The Covid-19 health crisis continues to evolve globally, and slowly we are learning more about the virus. There have been quite a few serology studies in various regions of the country, where they are examining how many people possess Covid-19 antibodies. The results of the studies seem to indicate that the true number of infected is many many times greater than we know, which would greatly reduce the mortality and morbidity rates of the virus. It doesn’t change the fact that we still have to deal with it and there are risks to all of us and our families, but it is important to understand what we are dealing with, because every decision has pros and cons. The current lock-down obviously has devastating economic consequences, which leads to tremendous health and other problems in its own right.
Slowly, regions are starting to either open up or develop plans to do so. Even hard-hit NYC and Italy, are making plans, which is really encouraging. Fiscal stimulus has been very slow to filter its way through the economy, but ultimately it will, and will help mitigate some of the damage done. However, there is no doubt we are currently in a deep and severe global recession, unlike anything we have ever seen.
Many market participants and analysts look at this recession and believe it only makes sense for stocks to fall further, as they did in 2008 and 2000. The dynamics of this recession are very different, as there has been a much bigger and more rapid fiscal response. Even more importantly, is that there weren’t the same structural imbalances going into this one, as there were in 2008. The virus is a temporary plague on the world but businesses will re-open, and when they do, things will get better. They won’t go back to where they were immediately by any stretch, but they will get a heck of a lot better than how they are now. The market will be focused on 2021 and 2022, more than economic data from 2020, as it is a forward looking mechanism.
Value stocks have never been more out of favor than they are right now. Many are in cyclical industries that have been particularly hard hit during this crisis, where the economy went from strong to a disaster in such a short period of time. Money has flocked to healthcare and technology, which people may view to be “safe havens.” During the short-term that might seem smart, but what ultimately drives stock values are the business fundamentals versus the price. Tech companies are also susceptible to these economic headwinds, as consumers and businesses cut costs on things like advertising, subscriptions, hardware, etc. Valuations on these names are very stretched, versus the value areas being immensely cheap. Value stocks tend to bottom first in a bear market and recover the fastest. If the economy bottoms in Q2 of 2020 and starts recovering bit by bit, that would be hugely beneficial for those sectors that have been most heavily impacted.
The fear of the unknown has driven down prices to levels that would only make sense if we are going to go through a prolonged depression. As we talked about before with the banks, they still posted profits despite adding some of the biggest reserves in history, including an accounting change that front-loaded future losses. Even where there are still major prohibitions, people are venturing out more with the weather improving. The economy will bounce back and so will value stocks along with it. Value stocks are exactly what you want to own with a 3-5 year perspective, as they are more undervalued on a relative basis than they have ever been, and on an absolute basis, they are the only truly cheap area of the market. I see a very clear path for many of these stocks do rise by 50-100%, as more clarity emerges, which is consistent with how many recovered in 2009. The market will never give you a date at which things are going to rise or fall, so we need to be invested to see the benefit, even when news around us is still negative. We have the horses in the portfolio to really capitalize, which is vital.
Below is a great article by Verdad on Warren Buffett when he was posting his best investment returns, and then talking about some of the reasons he closed his hedge fund, which had a lot to do with valuations on value stocks, which were his favorites then, more than ever.
“From 1957 to 1969, deep-value stocks went from trading at 3x price-to-cash-flow to over 7x price-to-cash flow, nearing the all-time peak valuation for value stocks. Buffett’s return of 24.5% per year in his first decade was a virtually identical result to simply buying the cheapest 10% of stocks in the market (for context, during that decade, this decile of the market was about 75 stocks that averaged about $75 million in market cap).
By the end of 1970, Buffett had legendary trailing returns but was selecting from a group of stocks that was generating about one third as much cash flow per dollar invested as when he launched his fund. And he had to do this with $100 million (a large sum in 1970), which severely limited his ability to gain meaningful exposure to the smallest and most attractive bargains, as he noted in his letter.
Buffett’s decision to close down his fund proved prescient. Multiples for deep-value stocks compressed dramatically over the next few years, dropping to near all-time lows during the peak of the “Nifty Fifty” bubble.
Fast forward to 2020. What should a deep-value investor think about the US market today if they look at it the way Buffett did in 1970?
After the last few years of deep-value stocks selling off relative to growth stocks, and the last few months of deep value getting punished even further relative to others, deep-value stocks are now about as attractive on pricing as when Buffett launched his fund. They traded down to around 2.6x price-to-cash flow at the bottom in late March.
We believe that market multiples explain short- and long-term portfolio returns more than most market spectators probably appreciate. But this is how investors have historically achieved multi-year double-digit returns: buying stocks with high earnings potential at ~30% cash flow yield and holding through the near-term pessimism, rather than trying to predict next quarter’s earnings.
As Buffett later noted, “The most common cause of low prices is pessimism—sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer.”