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.
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 . 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 .
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.
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  was $5,847 million, with an operating income of $1,184, a reasonable 20% operating margin . 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.
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 .
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% .
"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.
Whirpool's revenue grew by 10% over the past 50 years. But at $90 per share, I thought I could earn a higher rate of return. Here's why.
Whirlpool (WHR on Nyse) operates in an industry that is shared by a small number of producers . According to IndustryWeek, the five major appliance companies are Whirlpool, Electrolux, GE, LG, and Samsung.
Yet Whirlpool is the only American-domiciled company. Out of its 36 locations in 13 countries worldwide, ten sites are in the United States. And the ability to manufacture products in the U.S. allows Whirlpool to be a low-cost producer, as shown by the better-than-average operating margins.
Between 2019 and 2017, Whirlpool's operating margin  was 12% in the United States. In other countries, the company's operating margin was tiny. In Latin America, the average revenue was $3,580 million, with an average operating income of $210 million, a 6% ratio. In Asia, Whirlpool's revenue was $1,547 million, with an operating income of $57 million, a minuscule margin of about 4%.
Also, LG reports on an operating margin of 2.6% for the home appliance division. Samsung said in 2019 on a 5% operating margin for the consumer electronics division.
The top-line has not changed much over the past few years. In 2015, revenue was $20,891 million and pre-tax earnings were $1,306 million. In 2019, revenue was $20,419 million and pre-tax earnings were $1,204 million.
The balance sheet didn't change much, either. In 2015, total assets were $19,010 million, and the assets slightly declined to $18,881 million in 2019. Long term debt was $5,592 million five years ago and grew to $6,394 million in 2019. Reported equity was down to $4,118 million in 2019 compared to $5,674 million in 2015 .
What dramatically changed was Whirlpool's market valuation. In yearend 2015, Whirlpool sold at $149 a share. At that price, for every dollar of revenue, investors paid 56 cents, and for every dollar of book value, they paid $2.4. In short, investors paid $15 for every dollar of earnings.
Today, you buy a dollar of the 2019 revenue for 30 cents. You pay $1.4 for one dollar of book value and about $7 for one dollar of the 2019 earnings per share. That makes all the difference in the world.
You would think something changed about the quality of the business. But in 2015, Whirlpool generated $617 million in free cash flow, and in 2019, it made $672 million in free cash flow . And long debt represented 30% of the total assets in 2015 and 34% in 2019.
So, perhaps, the gloomy valuation is because of something else?
The home appliance industry sells a commodity  that it is costly to make, with rising labor and retirement costs, and with low, single-digit profit margins. Compared to other businesses, the home appliance business is unappealing.
The industry also lacks sex appeal. We describe these products as "useful" or "helpful." But you wouldn't describe your wash and dryer as "disruptive" or "innovative."
This reminds me how author Bill Bryson once commented of people's fascination with particular machines, such as cars, but that we are completely oblivious to others.
"I can't for the life of me understand why anyone would want to know all this about a machine [car]," he wrote in Notes from a Small Island. "You don't take that kind of interest in anything else. I've been waiting for years for somebody in a pub to tell me he's got a new refrigerator so I can say, 'Oh really? How many gallons of freon does that baby hold? What's its BTU rating? How's it cool?. "
The home appliance industry is not winning the popularity contest. But as we deal with the first, large-scale uncertainty in the 21 century , the necessity and predictability of the home appliance business is attractive to me.
Between the year 2000 and 2019, the average operating margin was between 5% to 7%, and the pre-tax earnings margin was about 3% to 4%. Since the operating margins will invariably stay the same, to grow earnings, Whirpool will need to increase revenue over time.
The average 5-year revenue, between 2004 and 2000, was $11,416 million. Revenue almost doubled to $20,863 million between the average 5-year revenue between 2019 and 2015. The company expanded to markets such as Latin America and Asia.
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Over the past two decades, Whirlpool improved the operations margins. The average 5-year pre-tax earnings between 2004 and 200 were $480 million; between 2009 and 2005, the average pre-tax earnings were $513 million; between 2014 and 2014, pre-tax earnings were $583 million, and between 2019 and 2015, pre-tax earnings were $913 million.
The earnings grew while the costs to produce the appliances went up almost two-fold. This is using plastics material and resin price data by the Federal Reserve Bank of St. Louis. Also, visit the cold-rolled steel sheet for data on metals.
In Common Stocks and Common Sense, value investor Ed Wachenheim writes:
Our conclusion was that the company's [Whirlpool] revenues and operating profits could be about roughly $25 billion and 10 percent, and thus its operating profits could be about $2,500 million. We estimated that the company's 2016 interest costs, effective tax rate, and diluted share count would be $275 million, 28%, and 80 million, respectively. Given these educated guesses and projections, Whirlpool would earn about $20 per share in 2016.
Five years passed. And we can now update our expectations, following Wachenheim's logic.
Here is how the prior paragraph would read in 2019:
The 2019 company's revenues and operating profits were $20 billion and 7%. The interest costs, effective tax rate, and diluted share count were $187 million, 23%, and 64.2 million, respectively. Given these reported numbers, Whirlpool earned $1,184 million or $18.4 per share in 2019.
How should we value the $18.4 earnings per share? Again, let's follow Wacheniem's logic. He writes:
On balance, my best guess was that Whirlpool was not worth more than 12 times its earnings, and therefore that the shares might be worth $250 to $300 in 2016. However, I finally decided that my current valuation made little difference. If Whirlpool came close to earning $20 per share in 2016, the shares (which we were selling at about $80 in the spring of 2011) would be an exciting investment regardless of whether they were worth 15 times earnings or 12 times earnings or even ten times earnings.
In sum, and let the record show, that I believe that over the next 3- to 5- years, assuming earnings are between $18 to $20 per share, the market will value the shares at about $200.
I see three concerns. The first issue is the lack of revenue growth. Second, the fierce competition. And third, the Grenfell saga. A brief on the three points follows.
Lack of growth: Since 2015, the top-line at Whirlpool hadn't changed. The 2015 revenue was $20,891 million, and the 2019 revenue was $20,419 million. The same can be said for the operating margins of $1,560 million in 2015 and $1,391 million in 2019. Since 1949, Whirlpool compounded revenue growth at about 11% .
The competition: It is difficult to distinguish one brand of washer and dryer to others; they all have similar cycle times, size, features, weight, and pricing. And practically all of them break within 8 to 12 years.
It is also likely that the industry will experience a disruption. Think Casper's penetration to the mattress business. Think Harry's or Dollar Shave Club to the razor blade business. I don't know when and how the disruption to the home appliances business will arrive, but it is a matter of time.
The Grenfell Tower: In June 2017, London's Metropolitan Police released a statement that it had identified a Hotpoint-branded refrigerator as the initial source of the Grenfell Tower fire in West London. "The model in question was manufactured by Indesit Company between 2006 and 2009," wrote Whirlpool's management in response.
While Whirlpool bought Indesit five years after the incident, they are likely to be liable. And indeed, the saga is not helping Whirlpool win the popularity contest in the U.K. Read this Insurance Journal article as an example.
Pen&Paper is never about stock recommendations or trade ideas. Instead, it's about sharing business stories and attempting to understand what they can teach us about life. There are three lessons behind the story of Whirpool that I would like to highlight.
The first lesson is that price matters. A lot. Investors often chase popular names such as Netflix or Amazon. But I doubt you can earn a reasonable return over the long term when you buy a company at a multiple of 63 times the trailing earnings (Netflix) or 60 times the trailing earnings (Amazon). Why a hefty price will result in an unsatisfactory rate of return will be a topic for future discussion.
The second lesson is that predictable, understandable businesses bring comfort at stressful moments. One of my dearest friends bought ProShares Trust Ultra Vix Short three years ago, expecting the ETF to go up as capital markets would cool. But now that markets not only cooled but froze, the ETF is down 90% of its value three years prior.
If Whirlpool will halve in market price, I will not sell the stock. Understanding a business removes the need to react to market conditions. Also though the price of resin and metal, the main cost ingredients, was volatile in past decades, the company slowly grew earnings. Whirlpool shows that it is better to rely on business fundamentals than on capital markets.
Finally, the third lesson is that cultivating patience is one of the great tools they don't teach you in business school. In the stock market, you are not awarded for making fast decisions. You are awarded for good ones. As Charlie Munger said, "The big money is not in the buying and the selling, but in the waiting."