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Mar 20, 2020

Know Your Names, Stay the Course

Samantha McLemore

A Q&A with Samantha McLemore, co-portfolio manager of the Opportunity Equity

Q: We've always said that we tend to see the greatest investment opportunities when markets are in a state of panic. How do you assess fundamentals when we're in such a state of fear?

Samantha McLemore: We are definitely in a state of panic and fear right now. [Thursday] was about as extreme as you can get, so I think it's very timely to be asking this now. I think it's one of the keys to successful investing. Jason Zweig wrote a Wall Street Journal article earlier in the week about Chapter 8 in Ben Graham's Intelligent Investor. I thought it was a great article, so I went back and reviewed that chapter of the book. I was just going to share a little bit of it here.

Warren Buffett obviously is a student of Ben Graham, and he wrote the preface to the most recent edition. He says in the preface that when he read the first edition of the book in 1950, he thought it was by far the best book about investing ever written, and he still thinks it is.

He says, "To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What's needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework. This book precisely and clearly prescribes the proper framework. You must supply the emotional discipline."

"If you follow the behavioral and business principles that Graham advocates, and if you pay special attention to the invaluable advice in Chapters 8 and 20, you will not get a poor result from your investment. That represents more of an accomplishment than you think. Whether you achieve outstanding results will depend on the effort and intellect you apply to your investments, as well as on the amplitudes of stock market folly that prevail during your investing career. The sillier the market's behavior, the greater the opportunity for the businesslike investor. Follow Graham, and you will profit from folly rather than participate in it."

I thought one of the best excerpts from Chapter 8 is when Ben Graham says, "We are convinced that the average investor cannot deal successfully with price movements by endeavoring to forecast them. Can he benefit from them after they have taken place, i.e., by buying after each major decline and selling out after each major advance? The fluctuations of the market over the period of many years prior to 1950 led to considerable encouragement to that idea."

He shares a lot of great insights in the book and in that chapter. He differentiates between an investor and a speculator saying, "The investor's primary interest lies in acquiring and holding suitable securities at suitable prices." He said, "If you're an investor, price fluctuations have only one significant meaning: an opportunity to buy wisely when prices fall sharply, and to sell wisely when they advance a great deal."

The last thing I'd share from that is he says, "The investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage." When we get into environments like this, these are exactly the kind of times you have that are great opportunities. And that's not to say it's not going to get worse or things might not get worse, but we try to think like investors and owners of businesses.

We understand that we'll have bear markets and recessions. We don't necessarily try to forecast those because that's pretty much an impossible thing to do. We do use these periods to try to improve the portfolio any way we can, so we drew down the line of credit, which we had paid off during better times. Not completely, but partially. We've done some buying. We've swapped some names into other names.

We've been so thrilled that we've mostly seen inflows throughout this period, which makes me very proud of everyone because I think over the long term that's likely to be a great money-making time to put money to work in the market.

It helps, from my seat, to focus on the fundamentals – the companies, the businesses, to talk to them, to find out what's going on. We update our thinking and our analysis, given the fluidity of the situation. Some of our businesses have been hit really hard already, like the airlines. This is having a huge impact on their business. But they came into it in great shape. It's a serious strain for them - they're down 40 to 50 percent already.

On the other hand, in talking to ADT yesterday, they have 80% recurring revenue. In many ways, that's a recession-proof business, and it might even benefit from a recession. It has tons of free cash flow, and it's also down almost 50 percent. The market is kind of indiscriminately selling, and we've been adding to all of those names in this environment.

I do think for investors who can be long term and who can focus on the fundamentals, that's the job. That's what we do. I like to try to deal with the fear directly because on days like yesterday when many names are down 10%+ in one day - that's extreme, that's stunning.

It's good to step away from the screen in those environments. I meditate more. I talk to the companies. I think all of that helps you make the right decision and focus on, the underlying fundamentals.

Q: Focus on the fundamentals. Great advice. You mentioned the market is fluid. What are you mostly concerned about? What are you really looking at?

McLemore: There's been a lot of moving pieces. I am paying very close attention to the coronavirus. Oil is what it is, and I think part of what went on there is due to the coronavirus. But in and of itself, I don't think that would be enough to pull us into a recession. It wasn't in 2015-2016.

We're definitely having a cessation of a lot of economic activity right now, so the question is “how long does that last?” That's something we're watching closely. I think it's important to distinguish between the market and the economy.

On the virus, I follow a number of smart health sources like epidemiologist Marc Lipsitch at Harvard. There’s still a lot that we don't know and this is certainly something that we take seriously. We are watching closely. I think the more we do to contain the virus on the frontend and shut things down, the less severe the biological problem ultimately is. A thoughtful and systematic approach to dealing with it is a good thing and will ultimately lower the impact. To the extent we can push it out, there's a lot of positive things that might happen in terms of vaccines and other treatments. Ultimately maybe we could mitigate the spread if people really stay home when they're sick.

I think a lot of people have said maybe it will play out over March and April, and things will get better with warmer weather in May. If we quell it down enough, we could have a scenario where we're through this, mostly, in the next couple of months. Although, past pandemics have come back in the fall.

The good news on the economy and market side is that we've dealt with this before. We went back and looked at previous episodes, like the 1957 and 1968 flu pandemics, which both originated in China and had 0.5% fatality rates, which is in the realm of this one (we don’t know what this one is, good estimates range from .1% - 1%). The market peaked when those viruses came to the U.S., and it declined just over 20% and just over 17%, respectively.

If you go back and look at the 1918 flu pandemic, which was far worse than this - 2.5% fatality rate and it also had a W curve of who it impacted, so it was dangerous for young children. It was dangerous for older people. And it was also dangerous for prime working-age people. In that case, the Dow was down 37%.

The S&P yesterday had already declined 27%, so the market's already down more than it was with the ’57 and ‘68 flu pandemics. We just had the fastest 20% decline ever, so the market has priced this so quickly. In those earlier times, it took the market four to six months to make its initial lows. We're less than a month out, but it's possible, with the amount of panic we're seeing, that we're just doing that a lot quicker. That seems to happen in this environment.

In a social media age, you have information and panic and everything spreads much more quickly, but ultimately, the more proactive we are in shutting things down, the lower the biological impact. So you could see a scenario where we bounce back.

There were a lot of signs of panic on Thursday - the VIX above 70, put-call ratios blowing out. CNN has a Fear-and-Greed Index, which is based on a number of market measures. It was a 4 out of 100. The worst that it got in a financial crisis was a 12. This is really extreme, which is a good thing in terms of what's priced into the market.

When you're seeing those kind of market moves, that's an environment I feel really good about buying in. There's a lot of great values out there if you're a long-term investor. That doesn't mean it couldn't get worse in the short term. We could see the market make new lows. But at these prices, I think these are great places to deploy capital.

Even in the short term, you saw valuation spreads blow out. People don't want value companies who have led on the way down. Usually when you see this sort of thing, you can make money over the next year, and those outperform the rest of the market.

One great sign is that throughout this, you've actually had some positive money flows, so that is even more evidence that you might be seeing a divergence and a great moneymaking opportunity. We also know that this is not the financial crisis. We know there's no systemic financial system insolvency risk. The banks are extremely well capitalized. We've dealt with this before. The market, as soon as it gets visibility, can price this risk in. And we know that this too shall pass.

A lot of the economic research on these pandemics is that it actually improves growth on the other side over the next decade as the economy bounces back. So, there's a lot we don't know. Maybe we're closer to a deflationary environment, so there are real risks. Those are all things that we're watching closely. But I think a good buying opportunity for the long-term investor.

Q: Is there anything else you want to add on how you think about capitalizing on some of this volatility?

McLemore: Overall, we definitely put an emphasis on trying to monetize the volatility and improve the portfolio overall, so that we have the best risk-adjusted rate of return. We did drawdown the line of credit. We have been putting money to work. We are always looking at what upside our holdings have to what we think they're worth.

For the names that move down more dramatically in this sort of environment, unless something truly impairs the long-term business value, those would be the names that ultimately might have the best upside going forward. Everyday we're looking at that, and we're buying names where we think there's the best upside. If names have held in better, we're using those as sources of funds to fund some of those ideas. I think that that would be the key to how we approach these sort of environments.

(Comments from 3/13/20)

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