In my last post, I discussed how inflation's return has changed the calculus for investors, looking at how inflation affects returns on different asset classes, and tracing out the consequences for equity values, in the aggregate. In general, higher and more volatile inflation has negative effects on all financial assets, from stocks to corporate bonds to treasury bonds, and neutral to positive effects on gold, collectibles and real assets. That said, the impact of inflation on individual company values can vary widely, with a few companies benefiting, some affected only lightly, and other companies being affected more adversely, by higher than expected inflation. In an environment where finding inflation hedges has become the first priority for most investors, the search is on for companies that are less exposed to high and rising inflation. The conventional wisdom, based largely on investor experiences from the 1970s, is that commodity companies and firms with pricing power are the best ones to hold, if you fear inflation, but is that true, and even if it is true, why is it so? To answer these questions, I will return to basics and try to trace the effects of inflation on the drivers of value, with the intent of finding the characteristics of stocks with better inflation-hedging properties.
Inflation and Value
When in doubt about how any action or information plays out in value, I find it useful to go back to value basics, and trace out the effects of that action/information on value drivers. Following that rule book, I looked at the effects of inflation on the levers that determines value, in the graph below:
Put simply, the effects of inflation on firm value boil down to the impact inflation has on expected cash flows/growth and risk. At the risk of restating what is already in the graph above, the factors that will play out in determining the end impact on inflation on value are in the table below:
If you were seeking out a company that would operate as an inflation hedge, you would want it to have pricing power on the products and services that it sells, with low input costs, and operating in a business where investments are short term and reversible. On the risk front, you would like the company to have a large and stable earnings stream and a light debt load.
Looking Back
There are lessons that can be learned by looking at the past, about how inflation affects different groupings of companies, though there is the danger of over extrapolation. In this section, I look first at how classes of stocks have done over the decades, and relating that performance to inflation (expected and unexpected). I then examine how equities have performed in the less than five months of 2022, where inflation has returned to the front pages.
Historical Data: 1930-2019
To see how this framework works in practice, let's start by looking at the performance of US stocks, across the decades, and look at the returns on stocks, broadly categorized based on market capitalization and price to book ratios. The former is short hand for the small cap premium and the latter is the proxy for the value factor in returns.
The distinction that I made between expected and unexpected inflation comes into play in this table. It is unexpected inflation that seems to have a large impact on the behavior of small cap stocks, outperforming in decades where inflation was higher than expected (1940-49, 196069, 1970-79) and underperforming in decades with lower than expected inflation (1990-99, 2010-19). The value effect, measured as the difference between low price to book and high price to book stocks was highest in the 1970s, when both actual and unexpected inflation were high, but remained resilient in the 1980s, when inflation stayed high, but came in under expectations.
The 2022 Experience
As the focus has shifted back to inflation in the last five months, it is worth looking at performance across US stocks, broken down by different categorizations, to see whether the patterns of the past are showing up in today's markets.. For starters, let's look at the how the damage done by inflation on stocks varies across sectors, looking at the 2022 broken down in three slices, the returns in the first quarter of 2022 (when Russia competed with inflation for market attention), the period from April 1 - May 19, 2022 (when inflation was the dominant story) and the entire year to date.
In 2022, the collective market capitalization of all US firms has dropped by 19.75%, with the bulk of the drop occurring after April 1, 2022. During the period (April 1- May 19, 2022), the three worst performing sectors (highlighted) were technology, consumer discretionary and communication services, and the best performing sectors were energy (no surprise, given the rise in oil prices) and utilities, old standbys for investors during tumultuous periods.
To check to see if the outperformance of small cap and low price to book ratios that we saw in the 1970s is being replicated in 2022, I broke companies down by decile (based on market cap and price to book at the start of 2022), and looked at changes in aggregate value in 2022:
As in the 1970s, the small cap premium seems to have returned with a vengeance, as small cap stocks have outperformed large caps in 2022, and the lowest price to book stocks have done less badly than high price to book stocks. To examine the interaction and stock price performance in 2022, I looked at the aggregate returns on firms classified into deciles based upon both equity risk (betas) and default risk (with bond ratings):
The link between equity risk and stock returns support the hypothesis that firms that are riskier are more affected by inflation, with one exception: the stocks with the lowest betas have also done badly in 2022. On bond ratings, there is no discernible link between ratings and returns, until you get to the lowest rated bonds (CCC & below). In a final assessment, I break down companies based upon operating cash flows (EBITDA as a percent of enterprise value) and dividend yield (dividends as a percent of market capitalization).
Companies that generate more cash flows from their operations and return more of that cash flow in dividends to stockholders have clearly held their value better than companies with low or negative cash flows that pay no dividends, in 2022. Looking at these results, value investors will undoubtedly find vindication for their beliefs that this is a correction long over due, i.e., a return to normalcy where safe stocks in boring sectors that pay high dividends deliver excess returns. I do think that given how consistently growth stocks have been beating value stocks for the last decade, a correction was in order, but I believe it is way too early to proclaim the return of old fashioned value investing.
Bottom Line
This has been a painful year for investors in US equities, but the pain has not been evenly spread across investors. Portfolios that are over weighted in risky, money losing companies have been hurt more than portfolios that are more weighted towards companies with less debt and more positive cash flows. Even within some of the worst performing sectors, such as technology, breaking companies down, based upon earnings and cash flows, there is a clear advantage to holding money making, older tech companies than money losing, young tech companies:
The question of whether these trends will continue to apply for the rest of the year cannot be answered without taking a stand on inflation, and the effects that fighting it will create for the economy.
If you believe that there is more surprises to come on the inflation front, and that a recession is not only imminent, but likely to be steep, the returns in the first five months of 2022 will be a precursor to more of the same, for the rest of the year.
If you believe that markets have mostly or fully adjusted to higher inflation, betting on a continuation of the small cap and value outperformance to continue is dangerous.
To the extent that there may be other countries where inflation is not the clear and present danger that it is in the United States, investing in equities in those countries will offer better risk and return tradeoffs.
As I noted in my last post, once the inflation genie is out of the bottle, it tends to drive every other topic out of market conversations, and become the driving force for everything from asset allocation to stock selection.
In the midst of chaos and confusion, it is human nature to look for order and for a unifying theory that explains the world. As I have navigated my way through this crisis, I have used data from markets to try to come up with explanations for why markets have rebounded as quickly and as much as they have, and in the process, why they have added value to some companies, while reducing the value of others. It is in this pursuit that I noted that the crisis has enriched growth companies at the expense of value companies, flexible companies have gained at the expense of rigid ones, and young companies have gained on older, more mature businesses. But why have these shifts occurred? In this post, I look at a factor that lies behind all of them, and that is the resilience of private risk capital, taking the form of venture capital for start ups and private business, initial public offerings in public markets and debt (in the form bonds and bank loans) to the riskiest companies, as the crisis has unfolded.
Market Outlook
Let me start, as I have in my prior posts on this crisis, start with a market overview. In the three weeks since my last update, equity indices have continued their recovery, albeit at a more modest pace, from the worst days of the crisis:
Note that I have broken returns down into two periods for every index, the first period (2/14-3/20) marking the worst days of this crisis, and the weeks since (3/20-7/17) representing the comeback. By July 17, the NASDAQ had not just recouped its losses but was up 9.61% since February 14, my starting date for the crisis. Within each region, there remain divergences, with the DAX outperforming the FTSE and CAC in Europe, and the Nikkei and Shanghai doing much better than the Sensex in Asia. As stocks have gone through a roller coaster ride, US treasuries seem to have gone into a coma, after an initial period of frenetic activity:
The rates on US treasuries dropped significantly in the first four weeks of the crisis, but since the middle of March, have shown almost no movement, with short term treasuries staying close to zero, and 10-year treasuries at or around 0.7%. Tracking oil and copper, two economically sensitive commodities, here is what I see:
Both commodities saw prices drop between February 14 and the end of March, but oil dropped significantly more than copper in that period. In the weeks since, both commodities have recovered, with copper now trading 12.5% higher than it was on February 14, but oil his still down more than 20%. As the crisis has played out in the equity and bond markets, I also tracked gold and bitcoin price movements over the period:
Since February 14, gold prices are up more than 14%, reaffirming its role as a crisis asset, but bitcoin has been on a wild ride, dropping more than 50% between February 14 and March 20, as stock prices dropped, and rising almost 75% in the weeks since, as stocks have recovered. In short, it has behaved like very risky equity, not a crisis asset.
Equity Breakdown
While looking at indices, treasuries and commodities gives big picture perspective on this crisis, the real lessons are in the company-level data and to learn them, I examined market capitalization changes across all publicly traded companies, classified by region:
Emerging markets, at least collectively, have lost more value than developed markets, with Latin America, Eastern Europe and Africa showing the biggest losses. Asian stocks have done better, with China being the best performing region of the world and India being the laggard in that region. Updating the values globally, stocks have lost $3.6 trillion in market capitalization since the start of the crisis, but that is quite a turn around from the $26 trillion that had been lost through March 20. Breaking down the changes in value, by sector:
While every sector has seen improvement since the bottom on March 20, energy, financials and real estate still show substantial losses in market cap over the entire period, but six of the eleven sectors now show positive returns, with health care leading the way, up 9.5% since February 14. Breaking the sectors down further into industries, here is the list of the ten best and worst performing industries:
There are two striking features in this table. The first is that the worst performing industries are a mix of capital intensive businesses and financial services and the best performing industries are dominated by capital-light businesses and health care. The second is the divergence between the best and worst performing industries is striking, with the best performing industries (online retail and internet software) up more than 30% since February 14, while the worst performing industries (oil and airlines) are down more than 40% over the same period.
Risk Capital
There is little that I have said in this post, so far, that is new, since it is a continuation of trends that I have seen since March. That said, and now that we have information on winners and losers over the last five months, it is worth taking a closer look at the broader forces that are driving the market to reward some companies, and punish others, and what it is that is making market behavior so disconcerting to long-time market observers. Specifically, I will argue that the behavior of risk capital during this crisis has been very different from prior ones, and it is that difference that explains anomalous market behavior.
Definition and Crisis Effects
Risk capital is capital that is invested in the riskiest assets and markets, and it encompasses a wide range of investment activity. For young companies, private and in need of capital to be able to deliver on their potential, it takes the form of venture capital. In public markets, it manifests itself in the money that flows into initial public offerings and to the riskiest companies, often smaller and more money losing. It can also take the form of debt, lending to firms that are in or on the verge of distress, and investing in high yield bonds. In most market crises, risk capital becomes less accessible and available, as fear dominates greed, and investors look for safety. Thus, you will see venture capital, always a boom and bust business, become scarcer, and the young companies that are dependent on it have to either shut down or sell themselves to deep-pocketed and more established companies, often at bargain basement prices. In public markets, initial public offerings become rare or non-existent, and money flows out of the riskiest companies to safer companies (generally with stable earnings and large dividends). In corporate bond market, new issuance of corporate bonds drops off, across the board, but much more so for the riskiest companies (those below investment grade). As I will argue in the rest of this section, that has not been the case in this crisis. While the flight to safety was clearly a dominant theme in the first three or four weeks of this crisis, risk capital has not only stayed in the market through this crisis, but has become more accessible rather than less, at least in some segments.
Venture Capital
Investing in young companies, especially start-ups and angel ventures, has always been a high-risk endeavors for two reasons. First, these businesses have to be priced or valued with much less information on business models or history than more mature companies, and many investors are uncomfortable making that leap. Second, the failure rate among these companies is high, since more than two-thirds of start ups do not make the transition to being viable businesses. Venture capital's role is to nurture these young companies through these early dangers, and in return, the hope is that the investment will earn outsize returns, when they exit. This accentuated risk return trade off makes venture capital the canary in the coal mine, during a crisis, and you can see that play out in the following graph, tracking venture capital raised by year, both in the US and globally:
In the last quarter of 2008 and in 2009, as the public markets plunged into crisis, note the drop of in venture capital invested, down more than 50% globally, and 60% in the United States. In fact, it took until 2014 for venture capital to return to levels seen before the crisis (in 2007), but once it did, it found new buoyancy leading into 2020. When the COVID crisis hit in February, the question was whether venture capital would retreat as it did in 2008, and the numbers so far don't seem to indicate that it will:
Venture capital infusions did drop off in the first quarter of 2020, but not precipitously, and staged a recovery int he second quarter. It is true that less money is being invested in angel seed companies, presumably the riskiest class, and more in later stage businesses, but it does not look like venture capital has shrunk back into its shell, at least so far.
Public Equity Risk Capital
In public markets, risk capital plays out in more subtle ways than in private markets, flowing in and out of the riskiest segments of the market, as fears rise during a crisis. In most crises, as I noted earlier, the money flow favors the safer companies, pushing up their pricing and valuation, and works against the riskiest companies.
1. Risk Groupings
One measure of how risk capital has behaved in public markets is to look at market capitalization shifts from groupings of companies that are considered risky to groupings that can be considered safe. Since there can be disagreements about how best to create these groupings, I have considered multiple measures for the risk/safe continuum in the table below, and highlighted how market capitalizations have changed, in the aggregate, on each measure:
To make sense of this table, pick a grouping, say PE ratios. The Risk On/Off columns highlight the conventional wisdom that low PE stocks are safe and high PE stocks are risky. The returns columns report on what companies in the top and bottom deciles of PE ratios have earned during this crisis period, in both percentage and dollar terms. Thus, the stocks with the highest PE ratios (top decile) have seen their market capitalization increase by 10.81% ($674 billion) while stocks in the lowest PE ratio decline have seen their market values drop by 8.31% ($246 billion). On almost every measure that I use for risk in this table, this market has pushed up the valuations of the companies that would be considered riskiest and pushed down the values of the companies that would be considered safest. The only risk categorization where punishment has been meted out to the riskiest companies is financial leverage, with the companies that have the most debt (in net debt to EBITDA terms) seeing market capitalization decrease by 15.49% ($1,082 billion), while companies that have the least debt have seen market value increase by 12.32% ($300 billion). It is still only five months into the crisis, and markets can surprise and shift quickly, but at least from today's vantage point, this crisis has played out in a most unusual way, with the riskiest companies increasing in value, at the expense of the safest, with debt-driven risk being the exception.
2. IPOs
One of the most observable measures of market confidence in access to risk capital is initial public offerings, since companies going public are often younger, more risky companies. The best way to illustrate this is to look at initial public offerings over time, measuring both the number and dollar value raised in these offerings:
In terms of number of initial public offerings, the 1990s clearly set a standard that we are unlikely to see in the near future, and while the dot com bust brought the IPO process back to earth, you can see the damage wrought by the 2008 crisis. In the last quarter of 2008, as the crisis unfolded, there was only one initial public offering made in the US and the drought continued through 2009. While the number of IPOs has remained well below dot com era levels, the value raised from IPOs bounced back in the last decade, reflecting the fact that companies were delaying going public until they were bigger in market cap terms, with 2019 representing a year with several high-profile IPOs that disappointed investors in the after-market. When the COVID crisis hit in February, the expectation was that just as in prior crisis, the IPO process would come to a grinding halt, as private companies waited for the return on risk capital. In the graph below, I look at initial public offerings (both in numbers and dollar proceeds), by quarter:
As with venture capital, there was a pause in the IPO process, in the first few weeks, and you can see that in the first quarter numbers. However, initial public offerings returned to the market in the second quarter, in both numbers and dollars, and the pipeline of IPOs is filling up again. In fact, I have not counted IPOs of SPACs (or blank check companies) in my statistics in my analysis, and there were quite a few of those in the second quarter of 2020, another indicator of investors willing to take risk.
3. The Price of Risk (Equities)
When risk capital is on the move, the number that best reflects its movement is the equity risk premium, rising as risk capital becomes scarcer and falling with access. During 2008, for instance, my estimates of the equity risk premium reflected this fear factor, rising from 4.4% on September 12 yo a high of 7.83% on November 20, before dropping back to 6.43% on December 31 (still well above pre-crisis levels):
I have reported that process during this crisis, but my estimates of the equity risk premium for the S&P 500 are in the graph below:
The story embedded in this graph is the same one that you see in the VC and IPO pictures. In the first few weeks of the COVID crisis, the price of risk in the equity markets surged, just as it had in 2008, hitting a high of 7.75% on March 23. In the weeks since, equity risk premiums have almost dropped back to pre-crisis levels, as risk capital has come back into the market. Incidentally, this return of risk capital is not just a US-phenomenon, as can be seen in the picture below, where I report my estimates of the equity risk premiums, by country, through the crisis:
With each country, I report three numbers, an equity risk premium from the start of 2020 (reflecting pre-crisis values), from April 1, 2020, at the height of the market meltdown, and from July 1, 2020, as capital has returned. Just to illustrate, Brazil saw its equity risk premium rise from 8.16% on January 1, 2020, to 11.51% on April 1, 2020, before dropping back to 9.64% on July 1, 2020. Put simply, risk capital has returned to the riskier emerging markets, though the return has not been as complete as it has been in the US.
Risky Debt
Much of the discussion about risk capital so far has been focused on equity markets, but there is risk capital in other markets as well. In the private lending market, risk capital is what supplies debt to the companies most in need of it, often distressed, and in the corporate bond market, it manifests itself as demand for the riskiest corporate bonds, usually below investment grade.
The COVID Effect - Early Days
In the first few weeks of the crisis, the key concern that investors had about the economic shut down was whether companies that carried significant debt loads would be able to survive the crisis. This fear manifested itself not only in concerns about bankruptcies, but also in government bailouts to save companies that were most exposed, such as airlines. There was also talk of how this crisis could spread to other sectors burdened with debt, and put the banking system at risk. It is these fears that led the Fed to announce on March 23, 2020, that it would be provide a backstop in the corporate lending market, proving loans to companies in distress and buying corporate bonds. There is debate about whether the Fed should be playing this role, but it cannot be denied that this action, more than any other by any entity (government or central bank) during this crisis, changed its trajectory. It is not a coincidence that Boeing which had been having trouble raising debt, in early March, was able to borrow $25 billion in the corporate bond market a few weeks after the Fed's announcement. In fact, as you will see in the section below, the Fed's announced opened the flood gates for corporate bond issuances and caused a turnaround in corporate bond yields.
The COVID Effect - Corporate Bond Issuances
In the corporate bond market, risk capital is the lubricant that provides liquidity in the high yield bond market, and allows companies that are below investment grade to continue raising capital. Not surprisingly, during crises, it is this portion of the corporate bond market that is affected the most, with yields climbing and new bond issues becoming rarer. You can see this phenomenon play out in the graph below, where I look at corporate bond issuances by year:
During the 2008 crisis, bond issuances declined across the board in the last quarter of 2008 and the first quarter of 2009, but the drop was much more precipitous for high yield portion. During the COVID crisis, the numbers look very different:
After a brief pause in issuances in the first few weeks (between February 14 and March 20), bond issuances returned stronger than ever, with high yield bond issuances hitting an all-time high (in dollar value) in June 2020. For the moment, at least, the Fed's backstop bet has paid off in the bond market.
The Price of Risk (Bonds)
As with the equity market, there is a market measure of access in risk capital in the bond market, and it takes the form of default spreads. During a crisis, as risk capital leaves, you see spreads increase, as was the case in the last quarter of 2008:
Default spreads increased across the board for bonds in every ratings class, but much more so for the lowest rated bonds during the 2008 crisis. To provide a contrast, I looked at default spreads for bonds in seven ratings classes on February 14, March 20 and July 17:
As in 2008, default spreads surged between February 14 and March 20, as the crisis first took hold, but unlike 2008, the spreads have rapidly scaled down and are now lower for the higher investment grade classes than they were pre-crisis and only marginally higher for the lowest rated bonds.
Explaining the Resilience
If you accept the evidence that risk capital has stayed in the market during this crisis, in contrast to its behavior in prior crises, the follow-up question is why. For some of you, I know the answer is obvious, and that is that this market recovery has been engineered and sustained by central banks. While there is some truth to the "Fed did it" argument, I think it is too facile and misses other ingredients that have contributed.
Central Banks: Earlier in this post, I noted that the turnaround in this market can be traced to the Fed's announcement on March 23, that it would provide a backstop to the corporate bond/lending market. That said, the actual amount spent by the Fed on these programs has been modest, as can be seen in this graph:
While there is a healthy debate to be had about whether central banks have become too activist, I believe that the Fed's corporate backstop announcement is the type of action you want central banks to take, since in its absence, bankruptcies and bailouts would have been the order of the day. In fact, the very fact that the Fed has actually not needed to use it is evidence that it worked, since private lenders stepped in to fill the gap. I concede that some risk taking investors will take the wrong cues from this action, expecting that the Fed will protect them from the downside, while they take advantage of the upside.
Investor Composition: The Fed's actions worked as well as they did because investors in both equity and bond markets responded quickly and substantively, and that response may reflect the changed composition of investors today. First, markets have become much more globalized, and investors are much more willing to invest across markets, with money moving from equity to debt markets, and across geographies, much more easily than it used to. Second, the investment world has flattened, as retail investors (the so called stupid money) catch up to institutional investors (smart money?) in terms of access to information, data and tools and are more willing to deviate from conventional wisdom.
Unique Crisis: As I have noted in prior posts, this has been an unusual crisis, in terms of sequencing. Unlike prior crises, where market meltdowns came first and the economic damage followed, in this one, the economic shutdown, precipitated by the virus, came when markets were at all-time highs and risk capital was widely accessible. It is possible that risk capital, for better or worse, believes that this is crisis comes with a timer, and that economies will revert back quickly once the virus passes, and shut downs end.
Change in Corporate Structure: After two decades of disruption, it is quite clear that center of gravity has shifted for both economies and markets, with the bulk of the value in markets coming from companies that are very different from the companies that dominated the twentieth century. While much is made of the fact that the biggest companies of today's markets (in market capitalization terms) derive their value from intangible assets, I think the bigger difference is that these companies are also less capital intensive and more flexible. That flexibility, allowing them to take advantage of opportunities quickly, and scale down rapidly in the face of threats, limits downside and increases upside. At the risk of using a buzz word, there is more optionality in the biggest companies of today, making risk more an ally than an enemy for investors, and with options, risk can sometimes be more ally than enemy.
Five months into this crisis, I am still learning, and there is much that we still do not know about both the virus and markets.
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.
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.
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:
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:
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:
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:
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:
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.
