Benjamin Graham (the founder of value investing) originally came up with the concept of margin of safety. The idea is to buy a security at a large enough discount to its true worth, that you can greatly reduce your chances of losses, while also maintaining a maximum profit potential. To determine intrinsic value, one uses extensive fundamental and qualitative analysis. Buying undervalued securities, does not prevent the securities from dropping further of course, as we’ve seen in this Covid-19-driven bear market.
We are seeing levels of fear that are extremely uncommon and aberrational. The impact started abroad, reached Wall Street, and is now being seen in the day to day lives of billions of people across the globe. Nearly every stock and industry has sold off dramatically, which is a true sign of universal panic. While most industries will see reduced earnings due to this pandemic, that doesn’t mean that these businesses will actually be losing money.
In fact for the big banks, for instance, every year they run stress tests forecasting how they would hold up in disastrous recessions (which I don’t foresee with this.) They still make quite a bit of money, as would many technology companies, healthcare companies, etc. With our key financial positions, we own them at significant discounts to a conservative estimate of tangible book value, which is a proxy for liquidation value. They should be able to materially grow these metrics via earning money and buying back stock at absurdly cheap prices.
So if we own a stock at $40, which we believe on a conservative basis is worth $60, and it drops to $28 in a bear market, the key thing to keep in mind is the underlying business. Did the business lose billions of dollars to justify the decline? If so, maybe it is a warranted fall. I don’t see that in this scenario for companies that we own. Instead I see them in a rare position where they have so much extra capital that they can actually buy their stock at $28, so that $60 intrinsic value number would actually go up.
The Financial Crisis was very different. The banking system had far less capital and liquidity. When real estate tanked, it revealed a house of cards, leading to hundreds of billions of losses. Then in a need to raise capital, many companies had to issue stock at increasingly reduced prices. Turning to the current situation, we have dramatically more capital and liquidity. Profitability is strong and should continue to be, although down from the highs.
At some point, the Coronavirus concerns will dissipate. In China and South Korea, they are making incredible progress in reducing the rate of new transmissions. Unfortunately, the trajectory is not as promising in the United States and Europe, but major actions are being taken. The economy is going to face a major slowdown for a quarter or two, but the long-term outlook is still extremely promising. There will be material pent-up demand. Governments across the globe are beginning to take major fiscal actions to stimulate their economies, which has been overdue in Europe. This is a Black Swan event, so taking extra actions makes a lot of sense in my estimation, with fiscal ones being the most desirable, especially given these governments are borrowing at basically free rates.
It stinks going through a bear market, especially one as sudden as this. If you own a restaurant, a bar, or a coffee shop, you are going to be impacted by this. Are you going to sell them, because of a few terrible months? If you can hold on you wouldn’t, but of course weaker competitors might succumb to the pressure, providing better opportunities for those that can make it through. The stock market is forward looking, so I’d expect that when things still look really bleak, prices will recover, but I can’t tell you when that will be. We’ve likely endured the biggest mark to market pain, but maybe 10-15% more potential downside, is worth the 50-100% upside over a few years on certain investments.
Beyond finances, people are scared for their loved ones, their jobs, etc. Hopefully these concerns are proven to be overblown, but taking due caution for a virus we don’t totally understand seems rational to me. We will all be better off working together to get past this bizarre episode. Since everyone is focused on this now, I think it is likely that we can start seeing real progress.