Q2 2020 Update

Performance

Year to date, I am down 17.77% and the S&P 500 is down 3.9%.

This is actually pretty good in context of my deep value strategy. VBR, the Vanguard Small Value ETF, is currently down 22% YTD. QVAL, the deep value Alpha Architect ETF, is currently down 26% YTD.

The deep value universe of stocks with an EV/EBIT multiple under 5 is currently down 30% YTD.

17% isn’t all that bad in this context.

Due to my large cash position going into the crash, I was only down 26% at the lows, while most of this universe was in a nearly 50% drawdown.

With that said, I missed my chance to gobble up bargains at the lows because I thought the worst wasn’t over.

A Mixed Bag: Good Decisions & Bad Decisions

In the last year, I made some key decisions. Some of them turned out to be good moves and some look like mistakes.

I started accumulating cash last year when the yield curve first inverted. I thought we were going to have a run-of-the-mill recession and I thought due to the overvaluation of the market that this would be enough to cause at least a 50% crash.

I went into the March crash nearly 50% cash. This was a good decision. When I saw that the recession wasn’t going to be a run-of-the-mill affair and was turning into the worst recession since the Great Depression, I started selling my cyclical positions aggressively. By the bottom, I was nearly 80% cash.

I was also convinced that the selling wasn’t over. I saw an index at internet bubble valuations hitting the worst economic event since the Great Depression and assumed that the crash would continue. Value stocks aren’t a place to hide during a crash, so to stay market neutral, I bought a position in an S&P 500 inverse ETF to stay market neutral. This was not a good decision.

What I didn’t anticipate was the extent to which fiscal and monetary policy were going to go full-throttle in an all out effort to boost the stock market and the economy. As a result, the S&P 500 rocketed upward and my short position was beat up.

As a result, I lost about 15% on the short position. I finally got out of it when the S&P 500 went above the 200 day moving average. Fortunately, it wasn’t enough to hurt my overall YTD results.

At the lows, net-net’s started to re-appear and the number of stocks below an EV/EBIT multiple of 5 increased. I didn’t buy any of them, thinking that the economic downturn was going to continue melting down the market with no regard to valuation. I didn’t buy enough at the lows. This was not a good decision. There were many stocks I should have bought and I didn’t.

One position I bought near the lows has worked out marvelously – AOBC, which has turned into SWBI. This is a gun manufacturer. You can read my write up here. I noticed that AOBC was trading at a low multiple to book value while simultaneously background checks were surging due to COVID. Gun sales continue to be strong, and this continues to skyrocket due to the unrest currently gripping the country.

I’m currently up 189% on this position. Obviously, buying SWBI was a good decision. I sold a piece of this position when it grew to 10% of my account from 5%. I plan on doing the same thing once this happens again.

I recently purchased a net-net, Friedman Industries. You can read my write up here. It is yet to be seen if this was a good decision, but I think that the risk-reward makes sense.

Looking Ahead

Currently, the market continues to be strong and seems invincible.

I’m not short after getting my butt kicked in my short position, but I’m still not bullish. I’m currently 80% cash and still only have a handful of positions.

It’s still yet to be seen how COVID is going to shake out.

I am finding it hard to figure it out. On one hand, the lockdowns worked, we flattened the curve. On the other, now that the economy is being re-opened, cases are surging. Skeptics say that this is simply because of more testing. Those who sounded the alarm on the virus say this is concerning.

I don’t know how this shakes out. What I do know is that the the present state of the economy is not good. Unemployment looks poised to reach its highest levels since the Depression in the 1930’s. Many businesses have been completely destroyed, and the number of businesses that are being destroyed continue to mount.

On the other hand, unprecedented levels of fiscal & monetary stimulus might create a new economic boom as the economy re-opens.

I don’t know how the economy shakes out, either. My instincts tell me that the economy is screwed, but my instincts can be wrong. We went into this with unprecedented levels of leverage and the only way that a lot of businesses are surviving is by taking on even more debt, making them even more fragile. On the other hand, the fiscal & monetary stimulus might work.

I don’t know how the virus shakes out and I don’t know what’s going to happen to the economy. The way I see it, the current situation is replete with massive uncertainty.

Uncertainty is something that an investor should get paid for with a cheap valuation.

Investors aren’t getting paid for that uncertainty.

What I know for certain is that the market is not cheap by any stretch of the imagination. From a market cap to GDP perspective, the market trades at 147% of GDP. At the peak of the internet bubble, we were at 140%. That’s right – we are beyond the valuation of the most extreme bubble in American history and we’re in the midst of the worst economic calamity since the Great Depression.

If the market were to return to 100% of GDP – the S&P would crash to near 2,000. If we were to return to the lows of the last two nasty bear markets, we would fall to nearly 1,500 on the S&P.

The CAPE ratio is at 29 – higher than the peak of the real estate bubble although not as high as it was during the internet bubble.

Looking at the value universe I operate in, it is currently only an average opportunity set. There were many stocks in the EV/EBIT < 5 universe at the lows, which was a pretty decent opportunity but not as big as 2009. There are now 75, which is a pretty average opportunity set.

An average opportunity set and a market trading at internet bubble valuations is not compelling. It’s definitely not an opportunity when we face the wide range of possible outcomes that we face today.

As a result, I’ll continue to be cautious and hold a lot of cash. If I find more stocks like SWBI or FRD that look like big opportunities, I’ll buy. What I won’t do is fill up my portfolio with subpar opportunities.

The large cash balance definitely weighs on my mind. Cash is a terrible investment long term, but I want to have the dry powder if the market crashes again.

I’ve considered deploying it into my passive asset allocation that you can read about here, but haven’t made up my mind on that yet.

My goal when I started this blog was to focus on Ben Graham’s low P/E, low debt/equity strategy during the good times. When the bad times arrived, I was going to buy net-net’s. The net-net’s started appearing in March and I didn’t buy enough of them. I barely had time to research any of them before they disappeared.

My instincts tell me this isn’t over and I’ll get another chance to buy them. We’ll see.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.