Taking a long term view on investing with market volatility

This type of market is not for the faint of heart especially those that happen to look at their portfolios on a day to day basis. The volatility seen in the first few days of the new year has certainly spooked a lot of investors and I’ve seen posts of fear on investing message boards I frequent.

There is a large portion of the population that will not act rationally when these types of market events happen. I’ve seen people who bought Apple or Disney in the recent run up in the 120s and are now seeing their investments evaporate before their eyes in a very short period of time as the stock prices sink into the 90s. The first thing to remember is that individual stocks bring with them additional risk and volatility when compared against the market as a whole and an bigger emotional aspect to the trade as well.

When I invest in the market as a whole where it be a large-cap fund or a small-cap fund, I’m investing in a basket of hundreds or even thousands of stocks that are essentially a stranger to me. I know that the stock market goes up in the long term and I’m generally dollar cost averaging through my paycheck via 401k contributions or HSA contributions or IRA contributions or even taxable accounts. I know that I will be putting money into these accounts for years to come so the purchase price isn’t all that relevant to me. If I buy shares in the S&P 500 today and it goes down tomorrow and then again the day after, I don’t mind as much because I know that I’ll buy more in two weeks or in a months’ time. A lower price is actually beneficial to me because since I’m buying for the long term – the short term price fluctuations don’t matter. Sure it still stings to go into my 401k and see my net worth decrease by 10% if the stock market takes a huge swing. However, if I truly believe that the stock market goes up in the long term and I don’t plan to retire and don’t need the money for 10+ years then I can see this as an opportunity to buy more at lower prices.

However, I think things are a bit different when I invest in individual securities. I think the anonymity that comes with index investing disappears when I look at one individual stock. That’s part of the reason people tend to over-react during these types of events when it comes to individual stocks. When I buy a stock, I tend to do a ton of research on it; whether it be looking into what the company does or pouring through their financial statements. Not everyone does the same amount of due diligence but I think even more relaxed investors see investing in an individual stock as a personal decision more so than investing in a faceless index fund. Individual stocks have faces – they have CEOs, they have products you use and love, they have financial statements that you looked at and deemed as good and they have valuations that you looked at and deemed as a fair value.

Individual stocks also tend to have anchors more so than index funds/etfs and people tend to use those anchors more often when it comes to individual stocks as a statement of value. These anchors may be things such as products, personal opinions – whether their own or others and even historical prices. All things that may have an impact on the price of the security but may be seriously overvalued by the individual investor when determining an effective price.

It’s often very hard to tell what has value and what doesn’t when it comes to stock valuation unless you have a thorough understanding of the company as a whole. A lot of people out there don’t do the analysis necessary to get there before making a decision to buy the company.

Let’s look at a company like Disney which had an amazing run up in recent months all the way up to the low 120s, a price that had an investor paying nearly $24.5 for every $1 in earnings the company made in the last year. That’s a pretty steep price for a mature company but certainly deserved if the earnings growth was expected to be high and with Star Wars coming up, how could it not be? The problem with Star Wars from an investment thesis is its capacity to deliver on expectations as a product anchor. I think Star Wars’ expected success made a lot of people invest in the company.

The movie came out, crushed box office records and the stock began to fall? I was personally invested in Disney myself but sold my position right after the release of the movie as the record breaking pop wasn’t there and I found the stock price too rich for my blood. Yes, Star Wars is a box office giant and will generate a ton of cash through future films and licensing but a quick look at the company’s financial statements would show you that Star Wars will only impact around 25% of their revenue and even less of their operating margin. Disney’s main drivers are their networks including ESPN and ABC and parks and while parks continue to thrive, the cable landscape is rapidly changing with ESPN recently losing ~7M subscribers and dropping by ~10% in ratings last year. While Star Wars and Marvel and Pixar will continue to be great performers for Disney, 50% of their revenue is tied up in something that has a questionable future and will likely be an earnings drag in the near future. Paying a P/E of 20+ for a mature company that has those types of issues just didn’t make sense to me so I sold out. I still like the company and will likely buy back in if the price drops to a value I deem fair but until then – I’ll look towards other stocks.

The problem is that some investors don’t do that type of analysis when it comes to their stock purchase. They may anchor themselves to one item they like such as Star Wars that may be a great product but have a small effect on overall earnings. They’ll end up buying something for the wrong reasons. When they see the stock drop following the more than successful release of the movie, they panic and sell out.

On top of that buying an individual stock is a decision you make yourself. As with all decisions, people tend to be overly emotional and driven by a need to be correct lest they be proven wrong or stupid to others or themselves. There is a level of shame that comes along with a bad investment as well that may cause people to make bad decisions. An investor may buy things for the right reasons but panic and sell when it drops 5% because they don’t want to seem like a bad investor. These emotional anchors also tend to weigh down gains because long term that stock may rise again. Since the investors considers the company a solid investment, they might buy back in at a higher price instead of just staying with the holding through the ups and downs.

Apple is a good example of this type of stock which moves up and down based on rumors often all while maintaining a solid valuation. Recent moves have been driven by rumors about supply chain cuts which may or may not be revealing of future earnings but have cause the stock to drop below 100. I’ve seen many people talking about buying the stock at 130 and now selling because of these new rumors – an emotional decision that might be driven by more than just valuation changes because nothing much has changes as far as analyst projections and expected sales. Apple is still a deal at a P/E of 10-11 when you look at its growth, cash hoard and product pipeline. Phone growth might certainly slow but the company is priced attractively now and I may purchase more if the stock market dip continues past today.

Price is another area where people anchor themselves too often. Buying Apple at $130 and seeing it at $100 doesn’t mean it was a terrible investment as the stock may be priced at $200 in a few years. The thing to ask yourself when these types of movements happen is whether or not your original investment thesis has changed since you bought the security. When I bought Disney, as an example, I wasn’t overly concerned by ESPN and was happy with the recent LucasFilm acquisition. I sold it later as new information about ESPN ratings and subscriber count came to light and the price rose above a fair value which changes my original investment thesis.

In my mind, Apple is still a strong company and I would be happy to buy in at $100. There are certainly risks with slowing growth but I think they are one of the better values out there right now in a market that is short on companies that seem like a good deal these days. There are plenty of companies out there that are great(JNJ, PEP, PG, etc are just some examples) but their price is simply too rich for my blood at this point and I’m a patient investor so I can wait on the sidelines a bit until their price reflects their value in my eyes.

Price can be an issue in the opposite direction as well.  Stocks of the many commodity companies that have dropped more than 50% in the past year. Companies that used to be priced in the $80 just a few years ago are now priced in the $20s as commodity prices sink. Investors will tend to anchor themselves to these old prices as something that the company can achieve again and fail to recognize the issues facing these companies regarding debt load and continued low commodity prices and try to catch falling knifes.

That’s not to say that emotions are always a bad thing or that it’s impossible to find attractive valuations on companies that have fallen too much or risen too much. It’s just that individual investing brings with it additional risks and emotional attachments that more people need to be aware of especially in times like these when the stock market sees repeated 2-3% swings in the wrong direction. There are certainly pitfalls in moves like this. You can sell fairly or even well valued companies in fear or you can buy overvalued companies that may fall more because you feel the stock market is on sale. All I’m saying is that investors that invest in individual stocks need to do more due diligence than those who invest in index funds or ETFs because the risk profile, analysis required and emotional connection is different.

Individual investing also means that the initial buy in price is important as well as you can easily over pay for an individual security. The company may be excellent and the financial statements may be amazing but I certainly don’t want to pay $30 for every $1 in earnings the company makes unless I expect the growth rate to be tremendous. There are mature companies in this market priced at P/E ratios of 25-30. These mature companies don’t have growth rates to support those kind of multiples so despite them being amazing companies with a good long term track record – I’d rather not invest in them now because the value isn’t there.

I constantly revisit my individual stocks. I recently sold Disney as mentioned because I felt the value was too high and recently sold off more shares of UNH for the same reason. I still think the stock market as a whole is priced a bit too high and has room to fall so I’m keeping some extra cash on the side in my individual trading account as I search for good values.

However, this is not the case in my index funds/ETFs.

When I look at an index fund or the S&P 500 in general. The only things I can really anchor to are earnings and market conditions. The S&P 500 doesn’t make a product, the S&P 500 doesn’t have talking heads talking about whether the CEO of the S&P is doing right or wrong. It’s easier for me to buy something like the S&P 500 because I don’t really have to look at financial statements, nor look at the product pipeline, nor see what everyone is saying about the S&P 500. There are of course still market conditions that I can look at but in general, the amount of noise about the S&P is a lot less smaller than the noise about any individual stock especially some of the more popular ones like Disney or Apple. As such, the volatility in these types of securities will be lower as will the level of analysis. In fact when I look at my these broad market securities, I don’t have an internal struggle about whether what I’m paying is a fair value because I truly believe that in the long run – the market itself will go up and todays price is likely to be lower than a future price. That just isn’t the case with individual securities as they have a much broader risk profile in my mind.

P/Es of individual companies are a bit too high for my liking so I’m not running to put my money into individual securities just yet. There is a very real fear out there of missing the next big thing and not buying when the stock is priced low.  But if stock market history has told me anything is that when it comes to individual securities, value will eventually show itself and a decent entry point will eventually arise. Apple is a great example of this as the stock was $60 in January of 2012, rose to 90 by April of that same year, fell to 75 by May, rose to 100 by September, fell to 55 by April of 2013, was back up to 75 by November and then rose to 100 by October 2014. This is the biggest company in the world with the most analyst coverage out there and it has such big swings.

Long term – the trend with any individual security will follow its fundamentals but short term fluctuations will exist due to emotional market sentiment so the fear of missing an entry point shouldn’t deter you from keeping money on the sidelines in a volatile market like todays. If you miss out on Apple, there will be plenty more out in the long run. I’m not advocating keeping money out of the market for the long term here but there are times – like now – where I think values of certain individual securities get stretched and I’d rather wait for them to get back to a more reasonable price. Yes, there’s certainly potential of missing an up trend which is why I’m never taking 100% of my money out of the stock market but I do think there’s value to waiting for value to present itself when the P/Es of individual stocks get a bit too far out of the realm of affordability.

Do note that I always keep 90% of my investment funds in either stocks or bonds as per my laid out asset allocation/strategy so this is not a deviation from my belief system that time in the market is the best idea. However, I do want to have some flexibility around my individual trading account when I feel like I can’t find any stocks that are priced attractively. I think it’s important for a long term investor to not lose track of their long term goals and minimizing the amount I can have out of the market is one way I do that.

Despite this propensity for me to keep some money on the sideline when it comes to my individual trading account; I have no real issues pumping in more money into my 401k, Roth IRA or individual account ETFs no matter the valuation. I think the long term stock market trend is up and there’s a lot more potential of catching this uptrend when I’m investing in the market as a whole than when I am in individual securities. I’m willing to do this for broad market securities(index funds or ETFs) because their risk profile is much lower than an individual security. It’s a lot less likely for me to buy the S&P 500 at 2000 and for it to remain below 2000 forever than it is for me to buy Company A at 100 and for it to remain below 100 forever. Neither is impossible of course but I’m a lot more comfortable with the S&P 500 at a P/E of 20 than any other individual stock company at a P/E of 20.

What I’m saying here is that an investor should ask for a much better value from his/her individual securities than from their index funds and ETFs because they take on much more risk and are more likely to make emotional moves and poor decisions when it comes to their friend; the individual stock. If I’m not finding an individual stock that I think is attractively priced at any given moment – the right response is to either keep some money on the side until that stock arises or put that money into an index funds or broad ETF that offers long term capital appreciation at a much lower risk than an individual stock.

There will be times where values emerge and that’s when I’ll be more eager to put more money into individual securities. In my mind – that time isn’t now but I’m no seer so I’ll continue to put money into the market as a whole despite the market turmoil simply because I know it’ll eventually start rising again. In the meantime, I’ll keep an eye out for good values and let you know when I find some. For us long term investors – these short term drops are a good thing despite the drops to your accounts. Buying at a lower price never hurt anyone.

Join the discussion!

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s