There are many things that remain uncertain with regard to the novel coronavirus and its effects. However, a few things are certain: the virus has created panic in financial markets and across society and will have a huge negative impact on the economy in the coming months. What is less clear is the impact it will have on equity markets two to three years from now.
News, assessments and revisions will provide a clearer picture as we proceed through the earning seasons, but in all likelihood some sectors and companies will reprice sharply. Companies with negative cash flow whose market valuations are based on overly optimistic expectations of future growth rates have a particularly large downside risk. There will also be some exciting opportunities.
Covid-19 is a great example of an outlier event. No-one was modelling zero revenue scenarios a few months ago for any business. “We find ourselves in a position to take advantage of an absolutely epic, once-in-a-decade type opportunity set where opportunities to make two to three times our money on highly beaten down, obscure stocks abound,” writes Connor Haley in the Alta Fox Opportunities Fund letter. “Everything seems like a bigger deal when you zoom in and highlight the most frightening statistics. When you zoom out and put the risk in its proper context you realise that for many high-quality businesses this slowdown will be largely irrelevant three to five years from now.”
Gary Lehrman at Wolf Hill Capital says: “In recent weeks there has been much discussion about the shape of an economic rebound. Will it be V, U or W shaped? I feel this line of thought is less relevant to predicting future equity prices than attempting to understand the long-term implications of the new world order on an industry-by-industry basis.
“On the back of the pandemic we believe some sectors will be relative winners and prove to be highly resilient, and some sectors will be relative losers with longer-lasting structural challenges. We view the current opportunity set on the long side as falling into three separate buckets:
• Counter-cyclical or highly recessionproof businesses;
• High-quality businesses that are severely but temporarily affected by the economic fallout from the virus; and
• Distressed equities that are trading at option value and offer the potential for multi-bagger returns.”
Good companies — those with strong competitive advantages, conservatively financed and run by operators with skin in the game — can always adapt to the environment. There are times when these stocks grow strongly for long periods after being brought to low valuations. But you have to be there. And there are long periods when this is not the case.
A limited reopening is bound to result in a more limited recovery. And a full reopening is likely to be accompanied by unforeseen problems that are likely to disappoint those investors who are eagerly expecting a quick and robust recovery. A second wave of infections may cause a longer and more severe recession than has been forecast. And even in the best of circumstances getting back to “normal” is likely to require some getting used to. Consequently, economic activity and corporate earnings are likely to remain depressed for quite some time.
Nevertheless, Felix Zulauf, founder of Switzerland-based Zulauf Asset Management, believes that if you can live with the fluctuations you should be buying during the setbacks. “A lot of negatives are priced in, and central banks support the system.”
But Zulauf’s advice is not without controversy. After pointing out that the Stoxx 600 has largely been in a sideways movement with large fluctuations for the past 20 years, he goes on to say that “anyone who has successfully tried to identify good stocks has made good money. Anyone who has managed to time the cycle — something that has been frowned upon in the wealth management industry for years — has also made money.
“So, anyone who has done exactly what the wealth management industry has proven to be unable to do, and which is why it says it is the wrong approach, has been successful. Whereas all those who have followed the buy and hold strategy as preached by most asset managers and major banks are sitting on poor results. Only in the US did the market manage to reach a new high — but only thanks to the questionable, loan-financed share buybacks of many companies.”
To come back to the things we can be more certain about, until a vaccine is widely available getting back to “normal” will not be the straight line expected by the markets. Therefore, there remains a lot of room for disappointment. That being the case, it’s worth remembering that bear markets don’t end when the majority of investors are still eagerly looking for opportunities and attempting to call the bottom. They end when investors give up.
The good news then, for those who are able to keep their capital and confidence intact, is that a more prolonged period of disappointment may provide the greatest opportunity to make purchases at the best valuations we’ve seen in more than a decade.
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