04 March 2020

    Time to be greedy?

    Is it time to buy? Time to be greedy when others are fearful?

    Share markets around the globe endured significant falls over the past week with trillions of dollars of value wiped off the market. Interest rates have fallen to historical lows. Is it time to buy? Time to be greedy when others are fearful? Valuations relative to interest rates look appealing but the bargains come with high levels of risk. We counsel neither fear nor greed, but patience.

    This article first was first published in the NBR

    Quite a week 

    Six days. Six days was all it took to for the pendulum to swing from a very buoyant start to 2020 on global share markets, to falling in excess of 10%. A fall of more than 10% is commonly referred as a correction. According to data from Deutsche Bank Global research six days is the fastest correction in the S&P 500, the most recognised measure for the performance of the United States share market, on record. Ever.

    At the same time the rush to embrace safe haven assets has meant interest rates have fallen towards all-time lows in almost every market around the world. In the United States 10 year treasury rates fell below 1.2% on Friday. That is an all-time low. New Zealand Government bond yields are hovering just above lows but look likely to head lower.

    So two records in a week. Fastest correction, lowest interest rates. Warren Buffet famously reminds us to be greedy when others are fearful. Well there is a lot of fear. Is it time to be greedy?

    Catalysts, context and coronavirus

    The catalyst for the fall in both shares and interest rates has of course been an increasingly widely spread epidemic of a new virus, SARS-CoV-2, coronavirus.

    While most market commentary is specific to the virus the extent that it might spread and the potential economic impact, this doesn’t necessarily explain why the market’s response to the virus has been, well, so virulent.

    The events that start a sell off and the long run share price consequences can get mixed up in volatile markets. An important question is whether coronavirus is the sole factor sustaining the markets swoon.

    To help answer that context is important. Without this context deciding what to do next as an investor is impossible.

    The context to this sell off is that share markets have been very strong, not only in the early part of 2020, but have had a decade long bull market. While the underpinnings of bull market were sound - strong and sustained earnings growth - even before the coronavirus cracks were beginning to appear.

    And it wasn’t just one crack.

    The market’s apparent strength had been increasingly concentrated in a smaller and smaller group of mega sized winners. Names that we all know like Amazon, Google and Microsoft were almost solely responsible for driving the market higher; in fact up to its peak in February 68% of the US share market’s gain thus year was driven by just ten companies.

    This same dynamic had pushed the valuation of shares towards peak prices, although still a long way below the infamous tech bubble of 2000.

    An increasingly narrow market of few winners and many losers and extended valuations, creates a tinder dry environment, vulnerable to a spark.

    Coronavirus provided that spark and of course is already having far reaching consequences affecting both economic activity and company earnings. But its impact is amplified by the market environment that it spawned into.

    Time to be greedy?

    With that background noted US shares are, as of Friday 28 February down 12.9%. That is a material fall. The VIX index, which measures market variability and is a good gauge of market fear is at its highest in a decade. Supermarkets are running out of products as people prepare for the coming coronavirus. This would all seem to fit Mr Buffett’s definition of “fear.” Time to be greedy?

    Maybe, maybe not. There are a few things to consider before answering that!

    The short and long term impact on companies

    2008 and the global financial crisis taught us all one very important lesson - when there is a material shock to an economy, think carefully about the impact both to the short term cash flows and the long term earning power of a company. Ignore either at your peril.

    Short term cash flow is about survival. The best business in the world is a bad investment if it runs out of cash and can’t pay the rent. While the coronavirus epidemic is unlikely to stress the balance sheets of larger companies it may do if it drags on for too long. And life will be tough for smaller import oriented businesses if global trade remains frozen.

    Long term earnings drive the long term value of a business. Coronavirus will, in our view, only have a small impact on the long run earning power of companies. Hence it will only marginally lower long run company value. The epidemic has exposed the risk of supply chains focussed on one country and in fact one part of the world. Expect this to change. That change will come at a cost.

    This is one point to the Greedy. The short term is manageable, the long run looks largely unaffected. Fear may be a chance to profit. But that’s just one point.

    What the market sell off implies for economic growth

    In the last seven days the US S&P 500 share market index shed $3.7t of value. To put that in context the entire productive capacity of the US economy, measured by GDP, was $21.7t last year. If coronavirus just has a one year affect the movement in market values suggest that the US economy could shrink by more than 10%. That seems unlikely, possible, but unlikely.

    Of course that very simple maths is just that, too simplistic. If the economy did fall that much it would take a number of years to recover, but the general point is valid. The market has already factored in a material fall in economic activity.

    Or has it? And that’s where the valuation picture going into the coronavirus epidemic complicates things. Part of the sell off is undoubtedly driven by a change in people’s risk perceptions and their enthusiasm to own highly priced shares into what will, at best, be softer economic growth, and at worst a recession. That might mean less economic damage is priced in than it appears.

    Let’s call that one a draw. No reason for greed there!

    Dividend yields attractive compared to fixed income

    Another way of looking at the outlook for shares is to consider returns against other asset classes.

    One simple approach to do this is to compare the dividends paid from shares against government interest rates. In practice that mirrors a decision that investor’s face in the real world. Where to put their money – in fixed income or in shares?

    As of Friday night US Treasury bonds yield a paltry 1.2%pa for the next ten years. On the other hand the dividend yield, based admittedly on analyst forecasts for next year, for the US S&P 500 share market index is 2.2%, a full 1% above Treasuries.

    This is unusual. For much of history dividend yields have been lower than government interest rates. In the recent past the only times dividend yields have approached anything like this premium to Treasuries it has been a good time to buy shares. Well at least in a relative sense.

    Therein lies the rub. In this framework shares do look like interesting value but that is partly predicated on extraordinarily low interest rates. Future returns for both asset classes look muted, shares just less so given recent moves.

    Half a point to the greedy.

    Are there lots of bargains?

    This is where the rubber meets the road. If it’s truly time to be greedy there should be a lot of cheap companies out there for us to buy. That was the case in 2008. High quality companies with long growth runways and great management looked very cheap. It was a portfolio manager’s dream.

    “Bargains” in today’s market are beginning to emerge. But you will need to be brave. The statistically cheap companies are in sectors most affected by the coronavirus. Think travel related companies, firms in the oil and gas sector and those companies servicing them, like Schlumberger.

    Cruise line company Carnival Corporation, for instance, is now trading on a single digit PE ratio, a 5% dividend yield with only 50% of profits being paid out as dividends. Feeling brave?

    Bargains in the sort of companies we prefer, high quality growth firms, are not yet there. Today we would characterise pricing of these as getting back towards reasonable from levels that were clearly stretched earlier in the year.

    Neither greedy nor fearful be

    Paraphrasing Polonius we would counsel neither fear nor greed, but patience.

    While the move down in share prices in recent days has gone some way towards improving the long run valuation arithmetic of the market the full extent of the coronavirus is yet to be seen and valuations for the sort of companies we would look to buy on a panic induced sell off are not outstandingly cheap.

    So patience not greed. But be ready, your chance to buy might not be too far away.