them when they become very overvalued.
“Be fearful when others are greedy and greedy only when others are fearful.” – Warren Buffett
The 8 Rules of Dividend Investing are designed to help investors take advantage of market fluctuations and build a portfolio of high quality dividend growth stocks.
Warren Buffett does not just talk about holding through recessions. He actually does it. This is best exemplified by Buffett’s investment in American Express (AXP).
Buffett first invested in American Express in 1964. He has held the stock for over 50 years. A lot has happened in those 50 years. The market has seen exponential growth – and severe corrections. Buffett held through all of it.
Warren Buffett is not the only investing great with wisdom on what to do when the market falls
Other Investing Greats' Wisdom on Stock Market Falls
Warren Buffett is the most famous investor alive today, but he does not have a monopoly on good investing advice.
Peter Lynch and Seth Klarman both have important takes on handling market declines.
Here’s what Peter Lynch has to say about market declines:
“You get recessions, you have stock market declines. If you don’t understand that’s going to happen then you’re not ready, you won’t do well in the markets.” – Peter Lynch
The market’s long term trajectory is upward. It does not go up in straight line, however. If you invest in the stock market you will experience market declines.
You must be prepared for them. Peter Lynch’s advice is to understand that markets will fall while you are invested. Coming to peace with this fact is critical for long-term investing success.
Humans in general (myself included – and you too) have a natural tendency to overreact to both positive and negative news.
This creates market bubbles and collapses. We hear good news and we overweight it. We hear bad news and we think the sky is falling and the S&P 500 could hit 0!
Seth Klarman (the billionaire hedge fund manager of Baupost Group) understands this very well.
“The stock market is the story of cycles and of the human behavior that is responsible for overreactions in both directions” – Seth Klarman
The act of knowing that we are predisposed to over-reaction can help us prevent it from occurring. Investing is very much a calm man/woman’s sport. You must separate yourself from your emotions and behavioral biases if you want a chance of doing well.
Watch Dividends Not Stock Prices
I believe that a good portion of the short run focus in the market is a result of investors paying attention to the wrong metrics.
Instead of worrying if a company will miss analyst expectations by a few pennies (does this really even matter?), why don’t we focus on how a business is expected to grow over the decade?
Price fluctuations tell us nothing about the underlying growth of a business. A company can announce it grew earnings 10% and see its stock price fall.
Stock prices lie. Dividend payments do not. Turning your attention to dividend growth and dividend payments instead of daily stock price moves will help you to hold through market falls.
Great businesses don’t cut their dividends when their stock prices fall. Take a look at Aflac’s (AFL) stock price movement versus its dividend.
Aflac’s dividend payments marched forward in a consistent manner. Aflac’s business has grown over time. As a result the company has been able to pay rising dividends.
Contrast the stability of Aflac’s dividends with its share price. The company’s share price (adjusted for splits and dividends in the image above) fluctuates wildly. Note the decline during the Great Recession from above $50 to around $10 per share.
Investors who watched Aflac’s share price during the Great Recession saw 80% of the value of their investment temporarily go away. Dividend investors who watched Aflac’s dividend just saw consistent growth through the Great Recession.
The stock market has fallen around 12% since previous highs.
Up to this point this article has discussed what to do when markets fall. Namely, buy high quality dividend growth businesses.
There are great businesses that are currently on sale. The sections below examine 3 great dividend paying businesses that are trading at a discount to fair value.
High Quality Stock #1 – Deere & Company
Deere & Company (DE) is the world’s largest farming equipment manufacturer. The company has large operations in the following countries/continents (among others):
- United States
The company was founded in 1837 and has grown to reach a market cap of nearly $25 billion. Deere & Company operates in 3 segments:
- Financial Services
- Agriculture & Turf
- Construction & Forestry
Deere & Company stock has fallen from highs of around $95 per share to ~$78 per share. The company saw earnings-per-share decline 33% on the year.
The company’s share price and earnings have declines due to falling grain prices and slower-than-expected GDP growth in emerging markets. This has resulted in farms purchasing less equipment. It is widely known that Deere & Company is a cyclical business. The company is currently in a down phase. It will recover when grain prices rise.
The company saw earnings-per-share fall from a high of $4.70 in 2008 to a low of $2.82 during the depths of the Great Recession in 2009, before hitting new earnings-per-share highs in 2011.
The company has done well reducing costs to increase profits during the current down cycle in agricultural prices. Total earnings were $1.9 billion in 2015. 2016 earnings are expected to be around $1.4 billion as weakness continues.
Despite weakness in the industry, Deere & Company remains a safe long-term investment. The company pays out about $800 million a year in dividends. Even during industry lows, the company expects to make around $1.4 billion in profits in 2016 for a dividend payout ratio of 57%.
Deere & Company has paid steady or increasing dividends for 28 consecutive years. A company must have a strong and durable competitive advantage to pay dividends for 28 consecutive years.
Deere & Company’s competitive advantage comes from its brand recognition and reputation for quality in the farming machinery industry. This competitive advantage is evident in the company’s 60% market share of the farming equipment industry in the US and Canada.
Deere & Company has compounded earnings-per-share in double digits using a variety of look back periods.
- Trough-to-trough earnings-per-share growth of 12.8% a year from earnings lows in 2009 to earnings lows in 2015
- Peak-to-peak earnings-per-share grew at 14.1% a year from earnings highs in 2008 to earnings highs in 2013
- Earnings-per-share growth of 12.2% a year from 2000 through 2015
When grain prices rise Deere & Company will see its earnings surge. I expect the company to continue to deliver 10% to 14% earnings-per-share growth a year over full economic cycles. This growth combined with the company’s current 3% dividend yield gives investors in Deere & Company expected total returns of 13% to 17% a year.
On top of excellent total returns potential, Deere & Company is also deeply undervalued. The company’s average dividend yield over the last decade is 2%. The company is currently yielding 3.1%. Based on its average dividend yield, Deere & Company’s fair value is around $117 a share. The stock is currently trading for ~$78 a share.
High Quality Stock #2 – ExxonMobil
ExxonMobil (XOM) is the largest of the 6 oil and gas super majors. The company is the corporate successor to Rockefeller’s Standard Oil. The company currently sports a tremendous $337 billion market cap.
The company is also a Dividend Aristocrat with 33 years of consecutive dividend increases. ExxonMobil and Chevron are the only 2 oil corporations that are also Dividend Aristocrats. The company’s dividend history is shown below
Oil price declines have caused a sell off in ExxonMobil shares. The company’s shares are down around 15% since highs reached in the summer of 2014.
ExxonMobil is still profitable despite oil price declines. The company is maintaining profitability thanks to its diversified operations. The company operates in 3 segments:
The company’s chemical and downstream operations generated $2.3 billion in profits in the company’s most recent quarter. Even with ultra-low oil prices, ExxonMobil’s upstream division generated $0.8 billion in profits in the same quarter. The image below breaks down earnings changes for the company in the fourth quarter of 2015 versus the fourth quarter of 2015:
Source: ExxonMobil Q4 Earnings Presentation, slide 7
Steep declines in the company’s profitable upstream division lead to questions about the company’s ability to pay its dividend.
ExxonMobil generated $0.67 in earnings-per-share in its most recent quarter versus $0.73 in dividends.
Normally a payout ratio over 100% would be cause for alarm. That’s not the case with ExxonMobil.
ExxonMobil’s management is committed to paying rising dividends, as evidenced by its 33 year streak of consecutive dividend increases.
In addition, 2 out of ExxonMobil’s 3 segments (downstream and chemical) are generating significant cash flows.
ExxonMobil has $3.7 billion in cash on its balance sheet and $38.7 billion in debt. The company’s balance sheet is in excellent shape. ExxonMobil is 1 of only 3 United States corporations with an AAA rating from S&P. The other 2 are Microsoft (MSFT) and Johnson & Johnson (JNJ).
An AAA rating is higher than the United States government’s rating – and the government has the power of taxation on its side. S&P has put ExxonMobil on a 90 day watch; the company may lose its perfect credit rating, but would still have an excellent credit rating nonetheless. This means ExxonMobil will have no difficulty tapping credit markets if it needs additional liquidity while oil prices remain low.
ExxonMobil’s combination of the following factors make it extremely likely the company will continue to pay rising dividends through the current low oil price environment:
- A management willing to pay rising dividends
- Profitable operations that are nearly funding the dividend today despite extremely low oil prices
- Excellent credit ratings
Shareholders of ExxonMobil should not worry about a potential dividend cut. Dividend increases will likely be minimal until oil prices recover. I’d be very surprised if the company increased its dividend by more than 1% to 3% a year until oil prices recover.
ExxonMobil’s power and influence on a geopolitical scale should not be underestimated. The company’s close ties with both the United States government and international governments combined with its enormous size give it a strong and durable competitive advantage.
ExxonMobil is the largest and most powerful oil corporation in the world. The company has a long history of rising dividends. ExxonMobil is likely undervalued at current prices. The stock currently sports a well-above-average dividend yield of 3.6%.
High Quality Stock #3 – Archer-Daniels-Midland
Archer-Daniels-Midland (ADM) was founded in 1902 and now employs over 33,000 people in 140 countries. The company is the largest farm products corporation in the world based on its $19 billion market cap.
ADM’s business is cyclical and is currently in a downturn. The company saw earnings-per-share of $0.61 in its most recent quarter versus $1.00 in the same quarter a year ago. The company’s share price has declined around 35% since highs reached in the summer of 2015.
A downturn in grain prices and oil have caused the company’s stock price and earnings decline. It is important to note that these declines are temporary. ADM’s earnings and stock price will recover when grain and oil prices rise.
Oil prices effect ADM because the company is a leading producer of ethanol. When oil prices are low, ethanol demand drops. Conversely, when oil prices are high, ethanol demand rises.
ADM’s dividend is safe despite the downturn. The company recently increased its dividend 7%. This is a sign of good faith from management that company’s dividend is not at risk. ADM pays a dividend of $0.30/share. Even with depressed earnings, the company has a payout ratio of around 50%.
ADM has increased its dividends for 41 consecutive years. For a company to increase its dividend every year over such a long time period it must have a strong competitive advantage.
ADM’s competitive advantage comes from its excellent global distribution network. The company owns the following: 283 processing plants, 413 procurement facilities, ~250 warehouses, and many rail cars, trucks, and ocean vessels for transportation. It would take an enormous upfront capital investment for a competitor to come close to matching the scale and distribution network of ADM.
ADM has compounded its earnings-per-share at 13.6% a year from 1999 through 2015. Investors should expect total returns of 10.5% to 13.5% a year from the stock’s 3.5% dividend yield and expected EPS growth of 7% to 10% a year.
The long-term growth driver for ADM is increased food consumption from growing global populations. ADM’s management is shedding low margin businesses and acquiring higher margin businesses. Recent acquisitions include: WILD Flavors (flavorings and additives) and Harvest Innovations (Non-GMO, organic, and gluten-free ingredients).
ADM’s cyclical downturn has made the stock a bargain. ADM is currently trading for an adjusted price-to-earnings ratio of just 10.9. ADM’s historical median price-to-earnings ratio over the last decade is around 13.5. Earnings are depressed at $2.98/share. EPS under normal economic conditions would be ~$3.50. Using ‘normal’ EPS of $3.50 and the company’s median average P/E ratio of 13.5 implies a fair value of ~$47/share. The company is currently trading at ~$32 per share.
What do you do when the stock market falls?
- Don’t panic
- See the long-term picture
- Watch dividends not stock prices
- Buy high quality businesses trading at a discount
This article examined what some of history’s most successful investors have to say about market corrections.
The 3 stocks examined in this article are all trading at a discount to fair value. All 3 are market leaders with strong competitive advantages and long dividend histories. I believe all 3 make compelling purchases at current prices.
These are not the only 3 stocks in the market trading at a discount to fair value (far from it). They are examples of what to look for in a business when the market falls. Namely:
- A shareholder friendly management
- Trading at a discount to fair value
- A strong competitive advantage
- A long history of success