The COVID-19 pandemic poses a clear threat to human life and the global economy. The leaders of countries across the globe are having to act rapidly to fight both threats, with measures that are unheard of in living memory. One-by-one countries have been closing borders and forcing citizens to stay at home, leading to an overnight halt in economic activity.
This has, of course, led to a rapid change of sentiment in financial markets, as participants struggle to comprehend the implications and become fearful of losing money. This will, undoubtedly, be viewed as a major turning point in economic history. Such changes of sentiment are, in my opinion, rarely predictable, but the fact that they will occur is to be expected. In the investor update I wrote in January I said:
I believe that the actions of very many investors are guided by how real the fear of losing money appears, and that this fear will be the most likely catalyst of falling asset prices in the future. Put simply, I do not think low central bank interest rates, alone, provide a guarantee that asset prices must keep moving higher. If the fear of losing money becomes more real for investors, I believe that it will become a more powerful force in markets than the actions of central bankers.
I could not have foreseen just how prescient these words would appear. So far, the actions of central banks have struggled to stem the tide of negative sentiment that is ripping through markets. This is, not least, because cuts in interest rates do nothing to protect their citizens’ health. I wrote this paragraph because, as a valuation-driven investor, I believed that markets were “priced for perfection”. It is from this starting point that the elephants have been stampeding for the exits of financial markets.
What is an investor to do next?
At times like these I believe that the interests of a long-term investor are best served by holding your nerve and not succumbing to panic. Furthermore, I believe that the panic of others creates the seed of opportunity for those investors who can be calmly analytical in their decision making.
Our approach to being analytical is to estimate what we think companies are worth based on their ability to generate future profits and the assets that they currently own (after taking account of all liabilities). This places us firmly in the school of “value investing”. It means that we look to avoid “jam tomorrow” opportunities, where a high price relative to the economics of a business is only justified on an expectation of a rosy future.
Although we do not attempt to predict when a company will have a bad year, our valuations are absolutely based on an expectation that they will periodically occur. Right now, I believe that the biggest threat will come to those companies that have weak balance sheets, where the burden of high debts leaves less room to cope with short term surprises.
It is almost certain that all the companies that we invest in will, in the short term, see a fall in their earnings as a result of the pandemic. But our rationale for owning them means the prospect of a bad year does not cause us immediate concern. For those companies that we judged to be most threatened by current events, we instigated reviews to content ourselves that they have the balance sheet strength to weather a protracted storm, and still be around for the long-term.
We entered 2020 with substantial holdings of cash and fixed income in the fund, both to provide dry powder and to offset the risk from a number of our holdings that we believed to have a higher-than-average sensitivity to fall in price during a general panic. This has allowed us to act as a “fire sale” buyer travelling in the opposite direction to the herd, albeit making sure not to act too eagerly in what may prove to be a multi-year depression in stock prices.
I do not know what will happen in markets in the coming weeks and months as the reality of the coronavirus pandemic unfolds. However, I believe that the virus is unlikely to meaningfully impact the long-term ability of the companies that we invest in to generate profits.
Governments around the world look set to increase their borrowings, financed in part by central banks “printing money”. For this reason, I believe that the apparent safe harbour of holding cash may prove to be an illusion over the longer term. I am not an economist, but history suggests that when the money printing presses are running over-time, the cash in your pocket will buy less owing to an increase in inflation. I believe, that owning a slice of the “real economy” via part-shares of well-run businesses, provides protection against this threat.
As the largest single investor in the fund I shall be standing shoulder-to-shoulder with our investors. If market prices continue their fall, then we will use it as an opportunity to deploy the fund’s stash of dry powder, cautiously increasing holdings of public companies. This forms part of a core belief that to be a superior investor you must often travel in the opposite (and uncomfortable) direction of the crowd.
In the meantime, I wish that you, and your families, keep healthy in the face of the very real human threat that is posed by COVID-19.