Check if the fundamentals of the company are intact. The challenge is that during uncertain times, the fundamentals itself becomes questionable.
"Volatility actually is the opposite of risk. It’s an opportunity. But you need to think through and fight some basic human weaknesses." - Jeff Ubben
Nothing blindfolds an investor more than a sharp fall or rise in equity prices.
Bottlenose dolphins of the shallow Florida Bay, Florida, USA, have devised a smart ambush strategy to catch fish effortlessly. One of the dolphins would beat its tail hard down the seabed to stir up the mud. While doing so, it swims circularly to create a ring of mushrooming mud aka fishing net made of mud.
The dolphin continues to swim inward in a circular fashion to tighten the noose around the trapped fishes. With tightening mud-net, agitated fishes jump out of the muddy net. However, they fall straight into the gaping mouth of the many dolphins who have been laying in the ambush outside the net. In this hunting strategy, dolphins successfully exploit fishes’ aversion to mud-nets, i.e., uncertainty.
Tightening mud-nets (uncertainty) in the capital markets
Unfortunately, humans (like fish) exhibit uncertainty/loss aversion mindset when faced with capital markets’ mud-nets aka uncertainty. During uncertain times, investors tend to sell into the falling market to avoid the pain of further losing money. Assuming the investment’s fundamentals remain intact, some investors do hold on to their investments. The hold decision does not continue for long.
With more investors throwing in the towel, prices continue to fall (tightening mud-nets). Irrationality and fear take precedence. Investors start doubting the company fundamentals. Falling prices form a base when the stock has dropped low enough compared to its fundamentals or the mud-nets start to dissipate. Then the security is mostly held by investors who are either numb to losses or who truly believes in the fundamentals of the stock.
Cautiously exploiting mud-nets: one man’s trash is another man’s gold
In the capital markets, mud-nets are common. We have to decipher them. If we are in the net, then we have to decide if it is time to fold cards or merely stay put or buy more. A thumb rule here is to check if the fundamentals of the company are intact. The challenge is that during uncertain times, the fundamentals itself becomes questionable. Then it boils down to reevaluating the business quality and management quality. Under such uncertain times, look for companies with an easy to quantify safety net. The safety net provides a backstop to the worst-case valuation and market price - ensuring that we have not caught a falling knife.
Here are three things to look for while ascertaining the safety net:1. Free net cash or fixed income generating asset;
2. Management quality;
3. Business quality;
An ideal combination would be to have a company with a fixed income-generating asset or free cash (net of debt) and a fundamentally strong operating business - both run by able and ethical management and is available at an enterprise value that is below the discounted cash flow value of its fixed income-generating asset or free cash. Thus, the operating business and able management come free.
To conclude, during uncertain times stocks with downside protection should provide enough confidence for investors to buy it. Moreover, during such times, the market tends to not price in growth, and so growth comes free. If we were to draw parallels, this theme in spirit is similar to Warren Buffett's deal to buy USD 5 bn of preferred stock of Goldman Sachs in late 2008 providing 10% dividends. In his deal, Buffett received downside protection, i.e., preferred dividends and the principal was placed superior to ordinary equity shareholders in the capital structure. In addition, he received USD 5 bn of warrants with a five years exercise period at a strike price of USD 115/share – serving a sweet and significant upside.
Coming back to current times, US-China trade-war; US Fed’s non-stop rate hikes; rising oil prices; volatile currency, sell-off in Indian mid and small cap companies; upcoming Indian election outcome uncertainty means we may be heading for times when such lucrative valuations may once again become commonplace.Ritesh Dhoot is an investment professional based out of Abu Dhabi, UAE. These are his personal views.