Although it was only three months ago, the market bottom on March 23 now seems like a distant memory with the S&P 500 having its strongest recovery in history, up 40% through June 4. Given the unusually strong rebound, many people have reacted by becoming more cautious. The train of thought usually goes something like this:
1) The market is down only slightly from the beginning of the year and actually up 5% from a year ago.
2) The economy is definitely not 5% better than it was last year: people are still dying from COVID-19 and unemployment is still double digits, and that’s before considering a possible double dip.
3) Thus, the market is overvalued and caution is warranted given the uncertainty.
To repeat again, I am not an epidemiologist, and have no special insights as to when COVID-19 will be over, whether there will be a double dip, and when a vaccine will be completed and distributed. Nonetheless, people forget that the stock market in the short term is always unpredictable. The market is no more unpredictable than it was last year before COVID-19 began. I don’t know whether the market will go up or down in the next month or year, and neither does Warren Buffett or any hedge fund billionaire on CNBC. Anyone who wants to worry will find something to worry about, and many of those things listed below were certainly things worth worrying about at the time even as the S&P 500 nearly quintupled.
Simply put, macroeconomic forecasting is extremely hard given the nearly infinite variables involved, and market timing based on macro forecasting (or anything else for that matter) in my view is a fool’s game. That is why we don’t even try to do it.
The only thing that is predictable about the stock market is that it tends to go up over time and there is a powerful mental advantage to investing for the long-run, and in ignoring short-term fluctuations. The same mentality can be applied towards individual stocks as well: great businesses by definition get more valuable over time regardless of what the share price is doing in the short or even medium term, and it makes sense to simply buy and hold companies that you want to own for the long-term. As such, we used the recent stock market turmoil to acquire shares of high-quality companies like Copart, Canadian Apartment Properties REIT, and Costco at what we consider to be attractive prices.
This doesn’t mean we indiscriminately buy and hold any stock. Things can change, and it is our job to evaluate whether some concern, whether it be external and beyond company control, or internal, within the power of management to change, is a temporary problem or a permanent impairment of the business. There were names in our portfolio that we believed would be negatively impacted by COVID-19 in a substantial and long-lasting way, and we accordingly sold our holdings in Hyatt Hotels, Delta Air Lines, and Walt Disney.
How to invest during this time?
Again, I am not saying the market is cheap, nor do I necessarily disagree with any of the arguments that bearish investors make. I just simply don’t spend any time thinking about what I believe is unknowable. It is certainly possible that the stock market will fall another 20%, but just as possible it will rise 20%. However, since any investor’s goal is to buy stocks when they are cheap (i.e. below intrinsic value), the current zero interest rate environment presents some interesting challenges from a valuation perspective.
Invest in leading growth stocks
In business school, we all learned that the value of any stock is the present value of all future cash flows. With the US 10-year Treasury currently yielding 0.7%, the hypothetical value of any stock that can grow earnings faster than 6% or 7% for an extended period of time approaches infinity. This result shouldn’t be surprising. If there is an infinite amount of nearly free money, then why wouldn’t assets also be worth nearly infinity[i]? Put another way, you could make a nearly riskless profit by borrowing money at a very low rate and buying something like Costco, which gives you a 3% yield growing at high single digits.[ii]
Low interest rates also mean that the “current” earnings of a stock are less valuable relative to its future growth and “terminal value”. Correspondingly, the long-term fundamentals of the business are much more important than the next few years of earnings. This, in my view, was the main factor contributing to the outperformance of growth stocks over the last decade, and should continue as long as interest rates stay low. Crucially, it also means that if the disruption from COVID-19 lasts a year or so, it does not have a significant impact on the value of a company that will resume growth when times return to normal.
Furthermore, an underrated advantage of companies like Amazon, Netflix, and dare I say Tesla, is their capital markets advantage in convincing the markets that their lack of current profits is due to investments for future growth. This is a luxury that incumbent competitors simply don’t have often because their investors have been trained to expect stable margins and dividends. With Amazon being able to issue debt for 40 years at 2.7% to build warehouses and build its fulfillment network, the hurdle rate for a positive return is pretty low, with the added benefit of increasing Amazon’s lead.
In contrast to the companies that invest for future growth, many traditional “value” stocks with low P/E ratios and high dividend yields are declining businesses with high cost structures that lack scale to compete against their well-funded competitors. Recently, many of these companies were forced to raise capital at highly unfavorable rates, which will hamper upside in a recovery. Our bet is that the gap between the haves and have-nots will continue to accelerate post COVID.
Invest in companies with strong reinvestment opportunities
The second implication of low rates is that companies which have the ability to reinvest capital at high rates of return are extremely valuable. These companies are sometimes called “compounders”. When a company generates cash flow, it can choose to reinvest it back in the business, repay debt, or pay it to shareholders. When interest rates are low, the return for reducing debt is low, and it is also tough for a shareholder to reinvest dividend payments into other high returning investments. Correspondingly, companies that have unique high-returning investments should be worth a lot of money. Companies like Costco, Copart, Parkland Fuel, American Tower, Domino’s Pizza and Constellation Software all have many years of high-returning reinvestment opportunities that exceed anything an investor can find in the public markets, and we expect the markets to recognize them as such over time.
To be sure, this is what we have always been doing at Baskin Wealth Management and clients can expect us to continue to improve the quality of the companies we own.
As usual, if you have any questions, do not hesitate to contact your portfolio manager.
[i] The implication that infinite free money also means money is worthless (hyperinflation) is not lost on me, but people have been predicting hyperinflation for decades, and this has not historically been a profitable bet.
[ii] Also referred to as Private Equity.