Yesterday, I was on a panel with the FT’s John Plender as part of a series of online workshops hosted by the Lorange Network. (Link)
Under Chatham House rules, I can’t tell you who said what. But I can share my thoughts. Below are some notes on a few of the ideas I touched on, amplified by some additional research I pulled for this post.
One topic that came up early was this widespread idea that “the market” is out of sync with “the economy.” The argument usually goes like this: We’re in the midst of a severe recession and yet the market floats near all-time highs. Boy, the market is dumb.
In the US, when people say “the market” they usually refer to some index, such as the S&P 500. Well, let’s look at the S&P 500. As many others have said, the top 5 dominate the index. They represent ~20% of the value of the index and have been the main driver of its return. In the first half of the year, about 30% of the S&P’s gains came from the top 5.
If you look at the rest of the index, you see a different set of results. Here is a table I saw yesterday on Twitter from somebody (forget who). Focus, for the moment, on market cap and year-to-date returns:
You can see that within the index itself, you get a wide variety of returns. And so far, returns have pretty much followed market cap. The bigger you are, the better you have done. The smaller you are, the worse.
Do you still think the S&P is out of sync with “the economy” now? You may still hold that opinion of course. But you might argue it differently.
Second, I always like to point out, because so many forget this, that the value of a firm is not much affected by 1 or 2 year’s worth of earnings. The value of a business is all the cash you can get out of it, discounted back to the present day.
Now, we can’t know what those cash flows will be and we don’t even know what the discount rate should be, but we know this is theoretically what a company should be worth. Just by playing around with numbers, you will find that years 1-3 contribute maybe around 10% of present value. (The exact number is not important). And most of the value of any business, say around 75%, comes from cash flows 5 years out and beyond. (There are exceptions, of course).
So, if the pandemic will cost us one year’s worth of earnings, then perhaps most stocks should not be down much. The market is looking ahead. Mr. Market is smart after all… (And I haven't even mentioned interest rates...)
This conclusion rests on, at least, two assumptions.
The first is that companies can get to next year without having to raise capital or otherwise suffer some kind of impairment. Long-term is a nice idea, but doesn’t help you if you go belly up in 2020. You might argue that many smaller firms, without the access to capital of larger well-capitalized businesses, won’t be able to make it to 2021 without help. Fair point, I think.
The second assumption is that the initial pre-pandemic valuation was correct. Aha, let’s talk about valuation…
You may have noticed something else in that table above. Look at those common valuation metrics -- P/E, P/S, etc. -- and see how they scale as well. The bigger you are, the better valuation you get. The smaller, the suckier.
This shouldn’t be. (I’m skeptical of these valuation ratios without some reference to some kind of return on capital and growth - but we’ll get to that in a minute.)
As I wrote about last week, I’ve been reading the new 7th edition of Valuation by Tim Koller, Marc Goedhart and David Wessels (hereafter “KGW”). They write:
“There is no evidence that size matters once companies have reached a certain size. The cutoff point probably lies in the range of a market capitalization between $250 million to $500 million…. Whether a company has a market capitalization of $1 billion, $5 billion, or more does not matter for its relative valuation in the market.”
I love the humility of the “probably,” which reminds us we’re not dealing with an exact science here. We’re trying to get the gist.
Alright, so if it’s not market cap, what does drive valuation? KGW: “the facts clearly show that individual stocks and the market as a whole track return on invested capital (ROIC) and growth.”
This is why I’m skeptical of those valuation metrics like P/E, etc., without some reference to a return on capital and growth.
You’ve surely seen those charts that show the price-earnings ratio of the market is above some long-term average. (Shiller P/E?) Ignore them. They are missing important pieces of the puzzle. What does ROIC and growth look like?
KGW again: “P/Es have shown an upward trend over the past 35 years… To a large extent, the pattern is driven by steadily increasing margins and returns capital.” Boom. (Maybe you say things will "revert." Well, maybe ExxonMobil and GE will once again be the largest market caps in the index some day. Maybe the railroads will come back too... I don't think so. Seriously, though, 35 years is a long time to be waiting for "mean reversion.")
Along these lines, you know all those charts that people like to throw out to show that some faraway market is the cheapest market in the world based on P/E, P/B, etc.? Toss them out.
The US is “more expensive” than European markets because US indexes carry higher P/Es than European ones? Toss this one out too.
All of these differences can (almost always) be explained by higher ROICs and growth rates in the higher valued market. Of course, when they are not in sync, then maybe you have an opportunity. Maybe you found a company with a valuation out-of-whack with its ROIC and growth profile. The point is, you don’t know much about valuation with the P/E alone (or the P/B, P/S, etc.).
The book has pages supporting the points I have KGW merely asserting here. I’m not going to go through all the research. If you’re that interested, I’d make the investment in the book.
So, was the initial pre-pandemic valuation correct? You might still say they were too optimistic. But, again, you will probably make the argument differently based on the above.
KGW also make this interesting point:
“Excess cash balances held by large companies form another factor [for elevated P/E ratios of recent decades]. Cash has a high implied P/E because it carries little after-tax interest. Correcting for the excess cash balance in corporate P/Es lower the 2017 ratio for the market as a whole by a full point, from 19 to 18.”
Counterintuitive, but… yeah. (Think about it).
Pandemic Investing
The theme of the Lorange panel was investing during the time of the coronavirus. I think pandemic investing is going to be a thing, like crisis investing.
Pandemics seem likely to continue to happen. We’ve already had a handful of health scares in the past 20 years or so and we finally got the big one. There’s lots of research out there that would support the idea that such pandemics will be more common in the future. For example, my wife is reading Spillover: Animal Infections and the Next Human Pandemic by Davi Quammen. I haven’t read it, but I’ve heard a lot about it from her. (She really likes the book). Here’s a bit of the jacket blurb:
“The emergence of strange new diseases is a frightening problem that seems to be getting worse. In this age of speedy travel, it threatens a worldwide pandemic. We hear news reports of Ebola, SARS, AIDS, and something called Hendra killing horses and people in Australia―but those reports miss the big truth that such phenomena are part of a single pattern. The bugs that transmit these diseases share one thing: they originate in wild animals and pass to humans by a process called spillover.”
Apparently, for a variety of reasons, these things are happening more frequently now. As investors, we have a new risk to underwrite, no different than the risk of recessions.
We have periodic recessions. They happen. We know they will continue to happen. It is a risk we underwrite and think about when we invest in a company. We look out over a full business cycle.
And the market takes this into account too. It’s why businesses such as auto manufacturers trade at relatively low valuations in good times. People know that in bad times they will lose money… so the market takes that into account in pricing those securities as compared to, say, a software company whose earnings are more resilient in bad times. The latter will enjoy a higher valuation as a result…
Now I believe we will see a new set of discounts and premiums imputed into stock prices. (To an extent, this has already happened). Those businesses most affected by a pandemic will trade at discounts versus those that can continue to operate normally (more or less). This shift will be permanent, in the same way we still price auto manufacturers with recession risk in mind, even when a recession ends.
Best Returns from Here?
** Having said that, the best returns from here over the next few years will probably be in areas most affected by the pandemic. Recall that a firm’s value is based on discounted cash flows. Recall, too, that most of the value comes from 5 years and beyond. Maybe 10% comes from years 1-3… but many travel stocks are down a lot more than that from their highs. Maybe there is an opportunity -- if cash flows do rebound on trend within 5 years.
** It’s not a gimme that travel rebounds quickly. Let’s look at business travel. In the UK, business travel fell for three years after 9/11… and even before the pandemic it was still below 2007 peak. Could that pattern repeat here? This is worse than 9/11... There is a risk the whole trend line just shifted downward, more or less permanently, because of the virus…
** The US might be different. In the US, about 90% of business trips are domestic, with about 80% of these trips happening by car. I suspect this kind of travel will continue. If they have a choice, people may prefer driving over public transportation or flying. There are many investment implications of this shift, if it happens...
** I would remind you to think about competition. If ¼ of bars and restaurants never reopen (as some are predicting), then that’s an opportunity for the businesses that remain. How much capacity has come out of (or will come out of) hotels, restaurants, office space, oil, etc.? In the wake of the withdrawals, the remaining capital may have a bright future.
By the way, there is a whole theory built around investing on capital cycles. See Capital Account: A Money Manager's Reports on a Turbulent Decade 1993-2002 and Capital Returns: Investing Through The Capital Cycle.
** Some business models are broken because of social distancing. What do you do if you run a bar or pub where people are usually packed in? Those businesses depend on volume, they depend on sales per square foot, or they do not work as well... which means margins come down, costs go up and the multiple placed on that business is much lower… I think we should underwrite businesses as if social distancing is here to stay -- if not continuously, then as something that recurs, like recessions.
** Will companies carry more cash? Will leverage ratios fall? There are a number of businesses, particularly in finance, that depend on leverage to generate a good return for investors. If these companies now must operate with lower levels of leverage because they have to factor in a potential period of being in a lockdown, then it seems valuations on those stocks will also come down.
Aircraft leasing, for example, only “works” because of leverage. The return on assets is very low. If they dial back the leverage, all else being equal, they are not as attractive return vehicles for equity investors as before. How many other businesses are like this? Dependent on cheap debt to generate an acceptable return? I suspect many more...
** More plastics and packaging… I was at a luncheon earlier this week. Everybody practiced social distancing and it was outside. I found it interesting that the host had all the side dishes in plastic containers. Suddenly there was a lot more stuff to this lunch, a proliferation of containers and wrappers and wipes, etc… We created a lot more garbage than usual.
Not a good trend, I admit. But I wonder if this kind of thing will become the norm. Lots of implications here -- from makers of packaging and plastics, to trash removal.
** There is a lot more to think about when it comes to “pandemic investing.” In some ways, there will be no return to “normal.” Just as in a post-9/11 world, we all got used to new security measures, etc.., we will all get used to a certain amount of post-COVID protocols too. And in the folds and creases of change, there will be some interesting opportunities, I am sure.
Thank you for reading and have a great weekend.
***
Published July 16, 2020
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