First Quarter 2020 Update
Globescan Capital was founded on the principle that investing in high-quality companies at attractive prices is the best and most consistent strategy to achieve long-run risk adjusted performance. This remains as true today as it has ever been. Regardless of any recent market movements, we maintain the same disciplined adherence to that principle.
In the first quarter of 2020, we continued our record of outperforming the returns an investor would have attained by simply investing in a passive S&P 500 product. Of course, we realize that this outperformance is little comfort when you, our clients, are still looking at double-digit absolute losses. It is in this context that we want to once again express our gratitude for continuing to maintain a long-term view in the face of a very real and very present public health crisis- as most investment firms have been inundated with calls from panicked clients wanting to sell out at the worst possible time, we have in fact seen net inflows into our strategy.
That said, we thought we would spend this update addressing two pertinent questions that may be on your mind:
Why didn’t we sell everything in February when it was apparent that a global pandemic was a possibility?
Why shouldn’t stock prices go lower, or even to zero, if the economy is effectively shut down and business earnings are going to be zero?
Question 1. Why didn’t we sell everything before this happened?
There are two parts to this answer: Firstly, hindsight is 20/20 and even the most experienced and highly informed doctors and pathologists in the world could not predict how this pandemic would develop back in February, so for us to have been able to do so would likely only have been the result of a lucky gamble.
Secondly, and more importantly, the very question itself isn’t really relevant when you’re thinking in terms of years rather than in terms of months. The reason for this relates to a concept that we have talked about before – long-term investing as a competitive advantage.
Recall that stock prices are driven by only two things: short term sentiment shifts and long-term fundamentals. When we say, “long-term investing”, what we are really saying is to ignore the former and focus on the latter.
Even if we could predict economic and geopolitical events with any degree of accuracy, we still couldn't predict how the market would respond to those events. The market can wake up sadder or happier on any given day than is actually warranted by the news flow – being driven at times by both extreme unfounded pessimism and extreme unfounded optimism.
Consider that the impact of Covid-19 could get much worse from today and stocks could actually go up. A counter-intuitive thought but recall that 2009 was the worse year of the last recession from an economic metrics perspective while being one of the best years ever from a stock market return perspective. The point being that short-term market movements are unpredictable and not related to underlying business economics.
But what we can predict (to varying degrees of certainty) are the economic fundamentals of the businesses we own. If we think a company is going to generate a roughly 10% cash earnings CAGR (compound annual growth rate) over the next few decades, it doesn't matter if its stock gets cut in half in any given year, our long-term investor returns will track that 10% earnings growth.
Trying to juice that return by jumping in and out of the market and predicting something that is unpredictable is no more than hoping to get lucky. We rather not rely on luck for our returns.
Question 2. Why won’t stock prices go lower from here?
Firstly, they might. But again, that isn’t really the issue for us. The real answer to question 2 relates to another concept that we have talked about before – business valuation.
Recall that during panics like these, stock prices stop being driven by underlying business value – rather, they are driven by a combination of emotion and liquidity needs. The volatility this creates is actually a good thing for us as active investors since it creates an environment where very high-quality companies trade at prices now where our future return potential is higher than it has been in a decade.
But back to the question, if the economy shuts down and earnings drop to zero for these companies, shouldn’t their stock price also drop to zero? Two points to make here:
Any given business is worth the present value of all the future free cash flow it can generate, discounted at a reasonable rate of interest to account for the fact that you won’t get all the cash today, you only get part of it each year. Without going into the math, what this means in practice is that the terminal (long-term) value makes up roughly 75% of the total value of any given 5-year discounted cash flow model. Therefore, if we value a given solvent company at $100, and then this virus shock causes earnings to collapse to zero for the whole year, it will only impact the company’s intrinsic value by 5% assuming demand bounces back, and by only 15% assuming no bounce back growth. If said company sold off 40%+, then it is actually more attractive today than before the virus shock. We have seen many such examples of this in the market over the last few weeks (see our recent articles and market updates).
Notice that we said, “solvent company”. Right now, we are having to assess genuine liquidity and cash burn rates, asking the question “how many months can this company survive if revenue drops to zero”. You’ll be happy to know that we have stress tested our portfolio and are comfortable that the shutdown can roll on for many months and even our most exposed portfolio holdings should be able to weather the storm. However, this isn’t true of all companies in the market, so take note passive and index investors – you are holding some companies that will likely go out of business over the next year.
This Crisis in Context
It is also important that we take some time to reiterate the fact that 100% of past crises have proven to be good buying opportunities over the long run – for the simple reason that people always panic and forget that humanity is really, really good adapting to adversity. We have talked about prior crises before – pandemics, world wars, the rise of communism, the threat of nuclear annihilation, etc, and while there are few major historical precedents for a near total economic shutdown, there are some.
Consider that in 1945, at the end of World War 2, German’s economy was effectively starting from zero. Allied Forces had bombed large parts of its infrastructure. The city of Dresden was completely destroyed. The population of Cologne had dropped from 750,000 to 32,000. There was very little hope at that time of them ever reaching their pre-war standard of living. But Germany returned to trend-line growth within a decade – a testament to human ingenuity triumphing over great calamity.
Unlike this example, today we have the enormous advantage of being able to resume our economic growth with our physical and human capital intact – as such, we should expect a speedier recovery.
And we are already seeing some good news on the Covid-19 front – it is possible the R0 (transmission rate) of the virus is much higher than is being reported, suggesting a much lower than estimated fatality rate and much greater probability of herd immunity developing. Recent data suggests slowing infection rates in many parts of the world.
At the same time, every research institute in the world has redirected their work towards solving this problem – maybe the first time in our lifetimes that the whole world is all-in on solving one single problem, allies and enemies alike. Additionally, central banks and fiscal authorities are committed to making sure there is a floor to the economic suffering world-wide – for starters, by slashing rates aggressively and sending out stimulus checks faster than in any previous crisis.
We here at Globescan Capital are hopefully optimistic that these initiatives will pay off and in a few years’ time we will look back at this as having been a fantastic buying opportunity.
As always, please feel free to reach out to us with any questions or concerns you may have. We hope everyone is staying safe and healthy during these times.
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