Trash is King

Most of the time, you want to buy businesses with “moats”. A moat protects a business from competition, and allows it to earn returns on capital over and above the general cost of capital for equities. Theoretically, the only way a no-moat business can earn outsized returns on capital is if competition is inhibited for some external reason. For example: demand in a particular industry has surged quickly and unexpectedly, and supply has not yet caught up. Or: competition is reduced due to the withdrawal of some competitor(s), or simply general under-investment in capacity for a particular industry. When are these last conditions most likely to occur? In a recession! So when should we buy low-quality, no-moat businesses? In a recession! Hold on, that sounds like a terrible idea. We should, of course, be buying the safest stocks during a downturn, as these are most likely to survive, and it will feel good to own them. In fact, extremely superficial internet research reveals it to be so! A few recently published articles offering stock-picking advice to individual investors: Johnson & Johnson: A Safe Dividend Pick We Are Only Buying SWANs During This Black Swan Event 3 Super-Safe Dividend Stocks You Can Buy Right Now 7 Safe Stocks to Buy on the Coronavirus Dip Even among those of us enterprising (risk-seeking?) enough to choose our own stock allocations, there appears to be some deep-seated impulse to seek relative safety in uncertain times. And if we were paying fixed prices for individual stocks, that would certainly be the right call. But we are paying prices that are based on current relative demand for each stock, which is influenced by everyone else’s deep-seated impulses, and so as is typical in investing, we should listen to our emotions, ask our inner selves: “what feels like a good decision right now?”, and then do the exact opposite. What feels like a good decision when we are clearly in a recession is buying the stocks of safe, high-quality, moat-endowed companies. The opposite of that is buying trash, so I guess we should... buy trash. How trashy are we talking? I just bought shares of Kohl’s, a somewhat downmarket department store with no particular competitive advantages. I put Denny’s on my watchlist. Dennys! These are two companies I would never consider in ordinary times, as there is nothing “special” about them. And there still isn’t! But they are, in a normal year, able to generate positive operating profits and cash flows, and they are currently trading at very low multiples of what they ought to be able to do in a normal year. Of course, some such companies won’t survive to ever see normal again, or will have to take on excessive debt or dilute shareholders to the point that it doesn’t really matter whether they survive (from a shareholder perspective, that is). But most will endure, and emerge from the downturn with some combination of lower cash reserves and more debt, but also with less competition, possibly even some pent-up demand for their products, and in any case, valuations significantly higher than during the downturn. Some caveats: really, the time to buy trash was two weeks ago, and it’s very possible that two weeks in the future will be a better time still. So I don’t intend this post as particularly well-calibrated market-timing advice. In fact I don’t intend any of this as investment advice. I am not an investment professional, and I will suggest that generally, if you find yourself about to go out and buy stock in Denny's (again, !) because you read a blog post, perhaps pause and re-evaluate your process. But if you do decide to try some bottom-fishing, make sure to do it in a non-taxable account. If it is indeed true that the only time you want to buy trash companies is during a crisis, the flipside is you don’t want to hold them in normal times, so you will probably want to dump these stocks at some point in the next 6 to 24 months. You certainly don’t want to be hanging on to Kohl’s shares 5 years from now simply to avoid capital gains. Also, when employing a strategy of buying cheap, crap companies, diversification becomes even more important than usual. The most obvious problem with buying low-quality businesses in the midst of a recession is that some of them won’t make it out. So if you are going to make this type of move, you have to be willing to accept that some of your positions will go to zero in order for others to triple. This is much easier done with lots of small bets than a few large ones. Finally, there are plenty of not-particularly-trashy companies that will also benefit from reduced competition in the wake of this current crisis, such as Ulta Beauty, or Chipotle. It’s just that those are 20-30% below their pre-crisis valuations, versus a 50-60% discount for our lower-quality targets. And to some degree that is very likely warranted: Ulta and Chipotle are in fact less likely to go bust in the next 18 months than Kohl’s or Denny’s, and may even make some money during that time. However, on a risk/reward basis I prefer the trash. The middle of a crisis is the time when you’re being most well compensated for accepting risk, so it’s actually a good time (in my opinion the only good time) to buy some junky companies. But I’m still not touching airlines.