The stock market hates uncertainty.
It’s why stocks with an uncertain future sell at a discount. Or why the companies bonds sell at a junk grade.
Investors simply don’t know how to price in uncertainty.
When talking to Chinese students at Peking University, Mohnish Pabrai spoke about some of his biggest losses.
He’s one of the best investors of his generation. Yet even Mohnish has his fair share of losers. One of which was a mortgage securitisation company in 2007–09.
At the time, securitisation stopped leaving the company with a whole lot of debt. That stock went to zero, costing Mohnish $70 million.
‘It was very painful because we lost $70 million…$70 million going to zero, not good,’ Mohnish told students.
But there are times when stocks fall on wide economic events that have little to no impact on businesses.
Mohnish posed the following hypothetical:
‘Let’s say the guy in North Korea launches a bunch of missiles. What do you think the stock markets are going to do when they open?
‘Straight down! No floor…We might be down 50%. If he actually launches and gets a hit close to a major city, we’ll be down 50%, 60%, 70%, we don’t know.
‘Most businesses will not be affected long-term by a missile launch. But the price [of the stock] will go down. What is the impact on real estate around Stanford? Unless the missile comes in there…no impact.’
All you’d have to do is ride out the decline, or better yet, buy quality stocks as they fall lower. Now with a potential trade war on the cards, it’s worth considering the impact on businesses.
Think like an owner
Before talking about the trade spat between the US and China, it’s worth noting the important point Mohnish makes.
Why does the value of a business and the value of their stocks differ? Why is it possible to buy stocks when they’re cheap and make oodles of money over the subsequent years?
It’s because a stock isn’t just a piece of paper with a gyrating price. A stock is a part ownership of a business.
Many people know this of course. Yet when it comes time to invest their money, they seem eager to forget it. Instead of basing their investment on the underlying economics of the business, they buy for some other reason.
They might jump into a stock because sentiment is growing, meaning more people like the stock. Or they might buy because some fund manager sees potential upside for the next quarter.
But thinking about stocks as part ownership in a business is what gives you the ability to hold when your position is 50% down. You know the value of the stock and the value of the business are different.
Thus, you’ll wait until the price of the stock reaches or exceeds what you think the business is worth.
Trade war put on hold
Take a look at what a few tariffs are doing to stocks.
First, Trump went after Chinese steel and aluminium.
China’s president, Xi Jinping of course came back with his counter. Xi put a $65 billion tax on US soybeans, small aircrafts and autos.
Hours after China’s retaliation, Trump thought of ways to tax Chinese goods by up to $100 billion, or from $50–150 billion.
Now, US stocks are down 10% from their highs this year. Aussie stocks have followed, falling almost 6%.
But it seems the war of tit for tat tariffs is momentarily on hold. Reported by the Australian Financial Review:
‘A freeze in negotiations between the Trump administration and China over an escalating trade conflict has skittish investors around the world bracing for months of elevated volatility after another sell-off on Wall Street.’
Trump has also mentioned that if this tar war does escalate, it will be China to buckle first.
‘China will take down its Trade Barriers because it is the right thing to do,’ Trump said on Twitter. ‘Taxes will become reciprocal and a deal will be made on Intellectual Property.’
But as things are now on hold, let’s take a moment to consider how this will affect businesses. Of course this depends on what kind of tariffs each country will apply. But for most Aussie businesses, it will be business as usual.
For example, imagine REA Group Limited [ASX:REA], owners of realestate.com.au, declined significantly with the rest of the market. While REA Group is trying to push into China a good chuck of sales come from Aussie property listings.
What kind of tariff can Xi or Trump impose to affect Aussie property listings?
In my mind there are basically none. But there’s another reason I choose to focus on REA Group. They are an incredibly high returning company.
From 2013–17, REA Group averaged a return on equity of more than 38%. That means the group generated 38 cents on each dollar of equity.
If you read yesterday’s Money Morning this is something I also talked about — buying high returning companies when markets fall.
As uncertainty picks up, it’s one of the best strategies to have.
Editor, Money Morning