Don’t Be Fooled!!

The rapid recovery of the market in 2020 was exceptional. Don’t count on a repeat during the next big sell off. Instead, plan for a “Margin of Safety” in your portfolio.

The bounce back of 2020 is the shortest on record. Most market recoveries take a lot longer. If counted in inflation adjusted terms, the drop that began in 1966 did not recover for 30 years. Stocks hits 1,000 on the DOW in 1966 and then bounced up and down for 16 years before going on to new highs. But inflation roared during that time and devalued the dollar by 70%. It took three times as many dollars on the average to buy the same goods in 1982 as it did in 1966. If the effect of inflation is included, the full recovery from the peak in 1966 until full recovery was 30 years.

The 2020 peak to full recovery was 140 days. Prior to that, the shortest period of recovery was 310 days. The average was 1,542 days (4 ¼ years). Not counting inflation, stocks took 30 years to recover from the beginning of the Great Depression of the 1930s.

What is a “Margin of Safety”? A portfolio margin of safety is having sufficiently more wealth than you expect to need to cover unexpected black swan and black elephant events. Black swans are those unexpected events with enormous ramifications. Black elephants are those events that are visible to everyone but no one really wants to address. Inflation is one of those black elephant events.

And if you are lucky enough to never have to use your Margin of Safety, then the worst case scenario is finding yourself with more money than you need. Having more than you need does not endanger your quality of life. Do you think that is a bad situation?

Don’t be fooled by forecasts for stock returns. How often do I hear or read someone who expects stocks to return 9% per year – or some other percentage. My first question is: “Based on what?”

The basic principle for determining stock valuation goes all the way back to Graham and Dodd, who said stock returns are realistically based on these three factors:

• Cash paid to the owners (dividends);
• Growth of such payments; and
• Change in the valuation of future payments.

But let me digress for a moment (I will bring it all back together). Consider this:

Suppose you had an investment that doubled every day, but you had but one penny to invest. How much would your investment be worth after 30 days?

Do you have your answer? Hang onto it while we circle back to the question at hand. Using the Graham and Dodd stock valuation:

Notice that the return in increasing the closer we get to today. If you take the return of the S&P 500 with dividends reinvested from 2009 to 2020, the return is over 16%.

So, if you had an investment that doubled every day and you started with just one penny, at the end of 30 days your investment would be worth $10,747,418.24!!

Yes, over $10 million. But understand half of that came on the last day. ¾ on the last two days. Over 90% came in the last four days. In the beginning, when one penny became two and two became four and four became eight, it seemed almost like a straight line. It was not until much later than the curve turned upward.

All of that to say that the returns on stocks appear to be following that ever-increasing curve.

There is one other factor at work. JP Morgan did a study in which they found that since 1980, 320 of the 500 stocks in the Standard and Poor’s 500 were removed from the index: “the S&P 500 deletions that were a consequence of stocks that failed outright [and] were removed due to substantial declines in their market value or were acquired after suffering such a decline”.[2]

In other words, almost 70% of the stocks in the S&P 500 lose money.

So even with returns which seem to be increasing, a good portion of at least the S&P 500 index is losing money and stock value. It is only a few stocks that are driving returns higher.

So don’t be fooled. There are stocks which are doing better than the index. Our philosophy is this: Owning those stocks paves the way for building that margin of safety. Do we pick the right ones all the time? No, but often enough to superior returns. And yes, we always have to say the past performance is no guarantee of future performance. But we don’t intend to change what has worked for sixteen years.

[1] “Supply and Demand for Stock Returns”, Financial Analysts Journal, 73(3):1-21, by Phillip Straehl and Roger Ibbotson, May 2017.

[2] “The Agony & Ecstasy: The Risks and Rewards of a Concentrated Stock Position”, Michael Cembalest, JP Morgan Asset Management, 2014.