Climbing a Rope

One technique to play with during times of duress

Published on:
April 25, 2020
Reading time: 4 Minutes.
Written on:

About The Author

Noam Ganel, CFA is the founder of Pen&Paper, a value-oriented, contrary-minded journal of the financial markets. Noam worked as a Vice President in Capital Markets at Silvergate (publicly traded on NYSE under SI since Nov-2019.) At SI, which he joined in 2010, Noam was responsible for advisory services to family offices,  private companies, and financial advisors.

COVID-19 impact on the first quarter of 2020 capital markets results was felt by all of us. And every profession slowly finds ways to respond and to adapt.  

In this essay, I write that treating your portfolio of stocks as a portfolio of businesses - and not a collection of ticker prices - may help you see things differently. 

A random walk on the Indices

Imagine an investor placed a $10,000 bet on a S&P 500 mutual fund on January 1. By the end of January, the value of bet would $9,984. The value would further drop to $9,144 by the end of February. The portfolio would drop to $8,000 by the end of the quarter [1]. In short, the investor's bet would be down 20% for the quarter.

The fall in market prices was felt across the indices. Nasdaq started 2020 at 9,151 points and ended the month of January at 9,190 points. By February, the index dropped to 8,667 points and ended the quarter at 7,459 points. A drop of 1,692 points or an 18% drop. One more example is the Dow Jones Industrial Average. The Dow started 2020 at 28,638 and ended the quarter at 21,227, down 7,411 points, about a 25% drop. 

Global markets were down, too. The MSCI World index dropped by 21% during the first quarter of 2020. And the MSCI Emerging Market dropped by 23.6%. (Try not to laugh next time you hear about the benefits of global diversification.) 

So it took just three months to bring back the five indices two to market levels seen over two years ago. Can we assume that's likely the time frame for the indices to return to the early 2020 levels? 

"No,"  nervous investors would say. They would further note that if we annualize the market loss over the past three months, the initial $10,000 bet in the SP&500 will be worth $4,096 by the end of 2021. 

Bearish investors would remind us that it can take a long time - much longer than two years - for indices to recover. They would recite that on December 31, 1964, the Dow was at 874 points. And that if we fast forward 17 years later, The Dow stood at 875 in exact on December 31 [2].   

COVID-19 effect on my portfolio

My portfolio of stocks was not immune to the vicissitudes of the market. Out of sheer luck, before the market fell, I didn't own any restaurants, cruise lines, hotels, retail, or restaurant businesses. I also didn't have any material positions in the gas and oil industry and airlines.

I did own three companies in the Gas and oil business (Gulfport Energy, Noble Energy, and CNX Energy). I also owned one Airline company (Hawaiian Airlines, which I wrote about in June 2019).  While the market value of the four positions more than halved, the overall effect was small. The four companies represent less than 7% of the portfolio. 


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But the portfolio's value took a hit nonetheless. It dropped by 38% over the past quarter. So I opened Excel and fooled around with a few "what if" scenarios, hoping this exercise may alleviate my mood. 

The 'What If's

My highly-concentrated portfolio of common stocks consists of 19 companies. The first ten names are three-quarters of  the value. 

Let's imagine one conglomerate had owned the 19 companies. Let's name the conglomerate G.H. Here is what G.H. would report to shareholders for yearend 2019: 

G.H. 2019 revenue [3] was $5,847 million, with an operating income of $1,184, a reasonable 20% operating margin [4]. The pre-tax earnings were $416 million, and the after-tax earnings were $330 million, a 5% profit margin.

With a market valuation of $6,867 million as of yearend 2019, the market valued the 2019 earnings at 21 times. 

Ganel Holdings 2019 Income Statement
G.H 2019 Income Statement

If G.H profit margin stays at 5% over the next five years, then the annual return between 2019 and 2023 will be a loss of one percent. This gloomy result assumed a 10 times earnings valuation in 2023 [5].

Ganel Holdings 2019 Balance Sheet
G.H. 2019 Balance Sheet

If G.H net profit is 10% sometime over the next five years, then the 5-year annual return will be 10%. Again, the earnings multiple assumption is 10 times the earnings.

Let's increase the earnings multiple valuation assumption from 10 times to 15 times the earnings. At a gutsy 15 times, the 5-year annual return will be 8%, assuming a 5% profit margin and 24% assuming a profit margin of 10% [6].


"While we see ourselves as rationale machines, constantly weighing the cost and benefits of our decisions, current research says otherwise," I wrote in January 2019 in The Ten Commandments of Value Investing. "It is only a matter of time before something drastically bad will happen to us. And it is important to prepare for times when we will recite that these are times that try men's souls." 

Indeed, these are times that try men's souls.

[1] The S&P 500 lost 0.16%, 8.41%, and 12.51% during those months, respectively. [2] Read more in Tap Dancing to Work written by Carol Loomis. [3] Figures are weighted average to reflect the proportional positions in each company. [4] Driven upwards because of GrafTech's operating margin of 53%. [5] For reference, the S&P500 earnings multiple was 18 times at the end of 2019 and 13 times at the end of the first quarter of 2020. [6] According to Factset, the S&P 500 profit margin is about 10%.

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