It’s in times like you notice if you’ve spent enough time reflecting on portfolio management. How did you feel when the DOW index fell ~780 points? Nervous? Did you feel the urge to swap one stock with another on “sale”? Did you extrapolate a negative scenario were all stocks plummet? News surely did.
Investing isn’t a numbers game, it’s a phycological game
Investing isn’t a numbers game. It’s a phycological game which rewards reflected people, and punish those who are lazy or act on emotions. The longer you’ve been in this game, the clearer you’ll see it. People buy based on financial numbers and potential value creation and sell based on fear or confusion.
That’s how it always works and how it’ll always be. You buy a stock because it used to trade at a 20% higher price a few months ago, G&S has a “buy” rating or the discounted cash flow analysis tells you it’s undervalued.
Then, the market takes a dive and you notice that not only is your upside potentially gone but might need to ride this ship down. Way down. So you start thinking – do I really want to own this stock? How sure am I that it’ll continue to pay dividends? What if the dividend gets slashed? What’s the value then?
…And you’ll find out that your investment analysis emphasized on the upside, and not the downside, and you sell. Not because of numbers, but because of emotional disturbance. And believe me, you’re not alone.
What you want to do is to reverse this process. Flip the coin so to speak. First focus on the downside, then the upside. This is how you keep a balanced mind.
Let’s illustrate this process by Kraft Heinz and Johnson and Johnson as examples
From a pure numbers point of view, Kraft Heinz could be a great value play
- There are 19 analysts following the firm and mean consensus is 10,8 % up
- The most optimistic scenario is 71,8% up (someone please fire this guy asap)
- Forward P/E is 10.93 (under market P/E so must be a gem right?!)
- Yield is 5.09% (
- Price to book is 0.69
- Eight $1+ billion brands
- Management is committed to an investment-grade capital structure
- And the worst one, it’s close to 52 weeks low.
Summed up, you get a 5% yield, almost a single-digit P/E, 70% potential upside and a former dividend aristocrat. The upside looks promising, right?
Then there’s the downside (often neglected)
- Net-debt-to-EBITDA (how fast earnings could remove debt) is 4.69. Less then 4 is healthy debt level. Meaning, they can’t really add that much more debt before this becomes an issue. It’s well beyond the target at 3x.
- Massive debt load, should focus on de-leveraging rather than paying dividends = should reduce dividends
- Only generated free cash flow 7/10 last years = inconsistent
- High volatility in cash flow ranging from $527 million in 2017, and $2.6 billion in 2016.
- Upwards dividend yield graph and downwards p/e graph = value trap
- Net cash generated the next 5 years – dividends next 5 years gives a negative dividend cushion = 2.9 (paying too much in dividends with respect to being a healthy firm)
- There’s a huge gap between return on invested capital and the weighted average cost of capital. ROIC is 2.3% while WACC is 8.6%. You want ROIC to be above WACC because if not, you’re not generating business value.
- Free cash flow margin is only 2% and not 5% which I want. Hence, not a cash flow machine by any means.
What about JNJ then? How does the downside look?
- Free cash flow margin is 22% (fantastic)
- Huge positive gap between ROIC and WACC
- Fenomenal dividend cushion
- Extremely low volatility in cash flow
- Generated positive free cash flow 10/10 years
- Payout ratio at 42%
- Lost only 27% during 2007 – 2009 (market 50%)
- Earnings dropped only 6%
- Net -debt to – EBITDA at 0.60 (crazy healthy level)
The list could go on forever. The difference between these two firms is astonishing, and it’s exactly the kind of information you need to gather before the market drops.
When the market drops, JNJ will fall less than many stocks because of the high-quality.
Do not make the mistake of punishing JNJ by selling because you want to buy something on sale. That’s bad portfolio management. Rather, add to strong firms when there’s market turbulence, and get rid of firms with a shaky downside.
Portfolio management is about focusing on quality and the downside. The upside will come by itself.
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