“A price fall in and of itself does not necessarily reflect adverse business developments or value deterioration” – Seth Klarmann
2022 has gotten off to a very rocky start as far as investing in the stock market is concerned. Looking at the American markets, the S&P 500 index is down close to 8.5% year-to-date while the Nasdaq composite is down over 15.6%. If we take a macro view of the world right now it is easy to see why things are the way they are;
The world is still recovering from supply chain constraints brought on by the surge in demand for goods during the pandemic. The increased demand coupled with supply issues has driven prices up resulting in inflation hitting a 40-year high of 8.5% as of March 2022.
Unfortunately, global tensions are not helping as the war in Ukraine continues. Besides the human suffering it is causing, it is further disturbing the supply of certain commodities such as crude oil and wheat, driving up prices even more.
China is experiencing a recent surge in Covid and is locking down certain parts of the country again further disrupting supply, driving up prices of certain finished goods, and adding to the world’s inflation woes.
The spike in inflation has forced the US Federal Reserve (US central bank) to not only put a stop to quantitive easing (printing money to purchase assets) and start raising interest rates but to do an about-turn and start quantitative tightening by selling the assets it has been purchasing to the tune of $95m a month. This is all done in the hope that it will keep inflation in check. The rise of inflation, resulting in the need to increase interest rates and the Fed taking liquidity out of the system has an obvious negative impact on the market;
The increasing interest rates have dried up access to cheap financing meaning that borrowing is going to get significantly more expensive. This will slow down borrowing by businesses and therefore slow the expansion of many of these fast-growing companies. The slowdown in growth lowers the value Wall Street is willing to assign these businesses.
Rising interest rates impact companies that already have a significant amount of debt on their balance sheet as they now have to pay a lot more than they were in interest payments and businesses that have been growing rapidly but are loss-making will continue to be loss-making for a lot longer due to the higher debt servicing costs, while some might remain loss-making indefinitely. All of a sudden the market is waking up to the realisation that paying five to twenty times revenue to invest in a business that has never made a profit and is burning through cash might not be the best idea. The valuations of these businesses have fallen greatly over the last few months as investors sell them. Unfortunately, this type of selling often drags the entire market down.
Lastly, there is the impact caused by the adjustment of assumptions applied by analysts when valuing a business, namely discount rates have to change for the worse which significantly lowers the “value” analysts assign to a business further driving down share prices.
We are not economists or macro investors, we don’t know what is going to happen tomorrow, and we don’t believe anyone has a crystal ball, but in our humble opinion the worst is far from over and we believe we are likely to enter a global recession. Hopefully, we are wrong!
So what do you do as an investor?
The normal reaction to what is happening in the world is to become negative and fearful as uncertainty about the future increases. The impulse is to sell all your shares and wait it out until the macro picture looks better and you feel more comfortable investing with more certainty. This reaction is not necessarily wrong, you could sell all your shares and put your money into bonds or the money market and earn a few percent on your investment. With rates set to rise so will the rate you earn on these types of investments. Perhaps you could earn interest between 3.0% to 7.5% per annum if you are smart about it. If you are happy with that rate of return then that is the right thing to do!
The other option is to ignore your initial reaction, take a step back and see this period of high uncertainty as an opportunity rather than something to be afraid of.
It is our experience that it is during moments of economic stress that separates the great businesses from the weak ones. Any business can do well during an economic upswing but only the best of breed companies will not only survive the downturn but will gain market share from their competitors, many of whom might struggle. When that tide turns and the economy starts moving up, which it will, these companies are going to come out better than when they entered the recession. We have seen this when we invested in Egypt shortly after the Arab Spring when inflation and interest rates were greater than 30%. We saw this in Nigeria which struggled with foreign currency shortages after oil prices hit lows in 2016 driving up inflation to over 18%, and we even saw it in Zimbabwe during periods of hyperinflation. The best companies not only survive but can consolidate their positions during times of hardship. As an investor is it our job to seek out these best of breed businesses and the best time to do it is when the tide is going out, and right now the tide is going out.
Of course, the journey is not going to be smooth, and even high-quality businesses’ share prices are going to decline as the market pulls them down, but if you know what you are doing, and this is a key concept to truly being a successful investor, you want the share prices to drop because it can present you with opportunities you might never get again. We know it is hard to believe so let us present you with an example. Let us examine one of our investments;
The Buckle Inc.
The Buckle is an apparel retailer in the US. The company has been in operation since 1948 and was listed on the Nasdaq in 1992. The largest shareholder of the business, who owns 32.5% of the company, is the current chairman and the son of the founder of the business and the second-largest individual shareholder is the current CEO who has been at the company since 1970. I think it is fair to say that the Buckle and its management have been through many interesting economic cycles including the periods of high inflation in the 1970s, and the financial crisis in 2008.
As with all our investments we have analysed the financials of the company in detail and have been through The Buckle’s financials going back to 1993, just after it was listed. In the last 30 years revenue of the business has grown from $113 million to close to $1.3 billion. The growth rate of 8.7% per annum is not the highest you will come across but the company has been able to achieve this with zero debt on its balance sheet. The business has been able to grow by opening up 10 to 20 new stores per year, slower than many of its competitors however, the controlled growth has been done consciously so that management can control expenses and keep its superior margins with gross profit margin consistently above 40% while operating income margins have averaged 20% for the last 10 years. Compare this to its peers whose margins can be low single-digit. The high margins have resulted in the company generating a significant amount of cash almost all of which is paid back to shareholders in the form of dividends.
What does this mean as an investment?
To give you some idea of the attractiveness of the business, if you had bought shares in the company twenty years ago your investment would have grown over 7 times for an annual return of over 11%.
Is that the best you can do?
There are better returns out there as many investors have been able to achieve over 15% even over 20% returns for long periods however 11% is far better than the 3.0% to 7.5% rate you were considering accepting in the money market.
But that is the past, what does that say about the future?
You are correct in pointing out that the historic return of The Buckle does not guarantee its future success and of course, the last 30 years of its business have not been smooth sailing, in fact since 2014 the company has been struggling as revenue growth not only stalled but declined up until 2019. During this time the company struggled with expansion as its number of stores declined from 470 stores in 2016 to only 440 stores as of today. Part of the reason for the decline is because of The Buckle’s lack of e-commerce growth as the company lagged its peers in setting up an online presence, combined with consumers downtrading to cheaper priced apparel during this time meant that not only was revenue declining but margins compressed to 20-year lows. However, even during these times the company still managed to make a profit, it still managed to produce significant amounts of cash, and still managed to pay shareholders a dividend every year with a yield averaging over 7% per annum (think of the 3.0% to 7.5% you are happy to earn on bonds).
Covid has been an interesting period for the company as it has allowed it to re-strategise. Management has moved stores out of poor locations, mainly closed malls, and opened new stores in areas with stronger demand, it has significantly invested in its online business, and has benefitted from trading up by consumers to higher-priced goods. This all translated into record revenues and margins in the last financial year. Of course, the shareholders were rewarded over this record year as the company paid out a massive dividend to shareholders of close to a 15% yield.
Based on our in-depth analysis of the business and management, we feel safe applying certain conservative assumptions about how the business will look in the next 12 months, 3 years, and even 10 years. We put a high probability on the business still existing in the next 10 years, continuing to generate cash, and continuing to pay dividends to its shareholders. Don’t get us wrong, this is not the investment of a lifetime, we know the apparel is not the highest quality business unless you have a brand like Nike which the Buckle certainly doesn’t have. Furthermore, we are acutely aware that margins are at a record high as the Federal Reserves’ quantitative easing and the government’s stimulus packages have fueled consumption during the pandemic. We do not expect margins to remain where they are and we don’t expect revenue growth to remain on the same path that it is on, but as things currently stand we believe that by buying shares in this company today we are locking in a 13.4% yield on normalised earnings before tax. We are not applying any crazy assumptions here, we are not forecasting massive earnings growth to earn that 13.4%, actually, we assume earnings will decline over the next 12 months. If revenue continues to grow and the company maintains current margins then we could be locking in a far higher yield on our investment.
But what happens if the share price continues to decline?
The Buckle’s share price is down over 26% since early December 2021 and we do know if it will continue to drop but this brings us to a very important point. So please pay close attention!
We do not mind if the share price continues to drop because the more it drops the more attractive our investment becomes. We have already stated we believe that if we buy shares today at today’s price of $32.50 per share, we are earning 13.4% on earnings before tax. That is 13.4% we will earn every year if the business continues to perform as we believe it can, again based on conservative assumptions. If the share price drops another 25%, that does not mean the fundamentals of the business have changed, so at a 25% lower price, we could buy shares that are locking in a yield of 17.9%. So the lower the share price falls, the more attractive our opportunity becomes and the more shares we will want to own. Once you grasp this core concept the world of investing will change forever! Our goal is therefore to find investments that can maximise the yield we can earn.
So when do you sell?
As long as The Buckle continues to grow its revenue, as long as its margins remain superior to its competitors, as long as it continues to generate cash and payout handsome dividends, we will continue to earn 13.4% per annum on our investment before tax, so why would we ever sell.
We would sell if and only if, 1) the fundamentals of the business deteriorate, or 2) we find a business that offers a more attractive yield.
What happens if the fundamentals do change?
We continuously monitor our investments and the beauty with the Buckle is they report sales every month so it is very easy for us to monitor sales trends and pick up on issues within the company. Furthermore, because we don’t manage a pooled investment fund of several million or even a billion dollars, we are very nimble and will be able to exit our position in a heartbeat if a business’s fundamentals deteriorate or we learn that our analysis is wrong.
Conclusion
We are living in very stressful times, and the future is uncertain but we argue no matter what point in history you choose it is all relative, and times always appear stressful and uncertain. But rather than fear the future, we are genuinely excited for the opportunities that are going to present themselves.
The portfolio is made up of investments such as The Buckle. Not all of them are as attractive while others are even more attractive. We continuously evaluate our investments, exiting the businesses we are uncertain of or are offering less attractive returns while increasing our positions in the most attractive investments we can find. So while the tide is going out we do not expect phenomenal performance but we are confident that by applying our minds we are going to find investments that over the long-term, far exceed the 3.0% to 7.5% we could earn from bonds.
If you are like us and believe you can lock in higher yields today for tomorrow, then now is the time to look for opportunities that will compound your wealth for years to come. We would love to help!
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