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Writer's pictureW. Allen Wallace

Commentary | Cutting Through the Noise

When red flashes on the screen and security prices start to drop, it may feel like the situation requires urgency, and that any action is better than no action. But our perspective is that every decision we make must be based on facts and experience, and further, must help you get closer to reaching your goals than the actions we have already taken.

Picking up pennies in front of a steam roller
“Nothing is more difficult, and therefore more precious, than to be able to decide.” - Napoleon Bonaparte

Dear Family, Friends and Clients:


The headlines seem grim: “Market plummets”. It’s enough to cause a person to lose sleep. But since our mandate is to help you eat well and sleep well, it may be instructive to discuss our perspective on volatility, especially in a world where some very smart people insist it is the most important thing. When red flashes on the screen and security prices start to drop, it may feel like the situation requires urgency, and that any action is better than no action. But our perspective is that every decision we make must be based on facts and experience, and further, must help you get closer to reaching your goals than the actions we have already taken. When we make decisions intended to give you good results over a lifetime, the threshold required for change must be set fairly high in terms of temporary price dislocations in any given week.


Risk, in modern financial jargon, is defined as fluctuations in security prices. Risk means that a stock may be $100 today and $105 next week and $95 the week after that. Everyone celebrates the 5% gain this week, and mourns the 10% loss next week as if what they own has changed substantially based on collective opinion. Our contention is that what you own does not change based on security prices. You own a small part of a business, and that business continues to earn income based on sales of products and services; that doesn’t change if the price drops. But the wise sages of financial television profess to have intimate and esoteric knowledge about how much further prices will fluctuate, and it is tempting to follow them in with the highs and out with the lows.


A business that earns a steady and reliable income is a treasured possession. It is a mistake to buy a prosperous business with the intention of unloading it when the price has risen by some arbitrary percentage just as much as it is a tragedy to unload the same business because collective opinion determines that it is now worth 10% less. In our opinion, if we like a company at $105, we should love it at $95 given the higher anticipated future returns. This assumes, of course, that the ability of the business to earn income has not changed significantly or permanently. Over time, the returns to shareholders of good companies will come from that company earning income and either reinvesting in the business or returning that income to shareholders in the form of dividends or share buybacks. The short-term fluctuations seem important in the moment, but in the long-run the dominating factor is the ability of a good company to earn income.


This doesn’t mean that we can turn a blind eye to a deteriorating business. We are firmly focused on the permanent ability of our companies to earn a fair return on invested capital. The earnings of a company can fluctuate in the short-term much like stock prices. Thankfully, since companies don’t report daily earnings, the fluctuations in earnings are not as drastic in most cases as the prices of stocks. However, our job is to make an evaluation of changing fundamentals and determine whether declines in earnings power are temporary, or if our holdings have been permanently impaired. This permanent impairment is the risk that we attempt to guard against. And in most cases, it has very little to do with stock market prices. Only in cases where companies depend on stock sales to finance operations do stock price declines permanently impair a business; we work very hard to avoid these types of businesses.


With that background in mind, it may be prudent to address the current volatility due to the COVID-19 Virus that originated in China several months ago, and which is now establishing a foothold in The United States. There are several risks to the economy and the businesses that you own in your portfolio from this virus, and each of them requires an unemotional evaluation to determine whether or not action is required.

  • The most apparent, but possibly not the most likely, risk is that the virus will freeze commerce and our companies will temporarily be unable to sell products and services to consumers that are sequestered in their homes. This risk is addressed by the necessity of a company’s products, and also by the ability of the company to withstand a prolonged downturn in revenue based on balance sheet liquidity. It is highly likely that any widespread quarantine will be measured in weeks, not months, and we typically utilize managers who put a keen eye to making sure that our businesses are not living paycheck to paycheck. Just like we demand liquidity in our accounts to cover emergencies, we typically demand that our businesses do the same. If this virus were likely to freeze commerce for years instead of weeks, it would be much more important for us to make changes based on a long-term reduction in earnings power.

  • A more likely risk is that our supply chain from China is disrupted. Many of the products that we use in the United States are either made in China, or have important components that are made in China. There is a risk to the economy that supply chain disruptions temporarily prevent companies from obtaining components needed to create products that they sell. In addition, there is the risk that our outbreak is worsened by shortages of medical supplies and critical medications due to the high reliance of our medical supply chain on Chinese imports. This again appears to be a short-term issue that can be resolved over the medium term by changing locations of supply manufacturers and is again addressed by adequate liquidity and availability of funding.

  • The final risk is of course the gravest, and also the least likely. There is a risk that a significant number of people are infected and that our death tolls could be high enough to cause an economic decline. This is the fear that most people probably have in mind when they are liquidating securities in fear of a total economic collapse. While this scenario is not impossible, it is in our opinion highly improbable. It has long been my contention that it is not an effective strategy to prepare for the worst-case scenario. This is especially true when worst-case is substantially improbable, and when preparing for a post-apocalyptic dystopia will significantly hinder your ability to reach your goals in the much more likely scenario that society does not collapse. Fear sells newspapers (or in our current world, clicks) but it never made anyone a dime.

Given our careful analysis of the situation, we believe it is prudent to continue the course as charted. We always maintain adequate liquidity, and the companies that we own have durable competitive advantages, high earnings power, and were already under valued in relation to current prices. This is our normal course of action, and it is intended to protect against this very situation. If the situation changes, we will change our minds. If our holdings appear to be compromised by permanent deterioration in fundamentals, we will not hesitate to make changes.


Another valid discussion could be had around whether or not we should take advantage of the fear and purchase more equity securities. It is important to note that equity prices, in general, were at a very high level before this correction, and although certain industries have fallen significantly, the general prices of securities are only as low as they were toward the end of last year. This is not the substantial discount to fair value that we would require to take more risk in your portfolio. However, if prices continue to decline and we are able to purchase companies at significant discounts, we will happily do so. We just don’t happen to be at that point yet.


I want to be very clear that we will never arbitrarily hold securities based simply on inertia. We consider “hold” to be a recommendation, not a default decision. We are constantly analyzing our securities and the other securities available to ensure sure that we own businesses that give us the best chance for long-term performance given our analysis. We are also monitoring the rates on cash options, the yields and spreads on bonds of different varieties, and prices of certain commodities. When opportunities arise, we are not shy about taking advantage of them for your benefit. We only require that the investment meets the demands of our 7 Principles, that the investment is in-line with your ability and willingness to take on additional volatility, and that by making the decision we bring you closer to reaching your ultimate goal of life-time financial success.


We are always here if you need to discuss your goals or your holdings. Our most important job is discussing your decisions with you. Please never hesitate to reach out to your Wealth Advisor, or to me personally. We appreciate your trust, and we will continue to try to help you make the best decisions given the current facts without regard to emotions. Over time this has proven to be the most effective way to reach important goals.


Warm Regards,


Allen


W. Allen Wallace, CFA Chief Investment Officer

 

Basepoint Wealth, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.

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