The Biggest Drop In History

For most reading this, they will already know that the market fell 1,700 points at its lowest, marking the lowest one day drop in the history of the markets. An incredibly satiable headline for sure, but what does this recent trend mean for investors, specifically deep value investors like myself? I wasn’t planning on writing a piece on the recent drop, because to be honest, it didn’t really mean that much to me, and I’ll let you know why. Before getting into it, I would like to take this time to thank those that are reading this blog. I’ve experienced a substantial increase in traffic to the blog, and I am continuously humbled and motivated to be myself, and to be transparent in my quest for outrageous value hunting. Alright, let’s get into it!

After falling 700 points on Friday, the market gave itself an encore with a 1,000 spot better than Friday, falling 1,700 at the lowest point today. Like I mentioned earlier, this is a great headline for newspapers, email tipsters, and CNBC, but how much value should you place on it? Well, the easy answer is: It depends. Let’s take the first camp of people in the market, those I like to call Closet Indexers. This camp of Closet Indexers is comprised of mutual funds companies, Investment Advisory Firms, and individuals with Traditional IRA’s filled with mutual funds. For this group, the most recent drop is a HUGE deal. Many mutual fund companies are more-or-less index-like vehicles with expense ratios. This means that the average mutual fund portfolio closely mirrors that of the S&P or DOW. Even if the fund’s beta is below one, most of their returns could still be generated by what risk models refer to as “Common Return Factors”, compared to “Specific Return Factors”, the kind of factors you want driving your portfolio returns.

Mutual Fund companies aren’t the only ones guilty of this maneuver. Many investment firms end up turning into closet indexes in order to keep their jobs. For example, if the market is in a long bull market (like the one we are currently experiencing), it makes the job of the investment advisor difficult if their goal is to beat the market every single year. So, in order to keep their jobs, many advisors will just mirror the market, making sure their clients can see the companies that are well-known and performing well. This is the exact reason why you see people lose money when they invest in the best – performing mutual fund. Why is that? People tend to invest when they know the fund is doing well or at all time highs, because it makes them feel nice and safe. However, in actuality, one should invest during the drawdowns of certain funds they are fond of.

The final camp is the individuals with their own IRA’s comprised exclusively of ETFs and mutual funds. While ETFs can be tremendously valuable instruments (I myself have used them to express my long thesis on Russia, for example), many people who use them use them to buy an index of the market, think of a Vanguard fund). This is great if you’re using it as a de-facto bank account where you’re just adding money every month with hopes to cash in when you’re 70, but this also means that you are at the mercy of whatever the market does.

How I Think About The Drop

The market doesn’t impact how I operate when it comes to analyzing businesses and finding deep value opportunities with substantial margins of safety. In fact, when it comes to research companies and investments, I don’t care about the market’s direction. It sounds crude, but I couldn’t care less what the market does from a fundamental analysis standpoint. I love Ben Graham’s definition of the stock market when he says the market is a seller that everyday, comes to you and offers you a price for a given security. Each and every day the market comes to you with a price, and it’s up to you to either buy it, sell it, or do nothing. Whether the market is at all time highs or all time lows, the decisions don’t change. Each and every day I can buy, sell, or do nothing. So when the market is at all time highs and I find an investment (think of JNP) that I deem undervalued to their intrinsic value, I am not thinking, “Well the market is at an all time high, I shouldn’t be buying.” The same goes if a market is at an all time low. If I find a company trading at an extreme discount to intrinsic value, and the chart setup is perfect, but the market keeps going lower, should I think, “Ya know what, this could just go lower, I shouldn’t buy because the market is in free-fall.”

Of course not! I will stress this again: When it comes to individual security selection, I do not care where the market is, how its trending, or what people are thinking. I don’t watch financial television. This isn’t to say that I don’t think I can learn from some of the people there, but I personally want to reduce as much outside noise in my investment analysis as possible.

Exploiting Volatility

With that being said, that does not mean I can’t take advantage of extreme market movements. Volatility can be a great way to squeeze out extra alpha over the course of an investment year if done strategically and carefully. Before the close of the market, I entered into long positions in VXX for 100bps as well as SH (Short S&P) for 25bps, for a total of 125bps position expressing volatility. These trades quickly shot up upwards of 40%, which is nice, but always makes me scared. Because of the rapid advancement, I aggressively moved my stop losses up to guarantee a profit in my long VXX trade, as well as moving my stop loss in SH up to a 10bps open risk.

Although I do not care at all about the market direction, it would be naive of me not to recognize the potential returns that can be had if you play volatility right. This is the advantage of a “no-rules” style of investing. It works for me, I’ve found my niche style and I’m sticking to it. There’s nothing wrong with a deep value investor grabbing a few basis points of profit through the use of going long volatility.

Closing Remarks

I want to reiterate my stance on the biggest drop in history. In short: I don’t really care. I don’t care because I don’t look to the market to determine when I analyze and invest in individual securities trading at discounts to what I believe the intrinsic business value is. Whether the market is at all time highs or all time lows, it doesn’t matter to me. My goal is to find what Michael Bury calls, “sheer outrageous value”. That is my job. My job isn’t to figure out where the S&P is and coordinate my investment research and selection to that. Sheer, outrageous value is out there in any market, my job is to turn over enough rocks to find them.