What we know in a world of unknowns
We are currently experiencing one of the world’s most significant periods since World War II and humans are panicking in the same way as they have done in every other crisis. As at 31 March 2020, the FTSE/JSE All Share Index is down 24.8% since the beginning of the year. Over this period, the average stock in the index has declined by 34.0%, only 6.4% of stocks in the index have delivered positive returns, and 39.1% of stocks are down by over 40%. This is a proper market crash – most of which happened in the space of only a month! It is extremely difficult to predict the timing and full extent of the outcome of the current crisis. However, in this article we look at some of the things we do know, and why we believe there are long-term opportunities.
1. The world will not stop operating – companies will still produce goods and consumers will still consume.
Despite all the unknowns we are facing what we do know is that we still need to eat, we still need healthcare (more so now), we still shop online, and we still phone our friends. In fact, now more than ever we are buying goods online, consuming more data as we work from home and our kids get schooled over the internet, and watching more movies than we have in the past.
While there may be a variation in consumption patterns over the short term, quality companies that supply the goods and services we need will still be here five, 10 and 15 years from now. We don’t know how long this crisis will last or what impact it will have on the economy. But in time things will normalise – as they have done after every other crisis.
‘The future ain’t what it used to be.’ Yogi Berra
2. There will be relative winners and losers as a result of the Covid-19 pandemic.
Theoretically, when an average company has a 30% drop in its share price, it is equivalent to losing approximately six years of cash flows (on a discounted cash flow basis and based on our assumptions¹). Does this imply that the Covid-19 pandemic will result in the average company losing six years of cash flow? No, it does not. We expect good quality companies with relatively strong balance sheets, good moats (competitive advantages) and sound management to recover well. These companies are now trading at significant discounts to their intrinsic value.
However, don’t be fooled by the ‘the market being on sale’. Companies with high operating costs and lots of debt will come under severe pressure and some will go bankrupt. It is not the time to allocate capital to highly geared companies that don’t have sufficient liquidity to see themselves through this cycle.
‘The stock market is filled with individuals who know the price of everything, but the value of nothing.’ Philip Fisher
3. Current valuations are extremely attractive.
Figure 1 shows the valuations of the FTSE/JSE All Share Index (ALSI) over a period that includes the 2003 SARS pandemic, the 2008 global financial crisis and the current Covid-19 pandemic. In each of these crises we have witnessed valuations at around two standard deviations from the mean.
The long-term returns earned from previous lows have been significant. From the market’s low in April 2003, when the ALSI was trading at a price to book (PB) ratio of 1.29x, the subsequent five-year total return was 351% (which equates to an annualised return of 35.2%). From the low of the global financial crisis when the market bottomed at a PB ratio of 1.46x in February 2009, the subsequent five-year total return was 181% (an annualised return of 22.9%). As at 31 March 2020, the ALSI was trading at a PB ratio of 1.47x.
Figure 1: In the last three crises (including the Covid-19 pandemic) we have seen valuations of the ALSI at around two standard deviations from the mean.
Source: FactSet, Denker Capital (31 March 2020)
4. Average company valuations are lower than they were in the cycles since 1998.
Figure 2 uses a sample of 85 companies that make up a large part of our investible universe and that have PB ratio data on FactSet going back to 1998. The figure shows the average PB ratios at the lows of the Asian financial crisis (1998), the SARS pandemic (2003), the global financial crisis (2009), currently, and over the past 10 years. The current average PB ratio of the 85 sampled companies is almost half the 10-year average level and lower than the previous two cycles. Similar conclusions can be drawn at a sector level, as shown in Figure 3.
Figure 2: Average PB ratio of a sample of 85 companies listed on the JSE (at the lows of each of the previous crises) compared to the 10-year average.
Source: FactSet, Denker Capital (31 March 2020)
Figure 3: Most sectors are trading at valuations well below the 10-year average.
Source: FactSet, Denker Capital (31 March 2020)
We use PB ratios as a metric because book values are more stable than earnings in a crisis, and they provide a good indication of the value of an asset. Generally speaking, the lower the PB ratio (in relation to the earnings power of the company as measured by its return on equity or ROE) the cheaper the asset. It provides a lot of insight into the relative value of assets, especially if you assume that a company’s earnings power will normalise after a crisis (i.e. that it will generate a return on equity similar to what it has been able to achieve in the past). This may not be true for all companies, as some will fail and some may be structurally affected by the crisis, but it will be true for most.
5. Long-term returns are generated from the price you pay.
It’s impossible to time the market. However, as long-term investors, if you can buy R1.0 of cash flows for R0.6 (for example) then you will be rewarded with long-term returns well above inflation over time.
Looking at the facts and historical evidence, we believe this is a good time to invest in long-term opportunities.
The current environment allows us to improve the quality of the holdings of the Denker SCI Equity Fund, while increasing the probability of earning long-term returns well above inflation for our investors. Our research and in-depth analysis helps support our conviction of what we believe are great companies – companies with good management teams and balance sheets that are strong enough to withstand the threats posed by Covid-19. Many of these companies are now trading well below their intrinsic values, which presents opportunities to add to the quality of the portfolio while increasing the potential for long-term returns.
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Since markets are driven by human behaviour fuelled by fear and greed, it is important to refrain from being caught in the headlights.
While we don’t know what the future holds, it is important to act as rationally as possible by basing our decisions on what we do know.
‘In investing, what is comfortable is rarely profitable.’ Robert Arnott
Claude van Cuyck
1 An average company discounted cash flow valuation
Source: Denker Capital
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