Market Correction? The Coffee Can Portfolio Might Help You Sleep Well

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Includes: NVO
by: Peter Cech
Summary

The markets have experienced some turbulence, which might cause uncertainty among investors.

If you think you cannot time the market, the coffee can portfolio is the right thing for you.

If you think you can time the market, this article will show you the key indicators to follow.

The easiest way to make money in the stock market is to invest in companies for the long term. This is particularly true if you invest in companies that have the potential to outperform other enterprises and industries. Once you have such companies in your portfolio, as long as the theme is intact, you might want to hold them for decades.

I am a true believer in long-term investing. When I have to sell a stock, it basically means that I made a mistake when buying it in the first place. The sooner I need to sell, the bigger the mistake I made.

However, what should you do in the current situation, if you think the markets are overheated? After an uninterrupted bull market without any significant corrections, the markets have become slightly nervous. One could have clearly seen it in the last couple of days. So, is it now time to sell? Well, I would like to present two different options on what to do.

The Coffee Can Portfolio

The biggest obstacle in multiplying your money in a stock might be the inability to endure the ups and downs of the stock market -- i.e., the inability to hold on. There is an important story, which might already be half-forgotten, but it stems from old and valuable sources about investing. It was first mentioned by Robert Kirby, who was a portfolio manager at Capital Group, one of the major investment management firms, in the 1980s. He came up with the coffee can idea as a coffee can was used to store valuable items in the olden days. However, you put only the best items with future potential in the coffee can.

The moral of the coffee can story is that sticking to your original ideas is much better than constantly buying new shares just to sell them within the next few months. Kirby discovered that an amateur investor had picked recommendations from his fund. However, the amateur investor completely ignored the "sell recommendations" and held the positions. After 10 years, the results were amazing. There were some broken stocks, but a number of them did so well that the value of several individual positions by far exceeded the value of the entire original portfolio.

Hence, I believe that it's better not to sell, even in a situation where markets are nervous. It is extremely difficult to predict the right time. Besides that, even if the market slides 30%, you will not notice that in the next 10 years if you invested in the right company.

Novo Nordisk - An Example of What I Put in My Coffee Can

I have my own candidate for a coffee can portfolio, and that is Novo Nordisk (NVO). It is a Danish healthcare company with more than 90 years' experience in diabetes care and active in the whole world. It is a market leader in sales of basal insulin, with a volume market share of 34% in the U.S. Besides diabetes, it focuses on the treatment of obesity, hemophilia, and growth disorders. These diseases will unfortunately occur more and more often. Moreover, it has expanded its R&D efforts to cardiovascular disease, non-alcoholic steatohepatitis, and chronic kidney disease. Hence, the business model remains viable and it has a future.

The company is consistently profitable with great margins. The chart below shows the impressive growth of the net sales (in DKK million), even during the financial crisis of 2008-09.

Net Sales

Source: NVO Annual Reports (2011, 2013, 2017)

The net profit margins have always been high, but even these increased in recent years from the net profit margin of 24% in 2010 to the net profit margin of 34% in 2017. As a result, the company is extremely profitable. The significant positive free cash flow for the past years documents the efficiency of the company.

NVO is also able to productively use its assets. The company achieved a return on assets of 38% in 2017. The return on equity was even higher, since NVO uses equity to finance 49% of its assets.

NVO Sales

Source: Company website

Another advantage of Novo Nordisk is its geographical diversification. It has a strong presence in North America, but it is also well-represented in Europe, China, Japan, and other countries. The company is established in developed countries, where people can afford high-quality healthcare, but NVO can profit from fast-growing economies as well. Last, but not least, NVO has been constantly increasing its dividend, even during the market crash of 2008-09.

All the above-mentioned factors combined create a suitable candidate for my coffee can portfolio. Although this was not a full-fledged analysis of Novo Nordisk, I hope that it served as a clear example.

There is no need to put all your money in a coffee can portfolio. You can put just a portion that you will not need for the next years. It is, however, very likely that this part of your investment will be the best performer. The whole idea described here should protect investors from the emotions and volatility of the markets that make them buy at the top and sell at the bottom.

Picking Tops and Bottoms

On the contrary, it would be nice to be able to buy at the bottom and sell at the top, but that is easier said than done. Investors who believe that they can time the market have an option to focus on major indicators, assessing whether the stock market is generally expensive and whether panic or euphoria prevails.

I would like to present four such indicators. However, it's important not to forget that even if markets look expensive, this does not mean that a correction will follow. Markets can be expensive for several years and one might miss great opportunities when constantly waiting for a correction.

1. Shiller P/E ratio for the S&P 500

This indicator monitors how expensive stocks are at the moment, based on their earnings. The Shiller P/E ratio takes inflation into consideration and it takes average earnings of the S&P 500 companies from the previous 10 years into account. This indicator shows that the current prices are high, but for example during the dot-com era, the prices were even higher. Although the current situation is rather extreme, prices are not as high as at the historical record level.

Shiller PE ratio Source: Shiller PE ratio for the S&P 500

2. VIX index

The VIX index basically measures the volatility of the S&P 500 stock index. One can also say that the VIX index is the "panic indicator." It monitors the demand for the S&P 500 stock options. Options might serve as an insurance since they can protect the option buyer against a price decline. If investors fear a decline in price, they want to buy options. The higher the demand for options is, the higher values the VIX index shows.

Options are extremely useful for institutional investors. They cannot just directly sell millions of shares because it would cause extreme price movements. Hence, institutional investors need to hedge their positions through options.

The VIX index is especially useful as an indicator of major market crises. However, this indicator cannot predict smaller market corrections that well. The VIX index constantly had been noting high numbers (above 22) for several months ahead of the dot-com collapse in 2000 and the stock market crash in 2008. Today, we are not in such a situation as the VIX index has been showing very low numbers in the recent months. Just last Friday, the number reached 18 and this Monday, the VIX reached 25. It can go easily up much more during a market correction. Nevertheless, here again, the VIX index usually signalizes a bear market months ahead with high values, not just a few days ahead.

VIX

Source: VIX Central, Feb. 5, 2018

3. Advance-decline line

The advance-decline line is a breadth indicator based on the number of advancing stocks less the number of declining stocks. The major thing to follow is when the stock market moves up while the advance-decline line moves down. The reason is that the stock market might still move up due to "popular stocks" with large market capitalization while the declining smaller stocks do not have such a visible impact on the S&P 500. However, the advance-decline line will reveal this. It just measures the numbers of advancing and declining stocks without considering the market cap. The divergence between S&P 500 index and advance-decline line often happens before a market correction. You can compare the graphs of advance-decline line with S&P 500 and see how it looks today and how it looked before a market crash in the past.

Advance-Decline Line Source: Stockcharts

4. Interest rates

Today, interest rates are considered as the major cause of the stock price decline. The economy is booming and there is a very low unemployment rate in the U.S. In addition, the government demand for borrowed money is growing, while the Fed cut quantitative easing. Hence, the reasonable thing to do seems to be to increase interest rates. Higher interest rates are a natural enemy of the stock market, and even though they have been steadily declining for the last 30 years, there usually were small but dynamic spikes before a stock market crash. This is also currently the case.

10-Year Treasury Rate

Treasury rate Source: 10-Year Treasury Rate

Conclusion

In the current market situation, it's probably a good idea not to initiate new positions in stocks. The only exceptions are individual stocks, which might have some specific features that make them interesting ahead of turbulent times.

The answer to the question of what to do in the current situation will be different for a trader than for an investor. It also depends on the time horizon for investors, whether they should choose to hold on to their best stocks or to time the market. That is to say, investors with a long-term perspective have the luxury to sit and wait without being overly concerned about every market action.

If somebody is able to choose the correct top once or twice, that's great. However, in doing so, there will be too many occasions when it is not the top and the rally might continue. In hindsight, it appears easy to predict a market crash or correction. But, then again, it's never easy, and hindsight is always 20/20. Now, I'm going to drink some coffee to free up the space in my coffee can.

Disclosure: I am/we are long NVO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.