What Toilet Paper Can Teach Us About The Current Market

The rush on toilet paper is on. Empty shelves everywhere. Rationed supply in the few remaining locations.

Source: Author

Yesterday, I watched a video reminiscent of old Black Friday scenes, where a host of people waited for the store opening just to rush the toilet paper isle and load up on multiple packs of 36 roll toilet paper. Kicking and screaming ensued. It looked like the global end of toilet paper supply was near.

With over 8,000 2-Ply sheets per pack, you have supply for a family of 5 for over half a year. Ration excessive use and you might be able to go a full year. Still people loaded up 2 or 3 or even more packs.

Toilet paper supply chains globally are obviously stretched to a point where the perforation is ripping…

You’d be forgiven to think that people had to stock up, because of the coronavirus.

The CDC (Center for Disease Control), however, does not have toilet paper on its emergency kit list.

Covid-19 is a respiratory disease with no known impact on the digestive track. So, no natural drivers for a sudden spike in demand.

Given that the modern form of toilet paper was only invented in 1857 by the unsung hero Joseph Gayetty, on could surmise that mankind did survive without it for most of its existence and, in a pinch, could do it again. The material of choice among colonial America was corn cob. When daily newspapers became commonplace in the 1700s, paper became the material of choice. Modern communication such as Twitter, I guess, lacks that added function. Turns out that this is not the first time we had a toilet paper supply crunch. The first shortage was caused by Johnny Carson on December 29, 1973.

America’s First Toilet Paper Shortage

And it was generated much of the same way this one was. He announced there soon to be an acute shortage of toilet paper in the United States (which was a joke), and sure enough, it created a run on toilet paper that did in fact create a temporary shortage, such fulfilling its own prophecy. Media outlets reported on it without fact-checking, compounding the issue.

What does that tell us about the recent stock market plunge?

Fear (however irrational) can drive strange group behavior. Everyone is going out shopping for toilet paper as it is presumably short in supply. Everyone is dumping stock for fear of a coronavirus-induced recession.

The market started dropping on a mix of fear of the coronavirus impact and OPEC oversupply, and next thing we know selling begets selling, and the market corrects 20% in a week with plenty of investors panicked. Media reports of ‘unprecedented’ market drops increase fear further, and the cycle feeds on itself.

Why panic?

When you look at the history of the Dow Jones up to last Friday the 13th (which was an UP day by the way), the current correction seems like a mere blip. Certainly, less dramatic than 2008. But we still have to fear fear itself.

Looking at the S&P 500, even if you had invested at the peak before the big recession in 2008, you’d still made a decent 5.5% rate of return up to now. That is if you could stomach the market drop of over 50% from 2007 to 2009 without panic selling. In the past couple of days, the S&P 500 took merely a substantial overvaluation and corrected to its historic average.

Some of us remember the scary outbreak of SARS, a definitely far more lethal virus.

It happened in 2003. You can barely tell on the chart above.

Warren Buffett presciently framed it up in his 2019 letter to shareholders:

“Anything can happen to stock prices tomorrow. Occasionally, there will be major drops in the market, perhaps of 50% magnitude or even greater. But the combination of The American Tailwind, about which I wrote last year, and the compounding wonders described by Mr. Smith [economist and financial advisor Edgar Lawrence Smith, writing in a 1924 book], will make equities the much better long-term choice for the individual who does not use borrowed money and who can control his or her emotions. Others? Beware!”

The feeling of market participants mirrors those scared running out of toilet paper. It is not the correction; it is the ferocity of the correction that makes people wanting to sell. It is not a shortage of toilet paper but the fear of a shortage that induces buying panic.

Both supported by a constant barrage of media frenzy.

Don’t panic!

The ferocity of the decline however isn’t necessarily driven by the market outlook (no one at this point has a clear view) but rather by the desire of investors to get out of pain all at the same time, which ironically compounds the pain.

Even the largest water utility company American Water Works (NYSE:AWK) took a 13% ‘bath’.

We are running out of toilet paper and apparently out of water too????

American Water Works came down from a lofty PE (price to earnings ratio) of 37 and dropped to a ‘mere’ PE of 32 sporting a paltry 1.7% dividend yield.

On Friday, March 13, the stock price jumped a cool 8.7% to $128.29, indicating robust demand. Apparently, someone figured out that the solution to less toilet paper must involve a higher water usage. More likely, we are observing the often quoted ‘flight to safety’ from riskier assets. Or there is no actual reason at all. Multi-day price fluctuations of this magnitude indicate that the efficient market hypothesis (all news are priced into the stock, thereby always reflecting correct value) is at a minimum temporarily suspended. And I will not in the slightest way presume I can explain one day market gyrations by sound underlying fundamentals.

Pun aside, this utility that shows a consistent 7-9% earnings growth still seems to be at stratospheric valuation. The danger doesn’t lurk in the recent drop but in its valuation.

Flight to safety has its own risks

How are other supposedly safe utility stocks such as Xcel Energy (NASDAQ:XEL), WEC Energy Group (NYSE:WEC), and Dominion (NYSE:D) faring? Not much better.

Energy utility stocks did also drop: 7.5% (WEC), 10% (XEL) and 16% (D). What has the coronavirus or the OPEC oil supply to do with electricity? Very little! If anything, falling natural gas prices should make utilities more profitable, not less. With Dominion down substantially more than Xcel, WEC Energy Group, or American Water Works, it is obviously the riskiest stock, right?

Not really. While Dominion holders might feel the urge to rush to the exits, thinking Dominion is going out of business, and Xcel Energy and WEC Energy holders might feel smug about owning a safe utility that did drop ‘less than market’, the risk is inverse to the prevalent emotion.

Utilities are slow-growth companies, so their PE ratios tend to oscillate around 15 and correlate closely with earnings growth. The constant search of better yield has driven valuations up. With bond yields at historic lows, slight premiums to the historic PE appear justified; however, not in the territory of high-growth company valuations. The earnings growth rate is negotiated with the regulating authorities, so utilities as a public service provider never get the opportunity to experience sustained accelerated earnings growth. Thus, gravity will ultimately pull them back down.

What does this mean for shareholders? You want to buy into a utility stock when it trades at or preferably below fair value (about a 15-16 PE). Xcel, which sports a current PE of 23, is still clearly overvalued and only provides 2.81% yield. WEC Energy trades at even loftier PE of 25 and lower 2.76% yield. American Water Company is at an eye-popping PE of 32! Dominion Resources, on the other hand, dropped below its historical PE of 17 and provides 5.27% yield. When the next recession comes (if it isn’t here already), Xcel and WEC could correct another -30% to return to fair value. It is not really a question of ‘if’ but rather of ‘when’. Mind you that, in 2009, these stocks went all the way down to a range of 12-13 PE despite continued growth in earnings. So, no recession impact!

It’s the valuation that counts

If you consider trimming positions, it is time to scan your portfolio for highly overvalued stocks. Make your decision dependent on valuation, not on price action. Dominion just became a fair value opportunity again, whereas Xcel and WEC are just another drop waiting to happen. Divesting out of Xcel and WEC possibly into Dominion strikes me as prudent action.

If you are considering a ‘flight to safety’ by switching to utilities, make sure you buy into valuations that are reasonable in historic context. Not all utilities are equal in this market. Utilities sporting a PE of over 25 are high risk! Yields of a little over 2% are not enough compensation for a highly likely 30% drop in invested capital.

In times of trouble cash is king!

Highly indebted companies with short-term debt maturities will be in trouble. When panic reins on Wall Street, banks become ultra conservative and re-financing difficult. Losing credit ratings can compound the cost of re-financing with higher rates. Companies rated just one notch above junk (BBB-) are exposed. So, check the balance sheet of your holdings for debt obligations and try not to get greedy with dividends.

Occidental Petroleum (NYSE:OXY) is a time compressed case study. This shale drilling company fell 80% from its high point, temporarily spiking dividend yield to over 20% until it slashed the dividend by 86% just a day later. With high profile investors on board such as Warren Buffett and Carl Icahn, you would be forgiven to think they know something you don’t and you should invest. And they do. Warren Buffett didn’t buy ordinary shares but rather lent them 10 bn USD at a hefty 8% preferred dividends for an ill-timed competitive takeover. His shares are senior to all the ordinary shares, and even if Occidental goes under, he will likely make his money back. Unlike Carl Icahn, you don’t have the fire power to oust the board either and press for substantial changes. Companies with high debt like Occidental Petroleum are at highly elevated risk. The outlook for shale producers has indeed changed substantially with Saudi Arabia initiating a price war on oil.

Ready to be ‘kindered’? Maybe not!

Kinder Morgan (NYSE:KMI), on the other hand, could be considered. Many Seeking Alpha readers still remember getting ‘kindered’ in 2015 and won’t touch the company ever again. History teaches us to be careful.

Kinder Morgan is a pipeline company that appeared ‘safe’ in the last oil crash as it had fixed take or pay contracts with its counter parties. Chairman Richard Kinder famously promised the safety of the dividend just months before the debt load of the company and a looming downgrade of its credit rating forced the company to cut the dividends. KMI has learned its lesson, deleveraged substantially and is now self-funding all their pipeline projects. Dividends are just 87% of free cash flow. While I do not expect Kinder to stick with the promised 25% dividend increase (which will undoubtedly lead to another outcry of ‘kindering’), the company is much safer than it used to be.

The same thing cannot necessarily be said for other midstream companies.

Is there a play on toilet paper?

There really aren’t pure play toilet paper companies out there that are publicly traded.

Kimberly-Clark (NYSE:KMB) has a sizable chunk of their product portfolio (~33%) in consumer tissues and business to business (17%). The known brands are Kleenex, Scott, and Alex. Both segments sell bathroom and facial cleaning tissues and together represent 50% of the company. That is about the closest you will get.

Procter & Gamble (PG) tugs its Charmin brand away in the 25% segment called Baby, Feminine, and Family Care.

Kimberly is classified as a consumer staples company, indicating their products have above-average recession resistance, as they are necessary and will continued to be bought as opposed to consumer discretionary.

The stock is holding up better than the market average and has a 3.19% dividend yield. Attractive compared to the today announced Fed rate of 0.00-0.25%.

A stable company with an A credit rating, a decent dividend yield, and more demand than they can satisfy. Sounds like a solid investment opportunity.

Before you pull the trigger, I’d like you to consider this: Q1 results should by all accounts blow expectations out of the water, as supply hoarding fully is fully loading manufacturing capacities. As outlined in the introduction, though, there is no long-term demand growth for toilet paper driven by the coronavirus. It just doesn’t affect the digestive track.

Whenever the panic subsides, demand will dip below average until the stockpiles are ‘burned off’. Annual earnings will be largely unaffected.

What matters is valuation. Kimberly-Clark with a reliable 5-6% a year earnings growth has an elevated PE of over 19. Its historic valuation tends to fluctuate PE between 15 and 17. In May 2018, it was available for a PE of under 16. During the great recession, it dropped as low as 11. This one goes on the watch list. When it hits fair value or below, it is a great stock to invest.

Probably right around the time we have stocks of toilet paper again…

Disclosure: I am/we are long KMI. 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.

Additional disclosure: I am not a professional investment adviser. While I have done quite well in the stock market, I always recommend you do your own diligence on the stocks discussed. Investing is the art of forecasting future earnings. Forecasting turns out to be rather difficult, especially when it concerns the future!

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