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THIS TOO SHALL PASS,
BUT WHAT THEN?
Renier de Bruyn
May 20, 2020
Read more below or listen to Renier's views here:
The extreme volatility in markets worldwide over the past three months is a clear sign of acute investor uncertainty over the outcome of the COVID-19 pandemic and the severe economic consequences of lockdowns in most parts of the world.
The uncertainty is of course understandable, given that the world hasn’t in living memory shut down its economies to such an extent before. We also don’t know for sure for how long these economic sacrifices will need to continue. Consequently, many companies have withdrawn guidance, while suspending dividends and reducing capital expenditure to preserve cash.
What we do know is that at some point, the crisis will start to abate and economic activity will gradually return. The question is, however: what exactly will this post-pandemic world look like, and what can investors do to ensure their portfolios are appropriately positioned in preparation for this new reality?
We’ve heard many quite logical predictions over the past few weeks of what we can expect beyond COVID-19. However, the truth is that there are just too many variables to accurately forecast the future with confidence. What’s more, many studies have proven the limitations of forecasting, even by specialists. With the benefit of hindsight, one can simply refer to the many ‘expert’ predictions made in the midst of the Global Financial Crisis (GFC) in 2008 to realise how inaccurate forecasts often are.
In the investment world, the problem is exacerbated by the fact that the market discounts new information very quickly. For example, the worldwide lockdowns have accelerated the trend of digital adoption by consumers. This is already evident in the disparate share valuations of online companies that have been more resilient to the lockdowns than companies in the airline, tourism and offline retail sectors, for instance.
Given the current relative valuation gap, future outperformance of the online players will be more challenging to achieve. In addition, while the lockdowns introduced digital services to many first-time users who may likely return, one can also argue that people will emerge post-COVID-19 with a renewed hunger for physical social interaction and ‘offline’ experiences.
The current crisis is something the world has never seen before, and its outcome is uncertain. We should remember, however, that the world has recovered from previous crises where the aftermath has been similarly uncertain. Warren Buffett stated at last month’s Berkshire Hathaway AGM that even though he can’t predict where the economy or markets will be a year from now, he knows he can always back the US economy over the longer term. Why? Because in his 89 years, he has witnessed the economy adjusting to and recovering from several global crises – including World War 2, the Cuban missile crisis, 9/11 and the GFC. He said that over the long term, the equity market will – as it always has – continue to outperform cash and government bonds.
While Buffett was referring to the resilience of his own country’s economy, his views are also relevant to other market-based economies with stable democracies. If allowed the freedom, human beings will always adapt and will continue to pursue opportunities to improve their lives – and this ultimately drives economic growth. Crisis periods can also help drive social change and innovation, as they disrupt our daily routines and force us to reprioritise our values.
Investors are often said to be constantly ‘fighting the last war’, meaning they’re emotionally inclined to pay more attention to recent events when making forecasts, and extrapolate current trends indefinitely into the future. This does have one advantage – while the memory of a crisis is still fresh, humans tend to spring into action to prevent anything similar from happening again, as we’ve done after previous global crises.
The GFC, for example, resulted in material regulatory changes to the financial industry to make the system more resilient during future crisis periods. This will certainly be tested in the current crisis. While it’s yet early days, we haven’t seen any material threats to the solvency of major financial institutions, while central banks have been quick to support the industry with liquidity. Similarly, we can expect the world to take tough action to prevent the next major pandemic.
It should be noted that while it’s hard to estimate how lockdowns will impact company profits over the next year, these profits only contribute around 3-5% of a company’s long-term valuation. In theory, in terms of long-term valuation, it doesn’t matter too much if profits decline by 20% or even 60% in a single year – assuming a company’s balance sheet is strong enough to survive. The pace and extent of earnings recovery is far more important for long-term valuation.
We can’t predict with certainty what will happen after the current crisis. Nor can we forecast what the next one will look like. In the face of uncertainty, the best approach for investors is to ensure their portfolios are diversified appropriately to protect against unforeseen events.
At Sanlam Private Wealth, we ensure that our portfolio companies have adequate financial strength and cash generation throughout the cycle to be able to withstand downturns. Crucially, our investment process will continue to focus on the price we pay for assets, where the valuation offers both better prospective returns and margins of safety.
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