William Smead: "Stuck in the middle with you"
by William Smead, Smead Capital Management
Unless you have been asleep on the floor for the last six weeks, you’ve noticed that the U.S. stock market has gone down. Even before stocks sold off in August, the average common stock had been performing poorly relative to the S&P 500 Index. In August, the market officially declined more than 10% from peak to trough. An anthem for situations like this comes from the one-hit wonder, Stealers Wheel, who penned the song “Stuck in the Middle with You.” Here is how the song described a circumstance like the one we have in the stock market currently:
Well I don’t know why I came here tonight,
I got the feelin’ that somethin’ ain’t right,
I’m so scared in case I fall off my chair,
And I’m wonderin’ how I’ll get down the stairs
When investors in common stocks get into a market decline period they wonder “why I came here tonight.” Stock market corrections are just as important to long-term investment success as positive market movements. The primary reason that long duration common stock ownership produces above average returns is because the results aren’t handed out in a straight line. In essence, long-duration ownership gets rewarded for patience through volatility. We “came here” looking for returns well above other liquid investments.
When you are in as volatile of a period as we are now (September 9, 2015), most investors look to experts and the media to make sense of what is going on in the stock market because “they have the feeling that something ain’t right.” Is the problem China’s economic slowdown, the Federal Reserve Board’s potential rate hikes? Do the uncomfortable feelings come from plummeting oil/commodity prices or the fact that the stock market has gone up a great deal since the bottom in March of 2009? Are common stocks overvalued on a P/E basis? These factors make the average individual and institutional investor “so scared in case [they] fall off [their] chair.”
How scared are investors? Both the American Association of Individual Investors and the Investor’s Intelligence poll of newsletter writers have recently registered polling numbers similar to March of 2009 near the bottom of the worst bear market since the 1930s. Most investors are wondering how they’ll “get downstairs.” Downstairs from a correction is a bear market decline of greater than 20%. Stealers Wheel continues:
Yes I’m stuck in the middle with you,
And I’m wondering what it is I should do,
It’s so hard to keep this smile from my face,
Losing control, yeah, I’m all over the place,
Are you “wondering what it is we should do?” As contrarians, we relish these corrective declines in the U.S. stock market. We use declines in the stock market to upgrade the quality of our portfolio and to concentrate our portfolio in the companies in which we have the most confidence. As we match up our buying with the story being told by insider buys from officers and directors of the companies we own, “it is hard to keep the smile from my face.”
Besides the great sentiment and the insider buying we are seeing, the fear created by other investors “losing control” has caused interest rates to stay low and oil prices to decline sharply. We use Ben Graham’s revised formula as a guidepost for determining intrinsic value. He researched interest rates on ten-year AAA-corporate bonds from 1944-1973 and concluded that the rate averaged 4.4% during those years. In his formula, the interest rate effect on intrinsic value is measured by dividing the numerator of 4.4 by the current AAA-bond rate.