Not All Stocks Fall With the S&P500. Here’s Why Some Continue to Rise.
After posting my article “Is It Safe to Invest In An Earnings Recession?”, some of you asked whether there are stocks in the green right now.
The answer is yes.
Since the start of 2022, S&P 500 and Dow Jones Industrial are down 19% and 14% respectively.
But index movement in S&P 500 is an outcome after netting off the different share price increases/decreases of the different 500 companies. The same goes for Dow Jones Industrial. This means while S&P 500 can go down, some stocks can move independently. For example, S&P 500 can go down and some stocks can go up.
(Comparison Chart of S&P 500, Dow Jones, World Wrestling Entertainment, Stride and International Money Express between 1 January 2022 to 18 July 2022. Source: CapitalIQ)
Measured across the same time period, stocks like World Wrestling Entertainment and Stride and International Money Express are up more than 25%. These are businesses with underlying demand even if we were to enter a recession. For example, money remittance into Latin America will continue to grow and this trend will benefit International Money Express in the long term.
Similarly, during the previous global financial crisis in 2008/2009, there were stocks that defied gravity and rallied ahead of the indices.
(Comparison Chart of S&P 500, Dow Jones, Chipotle, AutoZone and O’Reilly Automotive between September 2008 to March 2009. Source: CapitalIQ)
Some companies like Chipotle had a gentler decline, while AutoZone and O’Reilly Automotive recovered much faster than the indices.
AutoZone and O’Reilly Automotives are in the vehicle after-sales service industry. With America being so vast, many people rely on personal vehicles as their primary mode of transport. Whether we are in a recession or not, there is a sense of urgency to repair one’s vehicle if it malfunctions, since one is dependent on it to get around. This is why the demand for their services remained strong.
From 2008 to 2010, AutoZone grew its revenue and profits every single year. Its valuation was extremely cheap back then too.
After observing how these companies recovered faster than the indices in both scenarios, my conclusion is that:
- Demand for their products is resilient.
- They are small compared to their addressable markets.
Since we have limited cash to deploy during this market drawdown, we need to select companies well.
Instead of only looking at what good qualities we want in our companies, let’s invert it by understanding what qualities we do NOT want in our companies. From there, we can increase the odds of finding a good company to invest in.
This model of thinking is popularised by Charlie Munger. He looks at the downsides of an investment before even calculating the upside.
Qualities to Avoid
1. Heavy Customer Concentration
If a customer is responsible for more than 20% of a company’s revenue, avoid it. No matter how remote this risk is, the damage is fatal if it happens. Imagine if a business loses 20% of its revenue! How would the stock market react to it?
An example of a company like this is OnTrak – its stock price crashed previously when a major customer left.
Today, OnTrak is still facing the same issue.
2. Huge Debt and Razor-Thin Profit Margins
In bad times, a business may face lower revenues or higher operating costs. This will erode an already thin margin and profits would likely turn into losses. Without any profits, a business will struggle to pay interest expenses, running a higher risk of bankruptcy.
Back in 2002, US Airways suffered lower sales after the September 11 terrorist attacks. Their profit margins turned into losses and they could not pay off their debt. It eventually became bankrupt.
3. Stagnant Revenue / Profit for More Than 2 Years
A business that is not growing is bound to stay the same. Without any revenue or profit growth, the business’s value remains the same. We want strong yearly growth.
In my free investing workshop, I talk about this in greater detail.
4. A “Seat Warmer” CEO
This term refers to a CEO who accomplishes little or cannot get anything done.
It’s all about having a track record. If a company hasn’t been growing under the same leadership for the past few years, what are the chances that it will grow over the next few years?
“A leopard never changes its spots.”
5. High Levels of Stock-Based Compensation (SBC)
SBC is used to compensate employees for their hard work. It’s great for building loyalty. New shares are issued to employees and the overall share count goes up.
However, for existing shareholders, this means that their ownership of the company decreases.
When too many shares are issued, there is heavy dilution for existing shareholders.
Take Qualtrics International as an example:
Despite Qualtrics CEO Zig Serafin mentioning strong growth in Q1 results, its SBC as a percentage of revenue is 80%. What is left for shareholders? Absolutely nothing.
This is a clear red flag to us.
Summary
Selecting strong companies to invest in is not just about identifying patterns of stocks that did well in both market drawdowns (2022 and 2008/2009). It’s also about recognising risks.
If AutoZone is a recession-resilient company but has a customer that contributes over 30% of its revenue, would I buy its stocks? The answer is no. The risk is simply too high.
Look for companies that:
- Are recession resilient
- Have huge addressable markets
Avoid companies with:
- Heavy customer concentration
- Huge debt and razor-thin profit margins
- Stagnant revenue and profits for more than 2 years
- A “seat warmer” CEO
- High levels of stock-based compensation
In a bear market, it is crucial to come out alive. Don’t expose yourself to unnecessary risks and develop a proven investment strategy so that your chances of making money are higher.
In fact, the best investors secretly do this ONE THING during a bear market to ensure they can double or triple their wealth after (no, it’s not buying stocks or timing the market). It’s so simple and straightforward to implement, yet it makes the entire difference to your investment returns down the road.
If you’re curious about it, I’d love to show you how in the brand new workshop that I’m organising for FREE. Click on the link here to register!