Searching For Compounders In The Stock Market

Searching for Compounders

Before Ithaca Wealth Management, I served as a member of an investment committee that managed $4 billion in assets for more than 2,000 clients. At the firm, we managed two distinctive portfolios: one comprised of individual stocks, and another comprised of active and passive mutual funds and ETFs.

Over time, I observed that the more successful clients at the firm, the ones that didn’t panic sell during stock market corrections and instead kept the course, tended to be those that were invested in the individual stock portfolio. On the flip side, clients in the portfolio of mutual funds and ETFs would often be the first to call with concerns when the stock market was headed lower.

My takeaway was that clients directly invested in household names they recognized were more resilient investors during periods of market volatility, compared to clients invested in a handful of different funds they had little connection to.

That’s why the core philosophy at IWM is to help you compound your wealth and keep you committed to your long-term plan by investing in a well-balanced portfolio of high-quality, growing companies.

These companies are known as compounders.

Compounders are companies that operate high quality businesses and deliver superior rates of return over the long-term thanks to their ability to continually innovate and earn a high rate of return on invested capital.

Other characteristics of compounders include a strong management team, consistent pricing power, and high barriers to entry. Some compounders may seem obvious, like Apple and its lucrative iPhone franchise, but others you may be less familiar with, like Intuitive Surgical and its virtual monopoly in the surgical robotic market.

The purpose of managing an individual stock portfolio filled with high-quality compounding businesses is not to outperform the S&P 500 during any given time period, though that can sometimes be a bonus but rather it’s to increase the likelihood that you will stay invested when the going gets tough during the next inevitable period of market weakness.

“The first rule of compounding: Never interrupt it unnecessarily.” – Charlie Munger

Recency Bias: Understanding Investors’ Most Common Flaw

Recency bias is one of the most common cognitive biases that impairs investors’ decision making process. The bias occurs when an investor favors more recent events over historical ones, leading them to draw short-term conclusions in a long-term environment.

Over the past two decades, investors have been conditioned to always keep an eye over their shoulder for the next big stock market crash. A crash is defined as a decline of 50% or more.

The unwind of the dot-com bubble in the early 2000’s led to a 49% decline in the S&P 500, and the Great Financial Crisis of 2008 sparked a 56% sell-off.

But prior to those declines, you have to go all the way back to 1937 to get a stock market decline of more than 50%, which occurred when the US was still recovering from the Great Depression.

Investors often worry that stocks will stage a sizable decline at a moment’s notice because the market is high, but history suggests a stock market crash is a rather rare occurrence.

Stocks are actually more likely to continue making new highs than go down solely because they’re at records highs. This is called ‘momentum’ in the investment world.

Before the dot-com bubble peak in 2000, stocks staged an 18-year secular bull market that started in 1982 and included 474 record highs for the Dow Jones. The current secular bull market in US stocks started with new highs in 2013 and is approaching just 8 years in age.

If you think stocks are too high and are bound for a massive decline like in 2008 or 2000, recency bias could be creeping into your thought process. Prevent recency bias by re-calibrating your decision-making process to better align with your investment time-horizon.

Tech Valuations Today Vs. 2000 Dot-Com Era

The surge in technology valuations amid the pandemic has led to comparisons that today’s market is akin to the frothy tech valuations that were seen during the dot-com era.

But here is some perspective to sideline that fear for now.

At the height of the dot-com bubble, technology stocks represented 35% of the S&P 500 but generated just 14% of the S&P 500’s earnings. Today, technology stocks represent about 40% of the S&P 500 but generate 37% of the S&P 500’s earnings. (Tech + Communications sectors).

In other words, technology stocks are actually backing up their elevated valuations with earnings that are durable, sustainable, and growing at a fast rate and with a long runway ahead. Profitable tech companies have a long way to go to reach the sky-high valuations seen in 1999 and 2000.

Another important consideration when comparing today’s stock market valuations to the dotcom era is interest rates.

When technology stocks hit stratospheric levels in 1999, investors had a choice: they could either remain invested and hope the music never stops or they could sell, take profits and put the proceeds into a risk-free 2-year US Treasury note that guaranteed a 6% return.

Today, interest rates are near zero, with the 2-year US Treasury note below 0.50%. The second choice investors had two decades ago no longer exists, resulting in a higher premium being assigned to stable businesses that are growing.

Finally, sentiment is an insightful market gauge for investors to monitor. An old Wall Street adage is when your shoe shiner (modern-day plumber or UBER driver) is giving you stock tips, it’s likely time to head for the exits.

Investor euphoria was sky-high in the late 1990’s, with the promise of the internet fueling a multi-year mania. Today, euphoria is climbing higher after a new generation of investors that live on social media platforms were bit by the stock market bug during the pandemic.

The amplification effect of social media has sparked a consistent rise in aggressive risk-on TikTok videos from day trading high schoolers explaining why you should put all of your money in bitcoin and GameStop.

It’s hard to deny the surge in this type of euphoric sentiment, and it has led to inexplicable trading activity in unprofitable companies with dire outlooks.

Ultimately, increased participation is not a bad thing for the stock market, and it’s positive in the long-term as it creates more demand for stocks. But increased volatility can occur in the next market correction if this new generation of investors are unable to withstand the emotional toll of a sizable sell-off and panic sell, worsening the decline.

Fourth Quarter 2020 Review

US stocks continued their uptrend in the fourth quarter of 2020 and finished the year strong, with the S&P 500 gaining 12.25% in the last three months of the year. For 2020, the S&P 500 delivered a total return of 18.37%.

An annual return of more than 18% is exceptional when you consider two things: it’s nearly double the stock market’s average annual return of 10% (~8% less inflation), and it occurred during a global pandemic that led to the sharpest economic decline since the Great Depression.

Much of the fourth quarter’s return in stocks was driven by news that Pfizer and Moderna’s COVID-19 vaccines proved 95% effective in preventing transmission of the virus.

Fast forward to today and more than 30 million Americans have already received their first dose of the two-dose vaccine regimens, with 1.35 million Americans being vaccinated per day.

Three more vaccines from AstraZeneca, Johnson & Johnson, and Novavax should hasten America’s path to herd immunity and a fully reopened economy.

It’s worth reflecting on just how remarkable the swift development of multiple effective COVID19 vaccines is. Phase 1 trials of vaccine candidates began in March, and by December two vaccines were already approved for emergency use.

Prior to COVID-19, the fastest vaccine ever developed was the four years it took Merck to create a vaccine for mumps in the 1960’s. There seems to be no problem too big that humans can’t collectively fix, and while that may sound like an overly optimistic cliché, it’s an integral belief needed to be a successful long-term investor in stocks.

The resolution of the presidential election also helped boost stocks in the quarter.

It’s safe to say that the market would have gone higher no matter which candidate won the election, as the results represented one less uncertainty investors had to worry about.

Ultimately, Joe Biden won and secured a narrow Democratic majority in the House and Senate. Biden now has flexibility in advancing his agenda, which could include infrastructure spending, green energy initiatives, and additional stimulus related to the pandemic. Increased regulatory oversight and a hike in certain taxes could also be a hallmark of Biden’s term in office.

It has never paid to make investment decisions based on who controls the White House, so don’t let your political leanings cloud your investment decisions.

If 2020 taught investors one thing, it was hopefully this: stick to your plan and stay invested.

Don’t let short-term volatility take your eyes off of your long-term goals and fuel decisions you will ultimately come to regret down the road, no matter how dire the headlines.

Uncertainty will always exist in the stock market, because without uncertainty, there would be no risk. And with no risk, there would be no reward. Risk is the price of admission you pay to be rewarded in the stock market, and the sooner you accept it, the more levelheaded you will be when the next inevitable market sell-off unfolds.

(Reminder: The stock market on average experiences an annual intra-year decline of 14%).

2021 Outlook

An attempt to forecast what’s going to happen over the next year is a common practice by many investment advisors and it’s one that should be retired following what was 2020.

Who could have predicted a global pandemic would grind the economy to a halt? Very few. And who could have then forecast that despite the pandemic, stocks would gain close to 20%. No one.

Instead of forecasting what might happen in 2021, a more constructive practice is to set the stage as to where things currently stand, starting with the consumer, which is the heartbeat of the US economy and is responsible for driving about 70% of annual GDP.

Despite the pandemic, American consumers as a whole are in their healthiest financial shape in decades. They’re simultaneously paying down their mortgage and credit card debt while also boosting their cash savings.

This has been enabled by a drop in certain spending categories amid the pandemic (travel, leisure, restaurants etc.) combined with income that has remained relatively stable, if not increased due to stimulus payments and expanded unemployment insurance.

With consumers sitting on heightened levels of cash and lower debt burdens, the pent-up demand to go out and spend will be evident once herd immunity enables a full reopening of the economy.

Businesses have also proven to be resilient amid the pandemic. S&P 500 companies ended 2020 with the highest amount of cash as a percentage of assets on record, and they’re going to spend that cash once there is more certainty that the pandemic is behind us.

That spending will likely include stock buybacks, dividends, and acquisitions, all constructive for stocks. The better-than-expected health of US businesses is also showcased by the fact that 2020 marked the lowest level in annual bankruptcy filings in 35 years.

At the same time, there has been a record surge in applications for new business startups, as entrepreneurs finally get the kick they needed (a global pandemic) to jump start their small business (myself included!).

This is important, because the businesses being started today will help fuel returns for investors in the years to come. This is evident by the fact that the common founding date of many highprofile companies going public today was during or right after the recession of 2008/2009.

Finally, the booming residential housing market represents another sizable driver of the economy going forward. Heightened demand for single family homes combined with limited supply is driving a construction boom, and unlike the speculative housing bubble of 2007, this one may have legs as millions of Americans look to spread out from dense cities after the pandemic.

All in all, there is reason for optimism in the year ahead, and that goes without mentioning the continued easy monetary policies from the Fed and likely increased government spending from the Biden administration.