Wednesday, May 13, 2020

A Viral Market Update VIII: A Crisis Test - Value vs Growth, Active vs Passive, Small Cap vs Large!

In the weeks since my first update on the crisis on February 26, 2020, the markets have been on a roller coaster ride, as equity markets around the world collectively lost $30 trillion in market cap between February 14, 2020 and March 20, 2020, and then clawed back more than half of the loss in the following month. Having lived through market crises in the past, I know that this one is not quite done, but I believe we now have lived through enough of it to be able to start separating winners from losers, and use this winnowing process to address three big questions that have dominated investing for the last decade:
  • Has this crisis allowed active investors to shine, and use that performance to stop or even reverse the loss of market share to passive vehicles (ETFs and index funds) that has occurred over the last decade? 
  • Will this market correction lead to growth/momentum investing losing its mojo and allow value investors to reclaim what they believe is their rightful place on top of the investing food chain?  
  • Will the small cap premium, missing for so many decades, be rediscovered after this market shock?
I know each of these is a hot button issue, and I welcome disagreement, but I will try to set my biases aside and let the data speak for itself.

Market Action
As with my prior updates, I will begin by surveying the market action, first over the two weeks (4/17-5/1), following my last update,  and then looking at the returns since February 14, the date that I started my crisis clock. First up, I look at returns on stock indices around the world, breaking them up into two periods, from February 14 to March 20, roughly the low point for markets during this crisis and from March 20 to May 1, as they mounted a comeback.
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The divide in the two periods is clear. Consider the S&P 500, down 28.28% between 2/14 and 3/20, but up 22.82% from March 20 and May 1, resulting in an overall return of -11.92% over the period. While the magnitudes vary across the indices, the pattern repeats, with the Shanghai 50 close to breaking even over the entire period, and the Bovespa (Brazil) and the ASX 200 (Australia) delivering the worst cumulative returns between 2/14 and 5/1. As stock markets have swooned and partially recovered, the yields on US treasuries dropped sharply early in the crisis and have stayed low since.
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The 3-month treasury bill rate, which was 1.58% on February 14,  has dropped close to zero on May 1, and the treasury bond rate has declined from 1.59% to 0.64% over the same period. The much talked about inverted yield curve late last year, that led to so many prognostications of gloom and doom, has become upward sloping, and staying consistent with my argument that too much was being made of the former as a predictor of recession, I will not read too much into its slope now. Moving to the corporate bond market, I focused on 10-year corporates in different ratings classes:

Early in this crisis, the corporate bond markets did not reflect the worry and fear that equity investors were exhibiting, but they caught on with a vengeance a couple of weeks in, and the damage was clearly visible by April 3, 2020, with default spreads almost tripling across the board for all ratings classes. Since April 3, the spreads have declined, but remain well above pre-crisis levels. There should be no surprise that the price of risk in the bond market has risen, and as the crisis has taken hold, I have been updating equity risk premiums daily for the S&P 500 since February 14, 2020:
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The equity risk premium surged early in the crisis, hitting a high of 7.75% on March 23, but that number has been dropping back over the last weeks, as the market recovers. By May 1, 2020, the premium was back down to 6.03%, with pre-crisis earnings and cash flows left intact, and building in a 30% drop in earnings and a 50% decline in buybacks yields an equity risk premium of 5.39%. For good reasons or bad, the price of risk in the equity market seems to be moving back to pre-crisis levels. I don’t track commodity prices on a regular basis, but I chose to track oil and copper prices since February 14:
At the risk of repeating what I have said in prior weeks, the drop in copper prices is consistent with an expectation of a global economic showdown but the drop in oil prices reflects something more. In fact, a comparison of Brent and West Texas crude oil prices highlights one of the more jaw-dropping occurrences during this crisis, when the price of the latter dropped below zero on April 19.  The oil business deserves a deeper look and I plan to turn to that in the next few weeks. Finally, I look at gold and bitcoin prices during the crisis, with the intent of examining their performance as crisis assets:
Download data
Gold has held its own, but I think that the fact that it is up only 7.4% must be disappointing to true believers, and Bitcoin has behave more like equities than a crisis asset, and very risky equities at that, dropping more than 50% during the weeks when stocks were down, and rising in the next few weeks, as stocks rose, to end the period with a loss of 16.37% between February 14 and May 1.

Equities: A Breakdown
Starting with the market capitalizations of individual companies, I measured the change in market capitalization on a week to week basis, allowing me to slice and dice the data to chronicle where the damage has been greatest and where it has been the least. Breaking down companies by region, here is what the numbers updated through May 1 look like:
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Latin America has been the worst performing region in the world, with Africa, Australia and Russia right behind and China and the Middle East have been the best performing regions between February 14 and May 1. I continue the breakdown on a sector-basis in the table below:
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Health care, consumer staples and technology have been the best performing sectors and financials are now the biggest losers. Extending the analysis to industries and looking at the updated list of worst and best performing industries:
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Repeating a refrain from my updates in earlier weeks, this has been, as crises go, about as orderly a retreat as any that I have seen. The selling has been more focused on sectors that have heavy capital investment and oil-focused, burdened with debt, and has been much more muted in sectors that have low capital intensity and less debt.

Value versus Growth Investing
In the tussle between value and growth investing, value investors have held the upper hand for a long time. In addition to laying claim to being the custodians of value, they also seemed to have all the numbers on their side of the argument, as they pointed to decades of outperformance by value stocks, at least in the United States. The last decades, though, have delivered numbers that are more favorable to growth investors, and this crisis is perhaps as good a time as any to reexamine the debate.

The Difference
For decades, we have accepted a lazy categorization of stocks on the value versus growth dimension. Stocks that trade at low PE or low price to book ratios are considered value stocks, and stocks that trade at high multiples of earnings and book value are growth stocks. In fact, the value factor in investing is built around price to book ratios. If you are a value investor, your reaction to this categorization is that this is no way to describe value and that true value investing incorporates many other dimensions including management quality, sustainable moats and low leverage. Conceding all those points, I would argue that the key difference between value and growth investing can be captured by looking at a financial balance sheet:

Thus, the real difference between value and growth investors lies not in whether they care about value (sensible investors in both groups do), but where they believe the investing payoff is greater. Value investors believe that it is assets in place that markets get wrong, and that their best opportunities for finding "under valued" stocks is in mature companies with mispriced assets in place. Growth investors, on the other hand, assert that they are more likely to find mispricing in high growth companies, where the market is either missing or misestimating key elements of growth.

The Lead In
Until the last decade, it was conventional wisdom that value investing beat growth investing, especially over longer time horizon, and the backing for this statement took the form of either anecdotal evidence (with the list of illustrious value investors much longer than the list of legendary growth investors) or historical data showing that low price to book stocks have delivered higher returns than high price to book stocks:
Source: Raw Data from Ken French
Looking across the entire period (1927-2019), low price to book stocks have clearly won this battle, delivering 5.22% more than high price to book stocks, and this excess return is almost impervious to risk and transaction cost adjustments. Value investors entered the last decade, convinced of the superiority of their philosophy, and in the table below, I look at the difference in returns between low and high PE and PBV stocks, each decade going back to the 1920s.
It is quite clear that 2010-2019 looks very different from prior decades, as high PE and high PBV stocks outperformed low PE and low PBV stocks by substantial margins. The under performance of value has played out not only in the mutual fund business, with value funds lagging growth funds, but  has also brought many legendary value investors down to earth. Pushed to explain why, the defense that value investors offered was that the 2008 crisis, Fed interventions and the rise of the FAANG stocks created a perfect storm that rewarded momentum and growth investing, at the expense of value. Implicit in this argument is the belief that this phase would pass and that value investing would regain its rightful place.

The COVID Crisis 
In the early days of the crisis, there were many value investors who viewed at least some of the market correction as punishment for investor overreach on growth and momentum stocks in the past decade.  As the weeks have progressed, that argument has been quelled by the cumulating evidence that the market punishment perversely has been far worse for value stocks, i.e., stocks with low PE ratios and high dividend yields than for momentum or growth stocks. To illustrate this, I first look at how the market effects have varied across stocks in different PE ratio classes:

Note that it is the lowest PE stocks that have lost the most market capitalization (almost 25%) between February 14 and May 1, whereas the highest PE stocks have lost only 8.62%, and to add insult to injury, even money losing companies have done better than the lowest PE stocks. I follow up by looking at stocks broken down by price to book ratios:

The results mirror what we saw with PE stocks, with low price to book stocks losing far more value than the highest price to book stocks.  I then break down stocks based upon dividend yields:
Low dividend yield stocks and even non-dividend paying stocks have fared far better than high dividend yield stocks. Finally I look at companies, based upon net debt ratios:

Put simply, here is what I see in the data. If I had followed old-time value investing rules and had bought stocks with low PE ratios and high dividends in pre-COVID times, I would have lost far more than if I bought high PE stocks or stocks that trade at high multiples of book value, paying little or no dividends. The only fundamental that has worked in favor of value investors is avoiding companies with high leverage.

A Personal Viewpoint
I believe that value investing has lost its way, a point of view I espoused to portfolio managers in Omaha a few years ago, in a talk, and in a paper on value investing, titled Value Investing: Investing for Grown Ups? In the talk and in the paper, I argued that much of value investing had become rigid (with meaningless rules and static metrics), ritualistic (worshiping at the altar of Buffett and Munger, and paying lip service to Ben Graham) and righteous (with finger wagging and worse reserved for anyone who invested in growth or tech companies). I also presented evidence that it was bringing less to the table than active growth investing, by noting that the average active value investor underperformed a value index fund by more than the average growth investor lagged growth index funds. I also think that fundamental shifts in the economy, and in corporate behavior, have rendered book value, still a key tool in the value investor's tool kit, almost worthless in sectors other than financial services, and accounting inconsistencies have made cross company comparisons much more difficult to make. On a hopeful note, I think that value investing can recover, but only if it is open to more flexible thinking about value, less hero worship and less of a sense of entitlement (to rewards). If you are a value investor, you will be better served accepting the reality that you can do everything right on the valuation front, and still make less money than your neighbor who picks stocks based upon astrological signs, and that luck trumps skill and hard work, even over long time periods.

Active versus Passive Investing
Some of the readers of this blog are in the active investing business and I apologize in advance for raising questions about your choice of profession. After all, any discussion of active versus passive investing that comes down on the side of the latter implicitly is a judgment of whether you are adding value by trying to pick stocks or time markets. Consequently, these discussions quickly turn rancid and personal, and I hope this one does not.

The Difference
In passive investing, as an investor, you allocate your wealth across asset classes (equities, bonds, real assets) based upon your risk aversion, liquidity needs and time horizon, and within each class, rather than pick individual stocks, bonds or real assets, you invest in index funds or exchange traded funds (ETFs)  to cover the spectrum of choices. In active investing, you try to time markets (by allocating more money to asset classes that you believe are under valued and less to those that you think are over valued) or pick individual assets that you believe offer the potential for higher returns. Active investing covers a whole range of different philosophies from day trading to buying entire companies and holding them for the long term.

Put simply, active investing covers a range of philosophies with different time horizons, different and often contradictory views about how markets make mistakes and correct them,

The Lead In
Until the 1970s, active investing dominated passive investing for two simple reasons. The first was the presumption that institutional investors were smarter, and had access to more information than the rest of us, and should thus do better with our money. The second was that there were no passive investing vehicles available for average investors. Both delusions came crashing down in the late sixties and early seventies.
  • First, the pioneering studies of mutual fund performance, including this famous one that introduced Jensen's alpha, came to the surprising conclusion that rather than outperform markets, mutual funds under performed by non-trivial amounts. In the years since, there have been literally hundreds of studies that have asked the same question about mutual funds, hedge funds and private equity, using far richer data sets and more sophisticated risk adjustment models to arrive at the same result. You can see Morningstar's 10-year excess return distribution for all active large-blend mutual funds, from 2010-2019, below (with similar graphs for other classes of active mutual funds):
    If the counter is that it is hedge and private equity funds where the smart money resides today, the evidence with those funds, once you adjust for reporting and survivor bias, mirrors the mutual fund results. Put bluntly, "smart" money is not that smart, and the advantages that it possesses (bright people, more data, powerful models) don't translate into returns for its investors. Ironically, over the same period, there were hundreds of other studies that claimed to find market inefficiencies, at least on paper, suggesting that there is no internal inconsistency in believing that markets are inefficient and also believing that bearing these markets is really, really difficult to do.
  • Second, Jack Bogle upended investment management in 1976 with the Vanguard 500 Index fund, the most disruptive change in the history of the investment business. Over the next three decades, the index fund concept expanded to cover geographies and asset classes, allowing investors unhappy with their investment advisors and mutual funds to switch to low-cost alternatives that delivered higher returns. The entry of ETFs tilted the game even further in favor of passive investing, while also offering active investors new ways of playing sectors and markets.
The shift of funds from active to passive has been occurring for a long time, but the shift was small early in the process. In 1995, less than 5% of money was passively invested (almost entirely in index funds) and that percentage rose to about 10% in 2002 and 20% in 2010. In the last decade, that shift has accelerated, as you can see in the graph below:
Source: Morningstar
The increase in passive investing's market share has come primarily from almost $4 trillion in funds flowing into passive vehicles, but active investing has also seen outflows in the last five years. While some have attributed this to failures of active investors in the last decade, I believe that active investing has been a loser's game, as Charley Ellis aptly described it, for decades, and that the shift can be more easily explained by investors having more choices, as trading moves online and becomes close to costless, and readier access to information on how their portfolios are performing. 

The Crisis Performance
Active investors have argued that their failures were due to an undisciplined bull market, where their stock pricing expertise was being discounted, and that their time would come when the next crisis hit. There were also dark warnings about how passive investing would lead to liquidity meltdowns and make the next crisis worse. If active investors wanted to have a chance to shine, they have got in their wish in the last few weeks, where their market timing and stock picking skills were in the spotlight. With their expertise, they should have managed to not only to avoid the worst of the damage in the first few weeks, but should have then gained on the upside, by redeploying assets to the sectors/stocks recovering the quickest. While there is anecdotal evidence that some investors were able to do this, with Bill Ackman's prescient hedge against the COVID collapse getting much attention, I am sure that there were plenty of other smart investors who not only did not see it coming, but made things worse by doubling down on losing bets or cashing out too early.

As we look at the bigger picture, the results are, at best, mixed, and hopes that this crisis would vindicate active investors have not come to fruition, at least yet. I looked at Morningstar's assessment of returns on equity mutual funds in the first quarter of 2020, measured against returns on passive indices for each fund class:
Source: Morningstar
Note that the first quarter included the worst weeks of the crisis (February 14- March 20), and there is little evidence that mutual funds were able to get ahead of their passive counterparts, with only two groups showing outperformance (small and mid-cap value), but active funds collectively under performed by 1.37% during this period. Focusing on market timing skills, tactical asset allocation funds (whose selling pitch is that they can help investors avoid market crisis and bear markets) were down 13.87% during the quarter, at first sight beating the overall US equity market, which was down 20.57%. That comparison is skewed in favor of these funds, though, since tactical asset allocation funds typically tend to invest about 60% in equities, and when adjusted for that equity allocation, they too underperformed the market. Looking at hedge funds in the first quarter of 2020, the weighted hedge fund index was down 8.5% and saw $33 billion in fund outflows, though there were some bright spots, with macro hedge funds performing much better. Overall, though, there was little to celebrate on the active investing front during this crisis. On the market liquidity front, while much has been made of the swings up and down in the market during this crisis, the market has held up remarkably well. A comparison to the chaos in the last quarter of 2008 suggests that the market has dealt with and continues to deal with this crisis with far more equanimity than it did in 2008. In fact, I think that the financial markets have done far better than politicians, pandemic specialists and market gurus during the last weeks, in the face of uncertainty.

A Personal Viewpoint
I have been skeptical about both the reasons given for active investing's slide over the last decade and the dire consequences of passive investing, and this crisis has only reinforced that skepticism. For active investing to deal with its very real problems, it has to get past denial (that there is a problem), delusion (that active investing is actually working, based upon anecdotal evidence) and blame (that it is all someone else's fault). Coming out of this crisis, I think that more money will leave active investing and flow into passive investing, that active investing will continue to shrink as a business, but that there will be a subset of active investing that survives and prospers. I don't believe that  artificial intelligence and big data will rescue active investing, since any investment strategies built purely around numbers and mechanics will be quickly replicated and imitated. Instead, the future will belong to multidisciplinary money managers, who have well thought-out and deeply held investment philosophies, but are willing to learn and quickly adapt investment strategies to reflect market realities. 

Small versus Large Cap 
The small cap premium was among the earliest anomalies uncovered by researchers in the 1970s and it came from the recognition that small market capitalization stocks earned higher returns than the rest of the market, after adjusting for risk. That premium has become part of financial practice, driving some investors to allocate disproportionate portions of their portfolios to small cap funds and appraisers to add small cap premiums to discount rates, when valuing small companies.

The Difference
There are two things worth noting at the outset about the small cap premiums. The first is that market capitalization is the proxy for size in the small cap studio, not revenues or earnings. Thus, you can have a young company with little or no revenues and large losses with a large market capitalization and a mature company with large revenues and a small market capitalization. The second is that to define a small capitalization stock, you have to think in relative terms, by comparing market capitalizations across companies. In fact, much of the relevant research on small cap stocks has been based on breaking companies down by market capitalization into deciles and looking at returns  on each decile. One reason that the small cap premium resonates so strongly with investors is because it seems to make intuitive sense, since it seems reasonable that small companies, with less sustainable business models, less access to capital and greater key person risk, should be riskier than larger companies. 

The Lead In
As with value investing, the strongest arguments for the small cap premium come from looking at historical returns on US stocks, broken down by decile, into market cap classes.
Going back to 1927, the smallest cap stocks have delivered about 3.47% more annually than than the rest of the market, on a value-weighted basis. That outperformance though obscures a troubling trend in the data, which is that the small cap premium has disappeared since 1980; small cap stocks have earned about 0.10% less than the average stock between 1980 and 2019. The table below breaks down the small cap premium, by decade:

The data in this table is testimony to two phenomena. The first is the belief in mean reversion that lies at the heart of so many investment strategies, with the mean being computed over long time periods, and primarily with US stocks. The second is that once bad valuation practices, once embedded in the status quo, are very difficult to remove. In my view, the use of small cap premiums in valuation practice have no basis in the data, but that does not mean that people will stop using them.

The Crisis Performance
As with active and value investing, there are some who believe that the fading of the small cap premium is temporary and that it will return, when markets change. To the extent that this crisis may constitute a market shift, I examined the performance of stocks, broken down by market capitalization into deciles between February 14, 2020 and May 1, 2020.

I know that it is still early in this crisis, but looking at the numbers so far, there is little good news for small cap investors, with stocks in the lowest two declines suffering more than the rest of the market. In fact, if there is a message in these returns, it is that the post-COVID economy will be tilted even more in favor of large companies, at the expense of small ones, as other businesses follow the tech model of concentrated market power. 

A Personal Viewpoint
It is still possible that the shifts in investor behavior and corporate performance could benefit small companies in the future, but I am hard pressed trying to think of reasons why. It is my belief that forces that allowed small cap stocks to earn a premium over large cap stocks have largely faded. I am not arguing that investing in small cap stocks is a bad strategy, but investing in small companies, just because they are small, and expecting to get rewarded for doing so, is asking to be rewarded for doing very little. Markets are unlikely to oblige. It is possible that you can build more discriminating strategies around small cap stocks that can make money, but that will require again bringing something else to the equation that is not being tracked or priced in by the market already.

YouTube Video

  1. Market data (May 1, 2020)
  2. Regional breakdown - Market Changes and Pricing (May 1, 2020)
  3. Sector breakdown - Market Changes and Pricing (May 1, 2020)
  4. Industry breakdown - Market Changes and Pricing (May 1, 2020)
  5. Equity Risk Premium, by day (Updated through May 1, 2020)
  6. Small Cap versus Large Cap Stocks (1927-2019)
  7. Small Cap - Market Changes and Pricing (May 1, 2020)
  8. Value versus Growth ((1927-2019)
  9. PE breakdown - Market Changes and Pricing (May 1, 2020)
  10. PBV breakdown - Market Changes and Pricing (May 1, 2020)
  11. Dividend Yield  breakdown - Market Changes and Pricing (May 1, 2020)
Viral Market Update Posts
  1. A Viral Market Meltdown: Fear or Fundamentals?
  2. A Viral Market Meltdown II: Pricing or Valuing? Investing or Trading?
  3. A Viral Market Meltdown III: Clues in the Market Debris
  4. A Viral Market Meltdown IV: Investing for a post-virus Economy
  5. A Viral Market Meltdown V: Back to Basics
  6. A Viral Market Meltdown VI: The Price of Risk
  7. A Viral Market Meltdown: Market Multiples
  8. A Viral Market Meltdown: Value vs Growth, Active vs Passive, Small Cap vs Large!

Friday, April 24, 2020

A Viral Market Update VII: Mayhem with Multiples

I get a sense that I am approaching the end of this series of weekly posts, or perhaps I am just hoping that it is true, as the COVID crisis continued to play out in markets in the last two weeks, albeit on a more subdued scale and with a more positive twist. In this post, I will, as in the prior weeks, update the prior weeks’ market action (for two weeks, from April 4 to April 17) in different asset classes, and within equities, across regions, sectors and stock classifications. I will close this post by looking at how pricing tools, including a range of multiples (from PE ratios to price to book to EV to EBITDA multiples) will become shakier and less reliable in the aftermath of the crisis, and suggest ways in which we can compensate for the uncertainties.

Asset Classes
I started my crisis clock on February 14, reflecting the fact that I am US-based, and markets outside China did not wake up to the crisis until that week. In the weeks since, we have seen volatility rise and equity markets get whipsawed, with much of the pain being dispensed in February and the first three weeks in March. In the last month, equity indices around the world have seen positive returns, and in some cases, very good positive returns, as can be seen in the table below.
Download data
The week of April 10 to April 17 was a benign week, at least in sum, even though individual days still brought big movements, with most indices flat for the week. Moving on to the treasury market, we also saw steadiness, with both short and long term rates staying close to the lows that they hit just two weeks ago.
Download data
Looking at commodity prices, the divergence between oil and copper illustrated again the unique travails of oil, where a detente between Russia and China did little to stop oil prices from continuing to drop, while copper prices changed little.

Download data
In the two months since February 14, oil prices have dropped more than 65%, providing a contrast to copper, another commodity sensitive to the global economy, which has declined less than 10%. (To top of the craziness, the price of futures on Texas crude dropped below zero on April 20, but that is a story for another day/post.) 

To complete the picture, I looked at gold and bitcoin, and while both have settled into holding patterns, the divergence since February 14 is stark.

Download data
In sum, gold has held its own, increasing 6.3% since February 14, though investors holding it were undoubtedly expecting a bigger pop, given the economic and market chaos, but bitcoin has disappointed those who believed it would play the role of a crisis asset, down 31% since the start of this crisis.

Risk Update
In my last post, I focused on how the price of risk has changed since February 14, 2020, starting with the corporate bond market, where default spreads have changed significantly over the last few weeks.
Download data
Note the surge in default spreads across bond ratings classes from February 14, 2020 to March 3, 2020, though there has been a drop off from highs in the last two weeks. The fear that  has played out in the bond market has also affected the price of risk in equity markets. In the graph below, I updated the equity risk premiums, by day, that I computed in my post two weeks ago, through April 17.
Download spreadsheet
The implied equity risk premium which I computed to be 6.01% on April 1, 2020, has declined to 6.27% if I compute the risk premium using the (now stale) earnings and cash flows, and 5.60%, if I assume a 30% drop in S&P 500 earnings this year and a substantial drop in buybacks. I have a feeling that this roller coaster ride is not quite done and I will continue to estimate the numbers daily.

Equities Breakdown
In keeping with my practice in my prior posts, I looked at market capitalizations of all publicly traded companies (36,481 companies with market caps exceeding $5 million on February 14, 2020) and started by computing changes in market capitalization, by region:
Download data
Looking at the aggregated returns since February 14, 2020, the worst performing regions in the world are Africa and Latin America, and China remains the standout as the best performing market. Australian and Canadian stocks have been punished, largely because of their natural resource focus, and globally, stocks have lost $15.2 trillion in value, a huge amount but about half as large as the loss was four weeks ago. In the next table, I break market cap changes down by sector:
Download data
There are few surprises in this table, with healthcare and consumer staples being the best performers, and energy and financial services the worst. Breaking down the sectors into finer detail, I look at companies classified into 95 industries, and list the ten best and worst performers over the crisis period (2/14 - 4/17):
Download data
I know that it fashionable to talk about how inefficient and volatile markets are but this crisis, in many ways, has been surprisingly orderly and markets have dispensed punishment judiciously, for the most part. 

I also looked at other classifications, from pricing levels (PE and PBV) to momentum to dividends/buybacks and found no significant differences across companies. In fact, the evidence seems to more strongly support the notion that the market is punishing low PE, high dividend yield stocks that had little momentum coming into this crisis more than high PE , non-dividend paying stocks. That is disappointing news for value purists who have been waiting a long time to say "I told you so" to momentum and growth investors. In fact, the only variable that seems to offer support for financial moralists is financial leverage, as can be seen in the table below, where I break down global stocks based upon how much debt they had at the start of the crisis:
The most highly levered companies, with leverage measured as debt scaled to EBITDA, have suffered more damage as this crisis has played out. 

Pricing Update
In my earlier posts, I argued that just because uncertainty has increased, there is no excuse for abandoning valuation first principles or process; you can still value companies, albeit with a much wider range of outcomes. One common counter that I got to this argument was that valuation is pointless when the uncertainty is so great and while most of those marking this argument did not bother presenting alternatives, my guess is that many will fall back on pricing metrics to decide what to buy or sell. Put simply, they will use a PE ratio or an enterprise value multiple of EBITDA or sales to decide what stocks to buy or sell, acting under the delusion that this will allow them to escape having to make assumptions in the future. In this section, I will start by breaking down pricing multiples and then use simple valuation algebra to argue that there are assumptions about cash flows, growth and risk embedded in every pricing multiple. I will close by noting how multiples behave in a crisis, and report on pricing multiples, broken down by region, sector and industry, pre and post crisis.

Anatomy of a Multiple
I think of multiples as standardized prices, allowing investors to get past the challenge of comparing per share values, which are determined by share count. That said, it is easy to be overwhelmed by the number of multiples you see in practice, with some in wide use (PE, Price to Book, EV to EBITDA) and some obscure (EV per subscriber, EV to Invested capital). To put these in perspective, I will start by breaking down the choices that you have in constructing a multiple and using it to make a pricing judgment:

The numerator for any pricing multiple is a market value of equity, firm or operating assets, and the denominator is a scaling variable: revenues, earnings, cash flows or book value. There is no one "best" multiple or timing choice, since that will vary across time and across sectors, but here are two simple consistency rules to keep in mind, when constructing and using multiples:
  • Equity/Firm: If the numerator is an equity value, the denominator should be an equity value as well, while if the numerator is a firm or enterprise value, the denominator has to be an operating value. Thus, PE (market cap, an equity value, is divided by earnings per share, an equity value) and EV to EBITDA (EV is a market value of operating assets and EBITDA is a measure of operating cash flow) are consistent, but Price to EBITDA is an inconsistent abomination and Price to Sales is almost as badly constructed.
  • Timing: Multiples are constructed for comparisons across companies, not as stand alone measures. It follows therefore that you should be consistent in the timing you use for your scaling variable (revenues, book value, earnings) across companies. Thus, if you choose to use trailing earnings for your company to compute PE, you have to use trailing earnings for all your companies.
Put simply, in pricing, you estimate a value for a business or its equity, based upon how "similar" companies (equities) are being priced in the market place.

Determinants of Multiples
Many analysts who use multiples to find under and over priced stocks do so because they do not want to confront the uncertainty associated with forecasting future growth, margins and cash flows in intrinsic valuation. That is an illusion, since embedded in every multiple are assumptions about growth, risk and investment efficiency. When you pay a hundred times earnings for a stock or ten times book value, you  are assuming high growth in earnings for the former and a monstrously high return on equity for the latter. In the picture below, I list out the fundamentals that are embedded in each multiple:

This cheat sheet, designed to find the variables that are embedded in a multiple,  brings home a reality about pricing that should make anyone using it uncomfortable. The difference between intrinsic value, where you try (sometimes desperately) to forecast future growth and cash flows, and pricing, where you use a multiple, is that you are explicit about your assumptions in the future, making them both more transparent and easier to critique, and that you are implicit in your assumptions with the latter, making them easier to defend but also more dangerous.

Pricing and Crisis - A Time Line
In the aftermath of every crisis, investors abandon fealty to fundamentals, on the premise that they are in unique times and fall back on pricing. I am sure that will happen with this one as well, but if you decide to go this route, the nature of this crisis will make pricing much more difficult. To see why, take a look at how multiples will move as this crisis unfolds:
  • In phase one of this crisis,  the market reacts to the crisis by marking down stock prices almost immediately, but the scaling variable (revenues, earnings, book value) does not, partly because it takes time for the crisis to show up in operating numbers and even longer for accountants to record that in the financial statements. Consequently, as the crisis first unfolds, stocks will look cheaper on a trailing basis, as the market price drops and earnings/revenues/cashflows stay stagnant, and analysts/companies are too uncertain to offer guidance about future operating results. 
  • In phase two, analysts and companies start to provide forward guidance, and you can switch to forward values, if you trust them, but since the crisis can cause more companies to lose money, you will also see a greater dependence on revenue multiples in pricing. 
  • In phase three, as operating results more completely reflect crisis effects, trailing multiples will reflect the updated operating results, but you should not be surprised to see companies trade at much higher multiples of trailing earnings (if earnings are still positive), or have earnings multiples that are not meaningful. Again, a naive comparison of the trailing PE to historic norms will lead you to conclude that everything is over priced, even when that is not the case.
No matter which phase you are in, you ultimately have to make judgments about whether the company will come out of the crisis, and if it does, what it will generate as earnings, to make sensible investment decisions. Just as there is no room for lazy and mechanistic valuation, in the midst of a crisis, there is no payoff to lazy and mechanistic pricing.

Pricing Effects
We are still in phase one of this crisis, though we are hopefully approaching its tail end. Not surprisingly, as market prices have dropped and trailing operating numbers reflect what companies did in 2019 (pre-crisis), there has been a drop in trailing pricing multiples across all regions of the world:
Download data
The same story unfolds across different sectors:
Download data
In some sectors, such as financial services, energy and airlines, where the punishment meted out by the market has been severe, you should not be surprised to see stocks trade at extraordinarily low multiples of trailing earnings. At the same time, companies have been reluctant to offer guidance for the coming year, making it difficult to shift to forward values. You could, of course, get ahead of the curve and try to forecast earnings in a post-virus world, say in 2022 or even 2025, and scale market capitalizations to those values.

As companies start to report their first quarter earnings, you are starting to get a glimpse of the damage created by the crisis and my guess is that you will start to see more analysts and companies start to forecast forward numbers. For those companies where forward earnings are positive, you can switch to forward PE ratios, but expect these numbers to be much, much higher than historical norms. For those companies that expect losses in the next year, you will see revenue multiples or creative variations on future earnings, from earnings before COVID to earnings in 2025 used as the scalar. Later this year, as companies report numbers for the second and third quarters of 2020, the trailing operating numbers will finally catch up with the crisis, but they will come with caveats. Put simply, if you are abandoning or refusing to do intrinsic valuation, because you feel uncomfortable with having to make assumptions, the same uncertainty is going to pervade your pricing as well. 



  1. Market data (April 17, 2020)
  2. Regional breakdown - Market Changes and Pricing (April 17, 2020)
  3. Sector breakdown - Market Changes and Pricing (April 17, 2020)
  4. Industry breakdown - Market Changes and Pricing (April 17, 2020)
  5. Equity Risk Premium, by day (Updated through April 22, 2020)

Viral Market Update Posts
  1. A Viral Market Meltdown: Fear or Fundamentals?
  2. A Viral Market Meltdown II: Pricing or Valuing? Investing or Trading?
  3. A Viral Market Meltdown III: Clues in the Market Debris
  4. A Viral Market Meltdown IV: Investing for a post-virus Economy
  5. A Viral Market Meltdown V: Back to Basics
  6. A Viral Market Meltdown VI: The Price of Risk
  7. A Viral Market Meltdown: Market Multiples
  8. A Viral Market Meltdown: Value vs Growth, Active vs Passive, Small Cap vs Large!

Wednesday, April 8, 2020

A Viral Market Meltdown VI: The Price of Risk

It is a sign of how volatile the last few weeks have been,  that a week like the last one, where index levels move only 2-3% a day, high by historic standards, felt stable. As in prior weeks, I will start this one by looking at how the market action last week played out across asset classes, and within equity, across regions and industries first, but the bulk of this post will be an update on the price of risk, and how it has changed in both bond and stock markets over the last six weeks. In the process, I will compare this six-week periods to the 2008 crisis, which was also global, and shook the faith people had in markets, institutions and companies.

The Markets last week
The market action last week was more muted than it had been in prior weeks, but that is a relative statement, as we still saw big swings in almost every asset class. Using the same sequencing that I have used for the last few weeks, I will start with a  review of equity indices globally:
Download raw data
It was a quiet week for most markets, with the Nikkei and the Sensex being the exceptions, dropping 8,09% and 7.46% respectively. Over the last month, every market has seen double digit negative returns, with Shanghai being the only exception. Moving on to US treasuries, we saw more calm than in prior weeks, with rates staying close to where they were in the previous week:
Download raw data
The (relative) calm in equity and treasury markets also played out in the corporate bond market, with spreads decreasing slightly for higher rated bonds and increasing marginally for lower rated bonds.
Download raw data
The commodity markets continued on their wild ride, with oil again diverging significantly from copper:
Download raw data
Oil prices surged dramatically towards the end of the week, mostly on rumors that Saudi Arabia and Russia would come to an agreement on oil production, but copper prices stayed stable. Completing the analysis, I looked at gold and bitcoin last week:
Both gold and bitcoin saw little price action during the week, not a bad development in a crisis market. In summary, looking at returns across asset classes last week, and comparing those returns to prior weeks, it is clear that last week saw a reduction in the volatility that has characterized previous weeks. It is unclear, though, whether the week is just the calm before another storm, or a true break in the crisis. The next few weeks will tell!

Breaking down the weekly movements
As in prior weeks, I start by looking at publicly traded companies around the world, and looking at how they did, in market capitalization terms, last week, and break down the information by region, sector/industry and classes (PE, momentum, debt etc.). I start with the regional breakdowns:
As with the market indices, it was a  week of losses, albeit small ones, in much of the world, with the outliers being Eastern Europe & Russia, which saw a gain of 9.07%, and Japan, which lost 9.38% in market capitalization. Collectively, global stocks lost $1.6 trillion in the week of March 27-April 3, and have lost $22.7 trillion in market capitalization since February 14, 2020, a decline of 25.08%. Moving on to the sector breakdown:

The rise in oil prices pushed up the market capitalization of the energy sector by 6.31%, but most of the other sectors saw losses during the week of 3/27-4/3/20. Incorporating the last week into the data, financial service firms have now taken the dubious lead among sectors, of biggest percentage drop in market capitalization since February 14, 2020, and consumer staples and health care still lead the list of least damaged sectors.  Honing down to the industry level and updating the list of ten most hurt and least hurt industries:
Data on all industries
The loser list has many of the same infrastructure industries that showed up in last week’s list, but the winner list has a healthy sprinkling of energy stocks, pushed up by the rise in oil prices during the week. I also did the breakdown, looking at companies in PE classes, momentum classes (based upon price change over the year leading into 2/14/20, net debt classes and dividend/buyback classes) and found that the only categorization where there is significant differentiation in market damage is net debt, where more highly levered companies continue to be punished more than less levered companies. You can find these categorizations and results by clicking on this link. I did extend the analysis to look at companies that have bond ratings, a subset of 2271 Firms out of the total sample of 36,789 firms, and the results reinforce the finding that leverage has the biggest explanatory power for damage from this crisis:
As bond ratings drop, the decline in market value is more precipitous, with the ratings below investment grade (below BBB, in red) being particularly hit. 

The Price of Risk
In the last few weeks, as markets have tumbled, I have held back on reporting on a measure that I update every month, which is the equity risk premium. That said, the last six weeks reinforces a lesson that I learned the hard way in 2008, which is that dependence on a static, historical estimate makes no sense in a dynamic, shifting market. In this section, I want to focus on how the price of risk has changed over the last six weeks, and what lessons, if any, we can glean from those changes.

In a post from earlier this year on the topic, I argued that every risky asset class market has a price of risk, though that price is more observable in some markets than others. The price of risk changes on a day-to-day basis, and is determined by a combination of variables that encompass almost everything going on in the world from uncertainty about future economic growth (more uncertainty -> higher price for risk) to political stability (more instability -> higher price for risk) to worries about catastrophes/disasters (more worries -> higher price for risk) to investor risk aversion (greater risk aversion -> higher price for risk) to information availability/reliability (less reliable and accessible information -> higher risk premiums). I know that I am giving short shrift to weighty topics, and if you are interested in a more in depth assessment of these variables, you can read my 2020 update on equity risk premiums here. (Be warned. It is long and boring, and may put you to sleep, but that may be a good thing..) The more general point though that emerges from identifying the determinants is that changes in these variables will change the prices for risk, and since investing and valuation has to be based upon updated prices for risk, you need measurement approaches that capture these changes.

Bond Market Price of Risk
In the bond market, the price of risk is observable, since as investors see more default risk in the future, and demand higher prices for risk, bond prices drop and interest rates on bonds increase. That is what I chronicled when I reported on the default spreads on bonds in different ratings classes in the last section, and looked at how these spreads changed over the last few weeks of this crisis. It is true that default spreads, for a given default risk class, don't change much in mature markets during periods of stability, and this can be seen in the graph below, where I look at the default spreads on Moody's Baa rated bonds (translating into an S&P BBB rating)  since 1960:
Download raw data
Even during this period, there have been sub-periods of tumult, as evidenced by the change in default spreads in the 2008 crisis. Looking more closely at the the period between September 12, 2008 to December 31, 2008 at the spreads on bonds, here is what you saw:

In 2008, default spreads doubled between September 12, 2008 and December 31, 2008. In the last six weeks (February 14, 2020- April 3, 2020), the default spreads on bonds in every ratings class have widened, not surprising given both the economic damage done by the crisis and the higher likelihood of default and the fear factor:
It is interesting that the default spreads did not show much effect during the first two weeks of this crisis (February 14- February 28), but woke up to the crisis in the third week. Over the six weeks, spreads have almost doubled for the highest risk classes, and have increased significantly even for higher rated bonds.

Equity Market Price of Risk
Unlike the bond market, it is more difficult to measure a forward-looking and dynamic measure of equity risk, though there are short cuts that people have employed. For instance, there are some investors who use the earnings yield (the inverse of the PE ratio) as a rough proxy, arguing that it should be higher, when equity investors are demanding a higher price for risk. There are others who focus on the VIX, a traded measure of volatility that is observable and is a gauge of fear and worry, rising during crisis and market downturns. In the last six weeks, the VIX has gone on a wild ride, as can be seen in the graph below, peaking at 85.47 on March 18, 2020.

While the VIX is an instrument for measuring market fear, it is not a direct measure of the equity risk premium. My preference is an implied equity risk premium, computed by estimating the internal rate of return investors can expect to earn, given what they pay for stocks and expected cash flows in the future, and netting out the risk free rate:

As some of you who have visited my website know, I update this equity risk premium (ERP) at the start of every year, and the graph below summarizes the implied equity risk premiums on the S&P 500 at the start of every year from 1960 to 2020.
Download historical implied ERP
Note that the equity risk premium stood at 5.20% at the end of 2019, but is has been more volatile since the 2008 crisis, than prior to it. It was during that crisis that I developed the practice of computing the premium on a day-to-day basis to capture the battle between fear and greed that characterize every crisis. In the figure below,I graph the implied ERP from September 12, 2008 (the Friday before Lehman’s collapse) until December 31, 2008:

Note that on September 12, 2008, which was the triggering point for the 2008 crisis, the equity risk premium for the S&P 500 was 4.22% but during the next eight weeks, the ERP rose sharply to reach a high of 7.83% on November 20, 2008, before subsiding somewhat to end the year at 6.43%. One of the limitations that I faced during that period is that while I was able to update the index values and treasury bond rates every day, the earnings and cash flow numbers were being updated with a substantial lag, with the full changes not showing up until several months later.

I decided to do the same day-to-day calculation for the implied equity risk premium, with an augmentation. Rather than allow earnings and cash flows to remain stagnant, in the face of a crisis that will almost certaintly decimate both, I computed a COVID-adjusted ERP as well, with estimated drops in earnings and cash flows. In making these judgments, I did change my estimates across time, starting with a 15% drop in earning in the first two weeks of this crisis, and ending with a 30% drop in earnings for the S&P in the most recent two. Those changes may reflect my slow learning, as the gravity of the crisis magnified each week:
Download raw data
I understand that this crisis is by no means over, and I intend to keep computing the implied equity risk premium daily for as long as I think necessary, but if your estimates are close to mine, the equity risk premium for the S&P 500 was 6.01% (with the adjusted numbers) on April 1, 2020

Country Risk Premiums
At the start of each year, I compute equity risk premiums, by country, with the intent of using these numbers when I value companies, and leave them unchanged for the first half of the year. This year, though, the crisis has caused the numbers to change, and in some cases, dramatically. First, the base premium that I use is the US implied equity risk premium which has jumped from 5.20% to 6.01% (see above). Second, the additional risk premiums for countries are based upon sovereign default spreads, which like corporate bond spreads, have widened significantly. My updated basis for computing the country equity risk premiums is below:

My global picture of equity risk premiums at the start of April 2020 is provided below:
Download spreadsheet
Just to illustrate how much of a difference a few weeks can make to your estimates, I have also included the ERP from January 1, 2020, for comparison. Note that the premiums have not only climbed in every country, but they have increased more in the riskiest countries.

One of the lessons that I learned from the 2008 crisis was to move away from static approaches for computing equity risk premiums, dependent on looking at long periods of history. What I learned during the last three months of 2008 made me switch to using implied equity risk premiums in my valuation and corporate financial analysis, and to compute them on a monthly basis. This crisis has reinforced that practice. I have always found it difficult to grasp how companies can use hurdle rates that are not only set in stone, but set in stone a decade or two ago, even as the market environment shifts and the price of risk changes. The median cost of capital for a global company, which was 7.6% at the start of 2020, is now closer to 8%, with the increase in risk premiums more than compensating for the decline in risk free rates in much of the world and the rise in cost of capital, in US dollar terms, steeper in emerging markets than developed markets.

YouTube Video

Paper on Equity Risk Premiums
  1. Equity Risk Premiums: Determinants, Estimation  and Implications- The 2020 Edition
  1. Market Changes by Asset Class, 2/14 - 4/03
  2. Equity Market Changes by Industry, 2/14 - 4/03
  3. PE, Momentum & Dividend classes, 2/14-4/03
  4. Equity Risk Premium by day, 2/14 - 4/03
  5. Updated Equity Risk Premiums, by country (April 1, 2020)