During the current COVID-19 crisis, I’ve spent a lot of time thinking about how a long-term investor should react. We are all familiar with legendary investor Warren Buffett’s advice “to be greedy when others are fearful”, but how does this look practically? For this post, I will explore my chain of thoughts and attempt to create a framework to position a portfolio on surviving and benefiting from the current crisis.
Here is a summary of the current situation.
- As of this writing, the World Health Organization reports 167,515 confirmed cases with 6,606 deaths. In just the last 24 hours, there were 13,903 new cases and 862 deaths.
- Canada has closed its borders to all non-residents, and the EU and Russia have announced measures to limit movements between borders. Most restaurants, stores, concerts, and sporting events are closed or cancelled.
- The U.S. Federal Reserve has cut its benchmark interest rate to zero and launched a $700 billion quantitative easing program and the Trump administration is seeking $850 billion in emergency stimulus.
- The S&P 500 is down about 25% since the beginning of the year, with volatility at record levels.
- Not directly related to COVID-19, crude oil prices remain low with no end in sight to the Saudi Arabia and Russia price war.
I mostly share the sentiment that Howard Marks articulates in his latest memo: that I have no idea how long the virus will last, how long the economy will remain at a standstill, whether the government intervention will be enough, and whether the stock market is overreacting or underreacting. I can say though, that the longer the economy stalls, the more likely there will be negative second order effects that can make things ugly very quickly. For example, if there is a wave of bankruptcies, how does that impact banks? On the other hand, the recovery could be swift, particularly given low interest rates and cheap crude prices.
With this in mind, what we care about as long-term investors is not the share price performance in the next year or two (which is mostly unpredictable), but rather the long-term performance. Indeed, the sell-off has created an opportunity to buy shares of companies at multi-year or even decade lows. Here are some of my thoughts on how to position your portfolio to benefit from the eventual rebound:
- Focus on the long-term and don’t time the market: It’s entirely possible that the stock market can continue to fall from here…and equally possible that the market has bottomed. Historically, the stock market is a leading indicator and rallies in advance of an actual improvement of the situation. Attempting to buy at the absolute bottom is a fool’s errand, and it is even more silly to sell stocks just because they are down. Between 2004 and 2019, an investor that missed just the 10 best days in the market would have less than half of the compounded return as an investor who stayed fully invested. Given most of the “best days” occurred after the panic in 2008-2009, this is a cautious lesson for selling after a large drop.
Source: Putnam Investments
- Focus on what you understand: As tempting as it may be to purchase leveraged, cyclical stocks (such as theme parks or airlines) to maximize the benefit from the eventual recovery, there is a powerful psychological benefit in having conviction over a company that you’ve studied and understand, particularly when stocks are whipsawing up and down by 10% every day.
- Focus on companies that can withstand a high degree of stress: Being a long-term investor doesn’t matter if the business doesn’t survive in the short-term. An honest analysis of the balance sheet exposures; cash flow needs for debt, leases, and operations; operating leverage and revenues in an extended shut down should be conducted, and positions sized accordingly. Highly levered companies should be avoided given “terminal zero” risk, but healthy companies will have the opportunity to create value either by making cheap M&A or buybacks, or from gaining market share from weaker competitors that need to pull back.
- Focus on industries where demand will return: I have little doubt that people will eventually return to restaurants and attend concerts, but for some industries, it is possible that COVID-19 permanently changes consumer and supplier behavior. For example, Universal Studios announced it will release “Trolls World Tour” and three other movies directly available for VOD (in-home rentals), bypassing the original theatrical release. This is bad news for movie theater chains who were struggling with attendance and debt even before COVID-19, and it doesn’t require much imagination to think that studios will use this opportunity to shrink the theatrical release window even more to grow their streaming services. I would not be a long-term investor in movie theaters even at these share prices.
Put all these together, and the approach looks very much like our investment philosophy: invest in industry leaders operating in good sectors run by competent management teams.
I do think there are opportunities for a long-term investor to benefit from the upside by tactically investing in select industry leaders who have managed their businesses prudently in sectors that are more heavily affected by COVID-19 (such as restaurants, concerts, and ski resorts) . These companies will benefit twofold: first from the rebound in demand as the economy recovers, and secondly, increased market share and dominance over weaker competitors who cut back or folded during the crisis and, as such, we are currently exploring ways to increase our exposure in this area.
As always, if there are any questions or concerns, please contact your Portfolio Manager.