This is only a moment in time. It is not permanent and it will pass.
Lessons from past crises and other thoughts on investing during (and after) COVID-19.
BloombergSen shared the following thoughts with our clients in our most recent quarterly letter to investors:
Markets and economies are always vulnerable to uncertainty. When you see stocks moving as wildly as they did this past quarter, you realize that their movement is driven by fear and panic as opposed to fundamentals. During market shocks such as these, very few are doing rational analyses of what companies are worth; rather they are selling for a whole host of non-fundamental reasons: e.g., to meet redemptions, to cover margin calls, to deleverage themselves and because they fear their holdings will drop even further. The table below illustrates the indiscriminate nature of the selling in the first quarter.
The last time we witnessed indiscriminate selling of this magnitude was during the 2008 financial crisis. When the crisis ended, we looked back and made pages of notes and noted numerous lessons to help guide us in the next crisis. Below are eight lessons that we feel particularly apply today:
- Equities are the ultimate long-term bond (in that they have claim on the future cash flow of a business). Think about and hold them that way. You own a piece of a real business. Do not sell a good business that is both well managed and well financed when others panic.
- Selling in market panics feels good in the short-run but causes a tremendous loss of wealth in the long run.
- There will always be someone who profited by making a big call in advance of the chaos. However, making big macro calls consistently is tremendously difficult and typically very expensive to your portfolio.
- Prices can get horribly ugly but the world does not end. Governments will try everything possible to save the system. They may look like they do not know what they are doing and much of what they try will fail, but ultimately the system will recover and improve.
- When liquidity disappears, everything goes down in price regardless of its true value.
- It is dangerous to believe, “It’s different this time.” The causes of the panic may change but the outcome has always been the same: the economy and asset prices rebound. The table below shows the market returns over one, three and five years following the worst bear markets of the last century.
- Ignore the media. The media’s reporting is primarily surface level. Worse still, they are now in the business of sensationalism.
- Both humanity and capitalism are very resilient.
Going back in history, the worst global pandemic prior to COVID-19 was the 1918 Spanish Flu, which killed 50 million people worldwide. Yet within two years, the economy and the markets were entering the roaring '20s. During World War II, two nuclear bombs were dropped on Japan, destroying most of its cities’ physical infrastructure and killing millions of its citizens. By 1945, Japan’s GDP per capita had been cut in half. Yet, within a decade, its economic output per person had completely rebounded. Finally, over the period 1980-82, U.S. Federal Reserve Chairman Paul Volcker intentionally put the economy into one of the worst recessions on record in order to stamp out runaway inflation of 14 percent. His actions caused unemployment to spike to nearly 11 percent by 1983, reaching its highest rate going back to WWII (and not surpassed even in the Great Financial Crisis). Yet, the ensuing two decades produced some of the best economic growth and stock market gains in history (the S&P 500 rose 23? fold over the next 18? years).
In times like these, it is important to determine how the true value of your assets are affected. The intrinsic value of companies is determined by their earning power and, as such, is significantly dependent on economic potential. We believe that the world’s economic potential is largely unaffected by the coronavirus pandemic as no physical infrastructure is being lost, and the loss of life, while terrible and saddening, is very small in relation to a global population of nearly 8 billion people. No one knows when the world economy will get back to normal. Ultimately, the world economy will be reactivated and those that have sufficient liquidity to make it through at least the next 18-24 months will recover.
Many of our investors are business owners. We understand and sympathize with the tremendous pain and struggle their businesses and employees are going through. Due to the global shutdown in demand, owners of cash flow generating assets (real estate, businesses, intellectual property, etc.) have seen their revenues shrivel. Moreover, given the distressed state of financial markets and other investors, it would be difficult to find a buyer for most assets today, and even if a buyer could be found, the prices would likely be distressed. As a result, no one who can avoid selling assets in this environment will do so. They know their asset is worth significantly more than the current price based on its future stream of cash flows. We feel the same as owners of the businesses in our portfolio.
How much should the value (not price) of a business decline in this environment? As an example, if you have a business growing at nominal GDP (4 percent) and assume that it will make no money for the next two years, then the discounted value of the stream of cash flows from the business has declined just 7 percent. In addition, in response to the crisis, central banks have been slashing interest rates, which reduces the cost of capital and discount rate used in valuing a business. This means that an even greater proportion of the value of an asset is in the future years, making the decline in value from the absence of earnings for two years even smaller. Our portfolio is extremely undervalued on this basis.
With all that has been going on, one group has been going against the tide in this sell-off. Corporate insiders, those who know the most about what their companies are worth, are selling less and buying more of their companies’ stock. Normally, there are more executives selling than buying their shares on a monthly basis since shares and options are a major part of their compensation. Yet, in March, the ratio flipped to 1.75 buyers for every seller, the highest ratio since the bottom of the market 11 years ago. Through March 24, more than 2,800 executives and directors had purchased nearly $1.2 billion of their companies’ shares. This represents more than five times their monthly average and the third highest level since 1988. In addition, insider selling collapsed 64 percent from the same month a year ago.
As we have always done, both in good times and bad, we encourage you to maintain a longer-term view.
This is only a moment in time. It is not permanent and it will pass.