During the first quarter, in our Intrinsic Value Equity Strategy, we did two transactions, that psychologically can represent two of the hardest things to do in investing. The first, is recognizing a change in the company’s fundamentals/prospects, and selling the stock at a loss. The second, is increasing the position in a stock that has declined from the original purchase price.
The stock we sold at a loss, in our Intrinsic Value Strategy, was National Western Life. The company has been around for decades and is very well run. It is conservatively financed and has consistently grown its intrinsic value over the past few decades. The chart to the right compares the company’s stock price and our estimated intrinsic value since 1991. We bought the shares in April 2015 at $243.70. Our purchase price was 54 percent of our estimated intrinsic value. Based on the fact that over the long-term stock prices tend to track their underlying estimated intrinsic value (as indicated in the chart above), we thought it was highly likely over the next three to five years the gap between its stock price and intrinsic value would close.
Our opinion on the company changed early this year because we think there is a good chance we may have a prolonged period of low interest rates. In the past 12 months Switzerland and Japan have cut short-term interest rates below zero and Janet Yellen, the Federal Reserve chairperson, talked about the possibility of the U.S. cutting short-term interest rates below zero during the next recession. Negative interest rates could be disastrous for life insurance companies such as National Western Life. Life insurance companies price their products based on the life expectancies of their policyholders and being able to generate an attractive return on their assets. Interest rates are at their lowest levels in history-with history going back to the 1600s. We think life insurance executives did not expect interest rates to drop to this low for such a prolonged period of time. As a result, it is possible many life insurance companies will be “upside down” – where the value of their liabilities exceeds the value of their assets. In February we sold the shares at an average price of 212.49 for a 13.1 percent loss from our April 2015 purchase price due to the fact that the underlying risk in owning the company had changed. (Note: One of the benefits of a value investing approach is that since you are buying stocks with a “margin of safety”, where the company’s stock price is well below its intrinsic value, when you make a mistake, it is more likely you will lose a lesser amount than on stocks that follow a growth or momentum based investment strategy.)
The second so called “hardest thing to do in investing” is adding to a position that has declined from the original purchase price. During the first quarter, in our Intrinsic Value strategy, we bought more shares of CDI, a consulting and job placement company that we reviewed in last quarter’s newsletter. Our initial purchase in the company was in mid-December, at an average price of $6.76, or at 66 percent of our estimated intrinsic value. The stock sold off during the six weeks after our initial purchase and we added to our position at $4.88 on February 3rd— at 48 percent of our estimated intrinsic value.
Buying a stock that has declined is hard for two reasons. First, the market is sending a signal that is contrary to your original investment thesis about wanting to own the stock. Second, in meetings or conversations with clients there will be comments like, “That’s been a real dog.” or, “Why don’t you sell that loser?” Those comments run contrary to wanting to buy more shares. There is a lot of so called “psychological warfare” that must be endured when increasing a position in a stock that has declined. However, as long as we stay anchored on the relationship between a company’s stock price and its estimated intrinsic value, and maintain a long-term time horizon, we should feel comfortable increasing the position in a stock that has fallen below our initial purchase price.
The above post has been excerpted from a recent letter of Granite Value Capital.
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