We believe there are two key reasons for the recent stock market decline. First of all, there is a small decrease in earnings power. Secondly, company valuations have decreased.*
1. Earnings Power Decrease – In some industries, corporate earnings are not coming in as strong as expected. This is the case with industrials, banking, and some technology companies. These stocks are declining as investors seem to be re-evaluating the earnings power of the underlying businesses. We think that there are many reasons earnings are less than expected.
For example, management teams are citing increased raw material costs, higher wages, and growing transportation expenses. Some of this is caused by tariffs, such as steel, and some by natural market forces in an expanding economy including labor and transportation. These increasing costs are reducing profit margins.
Additionally, while America’s economy is very strong, in our opinion, we are hearing about a slowdown in China and Europe. Some of this is related to tariffs, but there are probably other factors at work.
2. Decreased Valuations – While investors seem to be re-evaluating the earnings power of businesses and there is a slowdown overseas, stocks were also trading at high valuations in our estimation. The stock market has enjoyed double-digit returns for several years as the earnings power of corporations increased and the multiple of earnings that investors were willing to pay also increased. Given the uncertainty on earnings growth, investors appear to be no longer willing to pay those high price-to-earnings multiples.
Due to a small decline in earnings power for some industries and companies, and a big decline in stock prices for many businesses, we are seeking to add to positions and invest in new, high-quality enterprises at a discount to our estimate of their intrinsic value. For more than four decades, Fenimore has seen stock market downturns as opportunities to strengthen portfolios and build wealth over the long term.
*FactSet & Bloomberg financial data systems. Data as of 10/23/18.