Never before have we experienced such volatility, which is indicative of the high level of uncertainty amongst investors. So far, global markets are down roughly 25-30% for the year to date. In US dollar terms, the FTSE/JSE All Share Index is down 45%. While we are not experts on epidemiology or Covid-19, we have substantial experience in analysing companies and have navigated several market panics in the past. In this article we look at what we’ve learnt from previous crises and how we capitalise on the opportunities being created.
It’s helpful to consider the facts and look back at how markets have behaved in previous crises.
Below are some of the lessons we’ve learnt from the past that are valuable in the current turmoil.
1. Markets recovered from every crisis in the past.
Every major crisis, going back to the aftermath of the Bretton Woods system collapse in 1971, has had a very different beginning. The good news is that the market has recovered fully from every market panic over the past 50 years.
2. Despite the significant short-term pain that may be experienced during a crisis, the subsequent return potential is enormous.
A recent study conducted by Dan Rasmussen of global asset management firm Verdad, ‘Crisis Investing: How to maximise return during market panics’, reminds us of this. Verdad defines a crisis as a period when high-yield spreads rise above 6.5%. This spread measures the difference between the yields that investors demand on higher-risk junk bonds compared to low-risk investment grade bonds. In times of crisis, our ‘fight or flight’ instinct drives investors towards safe-haven assets like cash, government bonds and investment-grade bonds. Currently the high-yield spread is almost at 9%, the highest level since it hit almost 20% during the global financial crisis.
Figure 1: US High Yield Index option-adjusted spread
Source: Ice Data Indices, LLC, ICE BofA US High Yield Index Option-Adjusted Spread [BAMLH0A0HYM2], retrieved from FRED, Federal Reserve Bank of St. Louis (20 March 2020)
With panic defined as a decline of more than 20% in the S&P 500 Index, Verdad’s work illustrates the strong recovery in equity returns in the 24 months following a sell-off that exceeded 20%. Clearly it pays to be greedy when others panic. As seen in Figure 2 below, the biggest opportunities have been in small cap value investing.
Figure 2: 24-month returns for different investment styles, starting three months from a 20% drop in the S&P 500
Source: Verdad, Ken French Data Library
Our funds have a reasonable exposure to high-quality small cap value stocks. These businesses have survived several market manias and have stood the test of time as a result of robust business models and strong management teams.¹
3. Investing in the three months after a market correction has produced exceptional results in the past.
We conducted a similar study in South Africa looking at the FTSE/JSE All Share Index performance during and after a market sell-off of greater than 20%, going back to 1969. As seen in Figure 3, committing capital in the three months after a correction of 20% has produced exceptionally good results over the subsequent 12 months, and even better over 36 months. Most importantly investors did not have to time the bottom (which we know is a futile exercise). On average these sell-offs have lasted 14 months – with the shortest being four months following the 1998 emerging market correction and the longest being 28 months after the demise of the Bretton Woods system – and are followed by stagflation (rampant inflation and low economic growth).
Figure 3: The performance of the FTSE/JSE All Share Index after the market sold off more than 20%, since 1969
Source: Denker Capital, FactSet (23 March 2020)
As in the past, the current market panic has been caused by a macro crisis and has resulted in an indiscriminate sell-off of stock prices around the world.
Each macro crisis is affected by many different factors, and it’s hard to form reliable conclusions. However, it is helpful to differentiate what we know from what we don’t know. What we do know now is that the likelihood of a long-term destruction of demand and therefore business value is very low in general. As with every generalisation, there will of course be some exceptions.
We were happy with our holdings before the panic and the companies in which we are invested have become cheaper.
The time to prepare for a recession is before it hits. Our focus is on identifying great businesses with a minimum past performance and quality current financial position, and to invest when they are trading at a discount to what we think the intrinsic value is. The intrinsic value is the true economic value, which we measure by net present value of the cash flow streams over the life of the business or asset. While share prices have fallen dramatically, it’s highly unlikely that the intrinsic value of a business has fallen to the same extent. The lower prices go, the higher the upside to intrinsic value and potential future returns. We do not believe it is possible to time the bottom, and prefer to be guided by the ever-increasing prospective returns as share prices fall. The hard decision is not knowing what to buy, but how to finance these purchases. Our approach generally uses the following guidelines in times when we see opportunity.
1. We will not easily sell holdings to switch into something that looks cheap simply because it has fallen further.
If we do sell, it’s because the facts have changed and the risks have increased. In an environment where cash is scarce, those companies that can secure sufficient funding in these challenging times will survive while weaker businesses will fall over. We have always been wary of companies that have both high financial and operating leverage as it is inevitable that at some point these businesses will come under severe strain.
Our biggest concerns currently are highly geared companies in the services sector that have a high proportion of fixed costs, such as airlines, hotels, and businesses in the retail, hospitality and entertainment industries. Furthermore, the double whammy of a supply and demand shock in the oil markets has translated into significantly lower oil prices, affecting both oil producers and countries that rely on oil exports. Fortunately we have very little exposure to these industries.
Since the global financial crisis ended in 2009, companies have funded a greater portion of their expansion with debt, making them more vulnerable to external shocks, while unfortunately returns have deteriorated (as shown in Figure 4). Going forward, revenues in some industries are likely to decline for one or two quarters and some company balance sheets will be tested.
Figure 4: The declining return on equity and higher debt levels of the FTSE/JSE All Share Index
Source: FactSet (23 March 2020)
As Charlie Munger says, there are only three ways to go broke: liquor, love and leverage. I cannot offer any valuable insights on the first two that you don’t already know, but using leverage to gear investments in the market may not give companies and investors the luxury of time to ride out the sell-off. Banks that are counterparties to derivative positions may be forced to sell shares in portfolios as the contracted prices are breached. We have seen this many times in the past. Just last week the Capitec price sold off heavily as clients were forced to sell stock to cover leveraged derivative positions. The very next day the price bounced 40%.
2. We would consider selling one or more of our investments even if the absolute upside has improved to invest in a better quality business that now offers a higher prospective return for less risk.
The share prices of a few great businesses that we have been following for a while are now on sale through indiscriminate selling. Most of our recent actions have been constrained to adding to a few select existing positions in the portfolio. We have funded these by selling stocks that have held up extremely well but now look expensive relative to other opportunities.
The current environment will continue to present great opportunities.
In a recent article in the Wall Street Journal, Jason Zweig reminds us that if you are an investor (as opposed to a speculator) price fluctuations have only one significant meaning: according to famous investor Benjamin Graham, ‘an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal’.
It may be tempting to say this time is different, but over the past 50 years stock markets have survived much worse, including two world wars, a great depression, three oil shocks and the global financial crisis of 2008. The headlines could get worse in the short term and markets will likely remain volatile and may even fall further. Getting the timing right is nearly impossible. Dramatic market sell-offs are temporary and the time to have panicked has passed. Losses will only become permanent if you lock them in by selling now.
‘The investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely converting his basic advantage into a disadvantage.’ Benjamin Graham
For investors and investment managers, it’s important to distance emotions, stick to investment philosophy and process, and remain rational.
As we have seen from other countries the harsh-but-necessary actions of governments to contain the spread of Covid-19 is extremely damaging to businesses and the economy. It is likely to result in the first global recession since the global financial crisis. Looking back at previous crises, uncertainty is likely to persist in the short term. However, for long-term investors this is a wonderful opportunity to invest wisely as prices fall. Price is what you pay and value is what you get – and today the market has gone on sale.
Ricco Friedrich
¹ Denker Capital has recently launched a fund that invests in small caps in South Africa, to capitalise on some of the biggest mispricing opportunities we have seen in the past 10 years. Contact us at investorrelations@denkercapital.com for more information.
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