“You make most of your money in a bear market, you just don’t realise it at the time” Shelby Cullom Davis, an experienced value investor.
It goes without saying that the circumstances we’re living in are extraordinary. As well as the substantial cost in human lives, coronavirus has triggered a slump in global equity markets, which have fallen around 35% since peaking in early February. Global stocks (at the time of writing) are now back to 2016 levels, while some large-cap UK equities have retreated to levels last seen in 2010.
In such unusual conditions, it’s understandable to see extreme market moves. Measures of stock market volatility (such as the VIX index) have surpassed levels reached in the financial crisis of 2008–2009. However, it’s important to remember that the global economy has recovered from financial crises in the past. Although we can’t say when, it’s our view that ‘normal’ economic conditions will return.
With that view in mind, we’ve outlined below some reasons why we do not recommend a ‘flight to safety at any price’ approach to our clients. We also explain why current market levels provide an attractive opportunity for investors willing to look beyond current uncertainty and volatility to increase their equity allocations.
Like previous crises, this one will eventually pass. Panicked investors are doing what they always do – greedily buying high when everything looks rosy, then fearfully selling low when markets fall. It is worth remembering that, as fears about the economic implications of coronavirus cause share prices to be marked down aggressively; these moves only seem logical if you believe that coronavirus will cause a permanent rather than a temporary reduction in companies’ earnings power. If, on the other hand, you believe that the issue will eventually be resolved and earnings will recover, the recent turmoil has created some very attractive investment opportunities.
Markets are a massive discounting mechanism. As value investors, we understand that markets tend to overreact on both the upside and downside and extrapolate short-term trends into the future. This causes company share prices to move significantly more than is warranted by changes in the intrinsic value of the underlying business. It also creates opportunities for those willing to take a longer-term view. The reality is that, for many companies with robust balance sheets, while the coronavirus will significantly impact what they will earn over the next few quarters (perhaps even 12 months or more), it will have only slightly lowered the intrinsic value of their business, which is a claim on a long-term stream of cashflows.
Therefore, for the long-term investor who has no need to sell assets to create liquidity, this volatility in share prices provides an opportunity to be taken advantage of, although this requires an unemotional and disciplined approach. These are the times when experienced value investors (Warren Buffett, Sir John Templeton, Peter Lynch and many more), are not, in poker terminology, ‘weak hands’. They take advantage of others’ extreme fear to buy companies at either attractive or exceedingly cheap valuations and hold them for the long term to realise their potential.
Risk is not volatility in share prices. Risk is permanent loss or impairment of capital. Selling now will only crystallise losses. If you think this isn’t the bottom, why do you think you will be able to pick the bottom? We don’t think we are so clever that we can time when we will hit the bottom, but we do know that by buying when valuations are in our favour and not selling if markets go down further (or even buying more) we are averaging down, giving us a much better chance of making good long-term returns.
Why not sell now and buy when things have become clearer?By the time things have begun to improve and we see evidence of the virus’s effects becoming less severe, or economic news has begun to improve marginally, markets will have already priced these improvements in. You will have missed out on some big gains. If there is a vaccine announcement, markets will have spiked before you get a chance to get back in.
No-one rings a bell at the bottom.Looking back, it is now obvious that you should have increased allocations to equities in March 2009, but it certainly was not clear at the time. Every corporate and economic headline was incredibly depressing and would have been urging you to stay away from equities, or even worse, capitulate and sell out. In the months following the market trough of March 2009, the corporate news flow continued to deteriorate, with numerous profit warnings followed by relentless analyst downgrades. However, markets had already discounted these, rallying before negative news flow had peaked. The growth in social media and the constant need to digest news over the past 11 years means that ‘noise’ is even worse this time around. Again, we focus on the long term and what will things be like in five years’ time.
Although it felt very uncomfortable at the time, 2008–2009 provided an excellent opportunity for those that were prepared to look past the volatility. Taking a dispassionate and rational investment view, you can take advantage of investors with short time horizons, who are liquidating portfolios because they are unwilling to take a long-term view and accept short-term volatility. We believe that the same opportunities are being presented currently.
Are we going to look stupid? Probably, yes, in the short term. Extreme market moves mean that it’s very unlikely that we are going to catch the bottom. If markets fall even further in the short term, we may even increase allocations to equities further if valuations become even more appealing and enhance the return profile of clients’ portfolios.
As value investors, we have been taking an incremental approach to asset allocation over the past few years, gradually shifting away from assets that have made strong gains and looked expensive relative to their earnings or income and moving into underappreciated assets that have lagged and look better value. We continue to take the same approach now as, crucially, we do not want to have the same portfolio coming out of this crisis as we did at the start. Hence, we are trimming more defensive assets, such as bonds and cash, that have held up relatively well and adding to more economically-sensitive assets, such as equities, that have fallen significantly but, from here, should provide strong returns for portfolios over the next three to five years. As per the recent note from Andrew Birt, we are recommending increased weightings to UK and Emerging Markets / Asia where appropriate.
The table from Cornerstone Macro below highlights the 20 biggest one day falls in the S&P 500 index and subsequent returns over various time periods. With a few exceptions, patient investors were rewarded 12 months later, while average returns were c24% higher 18 months later.