October 1, 2015

Dear Investor:

Some call the recent market fall a correction, but the magnitude and duration of declines spell a global bear market. From their May peaks, the market declines to the lowest lows are as follows:


Dow Jones Industrials -14%
S&P 500 -12%
MSCI All World Index -15%
Nikkei 225 -19%
MSCI Europe -15%
Shanghai Composite -43%


While the technical definition of a bear market is a 20% decline—and though domestic markets have held up better than their foreign counterparts—this looks, swims, and quacks like a bear market.

A few things to remember during bear markets:

  • By the time they are recognized, they’re closer to the end than the beginning.
  • Markets do not go straight up. After four years without a decline of any magnitude, this pain is necessary.
  • Markets function by periodically shaking out the weak hands and thus rewarding those who stay the course.
  • When stocks go down in price, their future expected returns actually rise. This is the most misunderstood feature of equity markets—that stocks have an intrinsic annualized return to which they hew regardless of economic conditions. When they rise, they borrow from that future return. By sinking, they pay it back.

To gauge future return, you must understand value as evinced by the underlying free cash flows. For speculators, the stock market is a casino with no logic and no analytical underpinnings. To investors, the truth couldn’t be more different.

Value investors, schooled as they are in the methods of Warren Buffett (who was schooled in turn by Graham and Dodd), understand that stocks are the legal claims on the cash flows of a business. Their value can be estimated within reasonable ranges.

For example, take the emerging market stocks. As measured by the SCHE (Schwab Emerging Markets ETF), they now trade at a mere four times operating cash flows and ten times free cash flows. This means that if their free cash flow (which legally belongs to the shareholders) were paid out entirely as a dividend, a holder would receive a 10% dividend yield.

Of course, very few companies pay out their entire free cash flows as a dividend, preferring to reinvest cash in the business. But to the extent a business is reasonably well-managed, this reinvestment accrues to the shareholder over time in the form of a higher share price. In other words, a 10% free cash flow yield should translate into at least a 10% total annualized return (actually higher because cash flows rise over time). This is no theoretical discussion: history shows that FCF yields above 10% indeed lead to double-digit returns.

After being overweight cash in all except the most aggressive accounts since last year, I’ve been putting that cash to work as stocks decline, buying what was already cheap much cheaper. These purchases, as foolish as they look in a plunging market, are the seeds that will sow excess future returns.

Please call with any questions.