A Viral Market Meltdown III: Pricing or Value? Trading or Investing?

This is the third, and I hope the last, of my viral market updates, reflecting how much change a week can deliver, and last week delivered more change than most investors could handle. Not only did we see two of the worst market days in history, in absolute terms, we also saw the worst single day in US market history since October 19, 1987, in percentage terms. In fact, the price change this week has been so dramatic that it makes the tables that I provided last week on market damage, across sectors and regions,  seem dated. In this post, I will update those tables, but I want to focus on a much larger question of how investors should craft a response to the market meltdown, and how that response cannot be one-size-fits-all.

Price versus Value

I have long drawn a distinction between price and value, two terms that get used interchangeably in both academia and practice, but with very different drivers and implications. As we watch stock indices around the world gain and lose trillions each day, it is worth remembering that markets are pricing mechanisms, not value mechanisms, or as Ben Graham would put it, they are voting machines, not weighting machines, at least in the short term.

The Drivers

To draw the contrast between price and value, I will use a picture that I have used many times before, where I outline the drivers of value and contrast them with the determinants of price:

Note that the drivers of value are cash flows, growth and risk, familiar ingredients in both intrinsic value and fundamental analysis. The determinants of price are both less complicated and more powerful, demand and supply, and all of the forces that drive them. While rational investors may use only fundamentals in setting demand and supply, we know, both from research and experience, that fundamentals are drowned out in markets, by mood and momentum. Markets have always been pricing games, with the degree of weight put on fundamentals ebbing and flowing over time, with less weight assigned in good times, and more after market corrections. During periods like the last three weeks, the market is all pricing all the time, with fundamentals not even on the radar. That does not make markets wrong, but it does make them difficult to decipher and tricky to navigate.

The Differences

If you accept the distinction between price and value that I have drawn, it can be used to draw out why price and value diverge, and frame investment philosophies around those divergences.

1. Price has no upper or lower bound. Value does.

Since price is determined by demand and supply, and there is nothing that constrains those buying and selling in markets, at least in the near term, it follows that there is no upper or lower bound to prices. In short, the prices of stocks can move towards infinity or towards zero, depending on where mood and momentum take them. Value on the other hand has both upper and lower bounds, with both bounds being set by expected cash flows, growth and risk. The upper bound is set by those who are more optimistic about a stock and what they forecast the fundamentals to be (high cash flows, high growth and low risk) and the lower bound by those who are most pessimistic about that same stock, in terms of future expectations or liquidation value. It is true that reasonable investors can disagree about where these bounds lie, but they should not disagree about the existence of these bounds. It is possible, for some stocks, especially early in the life cycle and with substantial uncertainty about the future, for the lower bound on value to be zero, but stocks collectively cannot have that lower bound. For equities collectively to be worth nothing, you would require an apocalyptic scenario, one in which there is little point thinking about investments anyway.

2. Price is reactive, Value is proactive!

Information is the lubricant for market movements, but information works differently in the pricing and value processes, on two dimensions:

1. Incremental Information versus Fundamental Information: If pricing is driven by mood and momentum, those forces can take information that, at least at first sight, seems insignificant, from a value perspective, and cause price changes that are disproportional. Thus, when the mood is upbeat, small pieces of good news can result in big jumps in stock prices, but if that mood turns sour, small pieces of bad news can cause large drops in stock prices. To illustrate, the 10% plus drop in US stocks on Thursday (3/12) was supposedly caused by the Trump Administration's decision to bar flights from Europe for thirty days, and the almost equivalent jump the next day (3/13) by its decision to declare an emergency. 
2. Reactive versus Proactive: Since pricing is determined entirely be demand and supply, and there is no value center to it, it is, by its very nature, reactive. Put simply, traders react to the incremental information to adjust the price, and put little thought into whether the starting price itself has a basis to it. Thus, a starting price that is too high (low) will only get higher (lower), if the incremental news that comes out is good (bad). On the other hand, value is driven by expectations of cash flows, growth and risk, and incremental information has to be used to reassess those expectations, a more difficult task, but one that forces you to separate the wheat from the chaff. 

In periods of pricing tumult, like the last three weeks, it is both futile and perhaps counter productive to try to explain big pricing moves, especially on a day-to-day basis, with the language and tools of value. If I could make a suggestion to the financial news channels now, here is what it would be. Remove all the talking heads (including me) from the screen, and just show the stock indices in real time. This is a market that needs no commentary!

3. Equity prices may never converge on value (at least in your lifetime or mine).

Old time value investors live by the adage that prices can go up and down, with little relationship to value, but that they eventually converge on value. That sounds reasonable until you consider what "eventually" means, at least in the context of equity in a publicly traded company. Absent a catalyst causing the convergence, it is true that price will not only diverge from value in the short term, but it could do so for very long time periods. Put simply, assuming that you will be rewarded for being right on value can be a pipe dream, and Keynes was correct when he said that the "market can stay irrational longer than you and I can stay solvent".  So what is it that keeps investors toiling at the fundamentals, hoping to get rewarded? The answer is faith, faith that they can estimate value and faith that the price will adjust to value. It is faith because I can offer you no proof for either proposition, and it is faith, because its strength will be tested by markets like this one.

An Investing Game Plan

If you are wondering what all of this discussion of price and value has to do with how you should react to the market drop, I will argue that your response has to be tailored to (a) whether you have faith in investing (b) how much liquidity you have or need and (c) where you see yourself as having the biggest edge over the rest of the market.

Do you have faith?

In the abstract, most market participants describe themselves as long term, patient and believers in value. Books about Warren Buffett outnumber those sold about any other market player, by ten to one, but I think one of his pithier sayings comes to mind, when evaluating whether people mean what they say about being long term value investors. Buffett once said that it is only when the tide goes out that you can tell who’s been swimming naked, and it is only when the market goes into crisis mode that you can tell the investors from the traders. So, if you came into the February 2020, describing yourself as a believer in value, do you still believe? If yes, what have you done or not done during the last three weeks that is consistent with that faith?  My faith in value and price adjusting to value is strong, but it is not absolute. I have found myself questioning my own beliefs at times during these weeks, just I did in 2008, and I believe that is not only natural, but healthy. My faith still holds, but I have a feeling that there are more tests to come.

Are you selling or buying liquidity?

There is no stronger resource to have during a crisis than a cash cushion, since investors seek out liquidity and are willing to pay handsomely for it. That said, whether you can buy or sell liquidity may not be in your control and is affected by outside forces:

• Income Predictability: If you are feeling a little less secure about your income prospects after the last three weeks, you are not alone, and while this will pass, it does affect how much cash you need to conserve, just in case.
• Cash Needs: Virus or no virus, house payments have to be made, credit card bills paid and unexpected costs covered, and a shakier economy make all of these obligations more onerous.
• Personal make up: I believe that the key to picking an investment philosophy that is right for you is to make sure that you can pass the sleep test, with it. Put simply, if you lie awake at night thinking about your portfolio, you’ve failed the test. If you are naturally impatient, your time horizon is shortened, and no lecture on the importance of long term investing or data backing up that it works, can change that.

If you add mortality to this list, and the fact that if you manage other people's money (in a mutual or hedge fund), it is their time horizon that may matter, not yours, it is easy to see why what is perceived as liquidity in good times very quickly dissipates in bad one. If you are sitting on a cash cushion, you are already in a much better spot than those who do not have that luxury, but there are two uses that you can put the cash to, one passive and other active. The passive response would be to hold on to the cash, preserve your sanity and pass the sleep test, as markets stay volatile. The active response is to use the cash to take positions, though what you will invest in will depend on whether you believe in value or price, and within each of these, where you think that market is mistaken. If you are in the less enviable position of needing cash quickly, either to meet a liquidity crunch or to stop failing the sleep test, you should sell some of your holdings, though what you sell will reflect again your beliefs about market mistakes.

What is your edge?

To succeed as an active market player, you have to bring something to the table, and recognizing the edge that you bring is key to success, and that is true whether you are an investor (who believes in value) or a trader (who plays the pricing game).

• As an investor, your skills may lie in assessing the entire market, sectors or individual stocks, and this crisis has brought those all into sharper focus. 
• As a trader, you can be good at riding momentum or detecting shifts in it and making money from reversals, and the opportunities for both have expanded, as market volatility has expanded.

In either case, you will get an opportunity in the coming weeks to plot your own path through this crisis, and as I mentioned at the start of this post, it will not be one size fits all. 

Choosing your Game Plan

In the picture below, I have outlined how your faith or its absence, liquidity or lack thereof and your perceived edge will all come into play in determining what is your best path of action.

I have never believed in offering investing frameworks, without being open about the choices that I am making, not because they are the “right” ones, but because they are the ones that work for me. I believe in value, and I am lucky enough to have liquidity. I believe that I can bring more to the table, when valuing individual stocks, than I can, in assessing sectors or markets. 

What now?

I know that this post has meandered and I am sorry, but in this last section, I will come back to the numbers, by first updating my valuation of the S&P 500 and then moving on to both update the tables on market damage from March 6 to reflect the last week's market action. 

Valuing the Index

While some of you will view this as a futile exercise, I revisited my S&P 500 valuation spreadsheet that I created two weeks ago, and updated it, to reflect an expectation that the earnings damage this year is likely to be larger than I initially estimated. Rather than provide a single value estimate for the S&P 500, I have run a Monte Carlo simulation around the four key inputs: earnings drop this year, the percentage that will be recouped by 2025, the percent that will be returned as cash flows and the equity risk premium:

Download spreadsheet & Simulation results

Note that on the earnings drop and subsequent recovery, I have used distributions with more downside surprises than upside, reflecting my belief that there is a chance of significantly greater damage than expected, albeit with small probabilities. The median value of 2750 is marginally higher than 2011, the level of the index on Friday, March 13, but this is not an investment for the faint of heart. 

Valuing Individual Stocks/Sectors

I have held back on individual stock valuations for the last two weeks, but I will start looking, and to help decide where to start, I created this very simple structure for thinking about what companies are most affected and least affected by the virus:

Using this framework, firms that sell non-discretionary products, are non-travel related, have low leverage (operating and financial) and are cash flow positive should be least affected by the virus, and discretionary product/service or travel-related companies with high fixed costs and debt, should be most affected. In the table below, I have updated both my sector and industry tables that I had posted last week, to reflect the additional damage from last week:

Download spreadsheet

The ten industry groups that were affected most and least by the market turmoil are below:

Download spreadsheet

Updating the regional tables to include the last week’s data:

Download spreadsheet

I also rechecked the momentum and PE tables, and while every decile of each lost money last week, there was no discernible pattern in either. Finally, I broke firms down by debt ratio (as percent of total market value of the firm), to see if firms with more debt were being punished by the market more than less indebted firms, and see only a mild relationship. You can download all of this data by clicking on this link. Collectively, global equity markets have lost a staggering $18.65 trillion in market capitalization, with US stocks accounting for $7.6 trillion in those losses. Note that the market damage lines up well with our priors, which is what makes investing tricky. In fact, there are two perspectives that you can bring to surveying these stocks, leading to contradictory strategies.

• If you believe that markets have over reacted, your best chance at finding value might be to look in the rubble, the worst affected regions, sectors and companies
• If you think that markets have not fully incorporated the economic damage from the virus, you should look at the regions, sectors and companies that are more protected.

The first two stocks on my radar for in-depth intrinsic valuation are Zoom, one of the few stocks that has benefited from this crisis, and Boeing, a stock that has lost more than half of its market capitalization, as its high-leverage, travel-focused business is put to the test by this virus. Implicit in both these valuations will be my own views on the macro and timing effects of this virus, but that is something that I cannot avoid taking a point of view on. Stay tuned!

YouTube Video


Spreadsheets/Data

1. Spreadsheet to value S&P 500, March 13, 2020
2. Simulation Results for S&P 500 (Run using Crystal Ball)
3. Market Capitalization Changes, February 14- March 13, 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 Update VII: Market Multiples
8. A Viral Market Update VIII: Value vs Growth, Active vs Passive, Small Cap vs Large!
9. A Viral Market Update IX: A Do-it-Yourself S&P 500 Valuation
10. A Viral Market Update X: A Corporate Life Cycle Perspective
11. A Viral Market Update XI: The Flexibility Premium
12. A Viral Market Update XII: The Resilience of Private Risk Capital
13. A Viral Market Update XIII: The Strong (FANGAM) get Stronger!

A Viral Market Meltdown Part II: Clues in the Debris!

Update on 3.9/20: In a sign of how volatile times are, over the weekend, oil prices plummeted to close to $30, the treasury bond rate to less than 0.4% and the market looks set to drop substantially. A work in progress indeed....

I wrote a post on how the Corona Virus was playing out in markets on February 26, two days into the market going into convulsions, and while I tried to make an assessment of the value effect, I also said that this analysis was a work in progress, that I would revisit as we learned more about the virus and its economic consequences. Eleven days later, we still don't have clarity on the health or economic effects of the virus, but we do have substantially more data on what the market reaction has been. In this post, I will begin by doing a quick update on the viral spread across the world, but spend more time on the market damage, looking at where it has been greatest, seeking clues for the future. 

A Virus Update

In the last week and a half, the virus has clearly expanded its global footprint, with Italy and South Korea now in the front lines, in terms of exposure, but with the numbers climbing rapidly across the rest of the world, it is clearly now on its way to becoming a global pandemic. 

NY Times, as of March 6, 2020

While the word "pandemic" alone is often enough to drive us to panic, it is not the first, nor will it be the last, and it helps to gain perspective to compare it to pandemics in the past, both in terms of contagion and health consequences. This chart from the New York Times reflects what we know about the virus as of February 28, 2020:

Note that the large band of uncertainty around the fatality rate related to the virus, reflecting how little we know about its potential consequences and how it measures up against other viruses in terms of contagion. Put simply, this is not just the common flu with side effects, as some have argued, but it is perhaps not the deadly killer that others at the other extreme has painted it as. The X factor that makes this virus potentially more difficult to contain and more likely to have global consequences is globalization, one more argument that populists will undoubtedly use to argue against it. The reality is that travel, especially across borders and continents, is not only easier than ever before but also more affordable, as income levels rise in the developing world.  Over the next few weeks, it is likely that we will see the case numbers rise dramatically in countries which have been hitherto exposed only lightly to the virus, the fatality numbers will rise among those affected, and health systems around the world will come under pressure. 

A Market Update

Over the last three weeks, we have had a glimpse of how quickly market moods can shift. Looking at the major US equity indices, you can see the euphoria that resulted in the market peaking on February 12, 2020, not only faded quickly but has been replaced with panic and desperation:

If there is one thing that can be said about markets during this tumultuous period, they were not playing favorites, since all of the indices registered double git drops, with the NASDAQ showing the smallest drop.

a. Melting Away - Dollar Value Lost

The focus on the indices can obscure the staggering decline in market values that occurred in a three-week period and in the table below, I chronicle the loss in market value globally, broken down by region.

Download spreadsheet

The first four columns look at total market capitalization and the change in both dollar and percentage terms between February 14, 2020 and March 6, 2020. Globally, equity markets lost $7.3 trillion in value over this three-week period, and it is ironic that China, the starting point for the Corona Virus, is the only part of the world where stocks have collectively seen an increase in market capitalization. That can be explained perhaps by the fact that Chinese stocks had already registered drops in the weeks leading into February 14, and that the rest of the world is playing catch up. The last five columns look at the percentage change in individual stocks to illustrate how widely the pain was felt. In ten of the twelve regions, with China and Africa being the exceptions, less than 25% of stocks went up during the three week period. In most of the markets, the percentage change in overall market capitalization is similar to the percentage change in the median stock, indicating that this is not a decline being caused by a subset of stocks being hit with extreme price movements.

b. The Sector/Industry Breakdown

There is no question that the virus not only has the potential to hurt the global economy, but the hurt will be felt disproportionately by companies in different businesses. To assess how the market has repriced different sectors, I look at the market capitalization lost, in both dollar and percent terms, by sector, for global companies:

Download spreadsheet

The biggest losers were energy and financial service companies, and the sectors that performed the best were utilities, health care, real estate and consumer staples. Breaking down the sectors into more detail, I looked at US stocks, by industry, and the following is the list of the five worst and five best performing industries between February 14 and March 6:

Download spreadsheet

The full list is available for download by clicking here. For anyone who has been following the news stories of airlines scrambling to cancel flights and mollify passengers and hotels dealing with cancellations, it should come as no surprise that aviation and hotel stocks were the worst performing industry groupings, followed by oil, broadcasting and life insurance. The best performing industry grouping also carries no surprises, with precious metal companies benefiting from the rise in gold prices, grocery retailers and tobacco drawing on their strengths as non-discretionary products and biotech companies benefiting from the focus on a solution for the virus.

c. Size Classes

The conventional wisdom, when there is a market crisis, is that investors move their money to safety. While that has clearly happened with money shifting into US treasuries, the question is whether investors are abandoning smaller companies for larger ones, presumably driven by the perception that smaller companies are riskier than larger ones. To answer this question, I looked at all global companies, broken down by market capitalization into ten classes:

Download spreadsheet

The results don't line up with expectations, as small companies saw a small increase in overall market capitalization and large cap stocks registered the largest decline. It is worth noting that even among the smallest stocks, the median stock lost 7.73%, suggesting that the increase in value is coming from a small percentage of stocks in the group. (Looking at just US stocks, you get very similar results.) 

d. Value and Momentum Classes

The drop in the market has provided some measure of vindication to those who have long been arguing that the market is over priced, but while the fact that the market was priced so richly set it up for a larger fall, breaking down the decline in market cap into classes can provide us some insight into whether the stocks that had gone up the most were the ones that saw the biggest drop off in value between February 14 and March 6. In the table, we break global stocks down into ten classes based upon the price change in the year prior to February 14 and look at the change in market capitalization, by class:

Download spreadsheet

In keeping with the story that what goes up the most must come down the most, you find that stocks that had performed the worst in the year leading into February 14 had an increase in market capitalization, though the median stock was still down, within this group. Using another proxy for rich pricing, I also broke stocks down by PE ratio classes from lowest to highest, based upon market capitalization on February 14, 2020, and looked at the change in market value between February 14 and March 6:

Download spreadsheet

Here, the evidence contradicts the market correction hypothesis, since there is no discernible relationship between PE ratios and market value change. In fact, the best performing stocks are in the top two deciles of PE ratios.

e. The Rest of the Story

One of the perils of getting focused on equity markets is that you can miss all of the action in other markets, and the changes in those markets can not only help augment the story that equities are telling us, but they can yield insight into other facets.

I. US Treasury rates

If the drop in stock prices over the last three weeks took your breath away, the shifts in the treasury market were even larger and more unsettling:

The 10-year US T.Bond dropped below 1% for the first time in history on March 3 and continued trending down to settle at 0.74% on March 6. In tandem, the other treasuries also dropped, bring the US dollar risk free rates closer to the Euro and Yen risk free rates. While some of the decline in rates can be attributed to a flight to safety, there is also a much depressing read of the same drop. To the extent that long term risk free rates are proxies for nominal economic growth, the treasury bond market seems to be signaling not just a shock to near-term economic growth from the Corona virus, but a long term decline. We will get a better sense of what the bond market is expecting, once equities settle in, but if the 10-year rate stays below 1%, it is not a good sign for the economy.

II. Gold and Bitcoin (Millennial Gold)

The other asset class that always attracts attention and money during crisis is gold, and for good measure, I will also look at Bitcoin, which some have suggested is the millennial equivalent of gold:

It is perhaps a little unfair to draw a conclusion from just contest, but the fact that Bitcoin has behaved more like stocks than like gold suggests that millennials who have held on to it, as their asset of refuge, may want to rethink their positions. 

3. Oil and Commodities

The final piece of the market puzzle comes from the commodity markets, with oil as its front runner. In the three weeks which have taken equity markets on a ride and caused US treasuries to hit new lows, oil prices have been on a journey of their own:

Not only have oil prices dropped 20% during the three weeks, they are plumbing depths seldom seen in this century. The decline in oil prices not only reflect an expectation of global economic slowdown but also how dependent oil and other commodity prices have become on China's continued growth and prosperity. The smaller decline in natural gas prices, much less tied to the Chinese market, reinforces this argument.

Revisiting the Viral Value

With this long lead in, you might have lost interest already, but if you are still reading, it is time to turn to specifics and look at how what I have learned in the last 12 days has or has not changed my views on the market.

Recapping the Drivers

Very quickly recapping what I argued were the drivers of the value of stocks, I argued that there were three components to value:

1. Earnings Growth: In my 2/26/20 valuation of the S&P 500 index, I argued that the corona virus is now almost certain to cause earnings effects for companies, and estimated the drop to be 5% (a significant revision down from the 5.52% growth that had been predicted in the index. In the last few days, analysts have started adjusting earnings expectations down for companies, and this snapshot from Zacks today captures some of the adjustment:
   
   Note that the expected earnings on the index for 2021 has dropped from 172 for next year, two weeks ago, to 163 this week, matching the earnings generated in 2019. That is still better than the 5% drop that I was projecting, but my guess is that I am still undershooting the actual earnings decline and I have increased the expected earnings drop in 2020 to 10%. To complete the assessment of growth, I also need to estimate how much of the earnings drop in 2020 will be recouped in future years. In my valuation on February 26, I had estimated that half of the earnings drop in 2020 would be recouped but that the rest would be lost for the long term. I will continue to hold on to that assumption In addition, since my long term growth rate converges on the US T.Bond rate, the precipitous drop in that rate has lowered my growth rate in perpetuity to 0.74% (to match the T. Bond rate).
2. Cash flow Payout: The second component of value is the cash that companies can return, in dividends and buybacks. I assumed that companies, driven by uncertainty, would scale the percent of the earnings that they return to stockholders from the 92.33% that they were returning prior to the crisis to 85%, more in line with the ten-year average. In the days since, there have been no announcements of dividend cuts or scaling back of already announced buybacks, but I would not be surprised to see that change in the next few weeks. 
3. Discount Rate Dynamics: The discount rate dynamics are the trickiest. On the one hand, the lower T.Bond rate will create a lower base from which to build up, but the increase in volatility (actual and expected, as captured in the rise in the VIX over the last three weeks) has pushed equity risk premiums up. I will scale up my ERP to 5.69% to match my implied premium at the start of March 2020.

With that combination of assumptions (10% drop in earnings, 50% recoupment between 2022-25, 85% cash return and a 5.69% premium), the value that I derive fo the index Is 2889, and much of the reason for the drop from the value that I estimated on February 26, 2020, can be attributed to the the lower growth rate that I am estimating in the near term and in the long term.

Value Dynamics

In the days to come, there will be more information that comes out about not only how the virus is spreading across the globe but also on its consequences for businesses and economies. To provide a measure of how this will affect stock values, I computed the value of the S&P 500 (which stood at 2972.37 on March 6, 2020) as a function of what I believe are the two big uncertainties; the effect that the virus will have on earnings in 2020 and how much it will affect long term earnings growth:

Download valuation spreadsheet

Note that the big concern, if you are an investor focused on value, is not how much the Corona virus will affect earnings this year, but how much of that earnings drop is permanent. If you are in the camp that believes that there will be an earning drop, but that it will be fully recouped, stocks look cheap even if earnings drop by 20% in 2020. Conversely, if you believe that this earnings drop is likely to be permanent, with none of the drop being recouped, the value drop will be more closely linked to the earnings drop and suggests that there is more pain ahead for the market.

What to watch for..

Needless to say, there will be plenty of distractions in the coming weeks, but my suggestion is that you stay honed in on the value determinants, screening news stories for consequences for these determinants. In particular, I plan to watch the following developments:

I know that my view that T.Bond rates staying low and getting lower is not a positive but a negative for stocks puts me in the opposite camp from those who believe that the Fed will be the savior. When rates are as low as they are, central banks are more helpless bystanders than powerful trend setters, and the message about future growth that is imputed in low rates more than drowns any short term positive effects. 

The Big Things in Life

As I write this analysis of how the virus can affect stock market values and portfolio returns, I am aware that there is a human toll that it is taking that makes any market effects seem trivial. If I were given the choice, I would trade a large market drop for a small loss of lives and a quick passing of the virus. At times like these, I am reminded again of the fragility of life and the importance of good health and family. Be well, Godspeed and please wash your hands!

YouTube Video


Datasets

1. Market Damage, by region, sector, industry, size and momentum

Spreadsheets

1. An Updated S&P Valuation Spreadsheet: March 6, 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 Update VII: Market Multiples
8. A Viral Market Update VIII: Value vs Growth, Active vs Passive, Small Cap vs Large!
9. A Viral Market Update IX: A Do-it-Yourself S&P 500 Valuation
10. A Viral Market Update X: A Corporate Life Cycle Perspective
11. A Viral Market Update XI: The Flexibility Premium
12. A Viral Market Update XII: The Resilience of Private Risk Capital
13. A Viral Market Update XIII: The Strong (FANGAM) get Stronger!

Data Update 5: Relative Risk and Hurdle Rates

In my last four posts, I focused on the macro variables that we draw on, in both corporate finance and valuation, to estimate required returns or hurdle rates. In data post 3, I looked at how the prices of risk in both the bond market (default spreads) and the equity market (equity risk premiums) dropped in 2019, in the US. In data post 4, I extended the discussion to cover country and currency risk. In this one, I will bring in the micro variables that cause differences in risk across firms, and how to convert them into risk measure.

Relative Risk Measures

To get from the macro risk measures to company-level hurdle rates, you need to make judgments on relative risk. Put simply, if you buy into the proposition, like I do, that some companies/investments are riskier than others, you need a measure of relative risk that captures this variation.  It is in this context that I think of betas, a loaded concept that carries with it the baggage of modern portfolio theory and efficient markets. If you add to this the standard approach to estimating betas, built on looking at past prices and running regressions against market indices, you have the makings of a perfect storm, designed to drive value investors to apoplexy. I have no desire to re-litigate these arguments, partly because those for and opposed to betas are set in their ways, but let me suggest some compromise propositions.

Relative Risk Proposition 1: You do not need to believe in betas to do financial analysis and valuation. 

While there are many who seem to tie discounted cash flow valuations to the use of beta or betas, there is nothing inherently in  a DCF that requires that you make this leap:

While the discount rate in a DCF is a risk-adjusted number, the approach is agnostic about how you measure risk and adjust discount rates for that risk.

Relative Risk Proposition 2: If you don't like to or want to measure relative risk with betas, you can come up with alternate measures that better reflect your view of how risk should be measured. 

While I do use beta as my proxy for risk, I do so with open eyes, recognizing its many limitations as a risk measure, and I have been always willing to consider competing risk measures. In fact, I have presented alternate measures of risk, drawing on the two building blocks of betas that draw the most pushback. The first is the assumption that marginal investors are diversified, and that the only risk that needs to be measured is the risk that cannot be diversified away. The second is its use of prices (stock and market) to estimate risk, seemingly contradicting intrinsic value's basic precept that market prices are not trustworthy. Since a picture is worth a thousand words, here a few alternative risk measures to consider, if you don't trust betas;

Put simply, if your primary problem with betas is the assumption that marginal investors are diversified, there are total risk measures that are built around measuring the total risk in a company or investment, by looking at either the standard deviation or adding premiums (small cap, company-specific risk) to the traditional risk and return model. If your concern is that past prices are being used to estimate betas, you can switch to using accounting earnings and computing risk measures either from the perspective of diversified investors (accounting beta) or undiversified ones (earnings variability).

Relative Risk Proposition 3: The margin of safety is not a competitor to any of the risk measures above, since it is a post-value adjustment for risk.

Rather than repeat what I said in a much longer post that I had on the topic, let me summarize the points that I made there. When value investors talk about protecting themselves from risk by using a margin of safety, they are talking about building a buffer between value and price, but to use the margin of safety, you need to value a stock first. To get that value, you need a risk measure, and that brings us back full circle to how you adjust for risk, when valuing companies.

Relative Risk in 2020

With that long lead-in, let's take a look at how companies measured up on relative risk measures, at the start of 2020. In keeping with my argument in the last section that you can use alternative risk measures, I will report on three alternative risk measures:

• Betas: I start with betas, estimated with conventional regressions of returns on the stock against a market index, for each of the companies in my sample. To get a measure of how these betas vary across companies, I have a distribution of betas, broken down globally and for regions of the world:
  
  It is worth noting that, at least for public companies, half of all companies have betas between 0.85 and 1.45, globally. If you are wondering why the betas are not higher for companies in riskier parts of the word, it is worth emphasizing that betas are scaled around one, no matter of the world you are in, and are not designed to convey country risk. (The equity risk premiums that I wrote about in my last post carry that weight.)
• Relative Standard Deviation: For those who do not buy into the notion that the marginal investors are diversified and that the only risk that matters is market risk, I report on the standard deviation in stock prices (using the last two years of data):
  
  Note that you can convert these numbers into relative measures, resembling betas, by dividing by the average standard deviation of all stocks. Thus, if you have a US stock with an annualized standard deviation of 35.00% in stock returns, you would divide that number by the average for US equities of 42.36% to arrive a relative standard deviation of 0.826 (=35.00%/42.36%).
• High-Low Risk: For those who prefer a non-parametric and more intuitive measure of risk, I compute a risk measure by looking at the difference between high and low prices in the most recent year, and dividing by the sum of the two numbers. Thus, for a stock that has a high price of 20 and a low price of 12, during the course of a year, this measure would yield 0.25 ((20-12)/ (20+12)). Note that the bigger the range in prices, the more risky a stock looks on this measure, and this too is broken down globally and by region:
  
  As with the other risk measures, this too can be converted into a relative risk measure, by dividing by the average.
• Earnings Variability: Finally, for those who trust accountants more than markets (even though I am not one of them), I have computed a risk measure that is built around earnings variability, computed by looking at the standard deviation in net income over the last 10 years for each firm, and converted into a standardized measure, by dividing by the average net income over the ten years (a coefficient of variation in net income), The global and regional breakdown is below:
  
  The earnings variability number has a bigger selection bias than the other measures, because it requires a longer history (10 years of data) and positive earnings, cutting the sample size down significantly. Here again, dividing a company's coefficient of variation in net income by the average value across all companies will give you a relative risk measure.

I follow up by looking at median values for each of the risk measures by industry grouping. Since I have 94 industry groupings, I will not report them all here, but you can download the data on all of the industry groupings, by clicking here.

Hurdle Rates in 2020

The relative risk measures are a means to an end, since the only reason for computing them is to use them to get to required returns. In this section, I begin by looking at the cost of equity, then bring in the cost of debt and close of by looking at the cost of capital.

a. Cost of Equity

There are three ingredients that go into the cost of equity and the last few posts have laid the foundations for the three inputs:

• The risk free rate is a function of the currency you choose to compute your hurdle rates in, and will be higher for high-inflation currencies than low-inflations ones. Since I will be comparing and aggregating costs of equity across more than 40,000 firms spread across the world, I will compute their costs of equity in US dollars, using the US T.Bond rate as of January 1, 2020, as the risk free rate. You can convert these into any other currency, using the differential inflation approach that I described in my earlier post from a couple of weeks ago.
• The equity risk premium for a company is a function of where it does business, and in my last data update post, I described my approach to estimating equity risk premiums for individual countries, and the process of weighting these (using either revenues or production) to get equity risk premiums for companies.
• For the relative risk measure, I will use betas but as I argued in the last section, I am agnostic about what you prefer to use instead. Thus, if you prefer earnings variabliity as a measure, you can use relative earnings variability as your risk measure.

With these inputs, I estimate the costs of equity for all of the companies in my database, and report the distribution in the table below:

Comparing this distribution to the one for betas, earlier in this post, you will notice a wider spread in the numbers across regions, as we bring in equity risk premium differences into the calculation.

b. Cost of Debt

The cost of debt is a simpler exercise, since it is a measure of the rate at which companies can borrow money today, not a reflection of the rates at which they have borrowed in the past. It is a function of the risk free rate and the default spread:

As with the cost of equity, the risk free rate is a function of the currency in which you estimate the cost of debt in, and I will estimate the costs of debt for all companies in US dollars, again to make comparisons across companies. For the default spread, I have little choice but to use bludgeon measures, since I cannot assess credit risk for 40,000 plus companies. For companies that have an S&P bond rating (about 15% of the sample), I use the rating to estimate a default spread. For the rest, I estimate synthetic bond ratings based on financial ratios (interest coverage and debt ratios). The US $ pre-tax cost of debt distribution is below:

Since these costs are all in US dollars, the differences across regions reflect difference in country default risk and reflect wide divergences. It is worth noting that the tax law tilt towards debt, represented in the fact that interest expenses are tax deductible and cash flows to equity (dividends and buybacks) have to come from after-tax cash flows, is not just a phenomenon for the US, but true over much of the world, with the Middle East representing the holdout. This tax benefit shows up in the cost of capital, through the conversion of the pre-tax cost of debt into an after-tax cost, using the marginal tax rate to make the adjustment:

After-tax cost of debt = Pre-tax cost of debt (1 - Marginal Tax Rate)

In my sample, I use the marginal tax rate of the country in which a company is incorporated. You can find these marginal tax rates, which KPMG should be credited for collecting, also on my website for download.

c. Debt Ratios and Costs of Capital

The final piece of the puzzle in computing the cost of capital is the mix of debt and equity that companies use in funding their operations. In keeping with the cost of capital being a measure of what companies have to pay for their debt and equity today, I use the market values of equity and debt, with leases converted into debt and included in the latter, to compute the cost of capital. While I will talk in more detail about debt loads and choices in a future post, you can sense of the debt load at companies, as a percent of capital (in market value terms) in the table below below:

With these debt ratios, and using the costs of equity and debt also shown above, I compute costs of capital, in US dollar terms, for all publicly traded companies and the resulting distribution is below:

This is a table that I will use, and have already put to use, in valuing companies since it provides a quick and effective way to estimate discount rates for companies, without losing yourself in the details. Thus, when valuing a young, money-losing public company in the US (like Casper, the only mattress-maker that went public last week), I will use a cost of capital of 9.15%, representing the 90th percentile of US firms, whereas to value a slow-growing European company in a stable business,  like Heineken, my cost of capital will be 6.02%, the 25th percentile of European companies. For all companies, the median cost of capital of 7.58% is a good proxy for the number that all companies will converge towards, as they approach maturity. If all of these numbers look low to you, that is because they reflect a risk free rate, in US dollars, that is low, and if it does rise, it will carry these numbers upwards.  As with the risk measures, I have estimated costs of equity, debt and capital, by industry group and you can download them for all companies globally, as well as regionally (US, Emerging Markets, Europe, Japan and Australia/Canada) and for India and China, separately.

YouTube Video


Downloadable Data

1. Industry Average Risk Measures at start of 2020
2. Betas, by industry (Global, US, Emerging Markets, Europe, Japan,  Australia/Canada, India, China)
3. Costs of Debt, Equity and Capital, by industry (Global, US, Emerging Markets, Europe, Japan,  Australia/Canada, India, China)
4. Marginal tax rates, by country, for 2020

A Viral Market Meltdown: Fear or Fundamentals?

It has become almost a rite of passage for investors, at least since 2008, that they will be tested by a market crisis precipitated sometimes by political developments (Brexit), sometimes by governments (trade wars), sometimes by war and terrorism (the US/Iran standoff) and sometimes by economics (Greek default). With each one, the question that you face about whether this is the “big one”, a market meltdown that you have to respond to by selling everything and fleeing for safety (or the closest thing you can find to it) or just another bump in the road, where markets claw back what they gave up, and then gain more. After yesterday’s global meltdown in equity markets, I think it is safe to say that we are back in crisis mode, with old questions returning about the global economic strength and market valuations. I have neither the stomach nor the expertise to play market guru, but I will go through my playbook for coping.

Start at the source
This crisis has an uncommon source, insofar as it is one of the few that is not man-made (at least based upon what we know now) and is thus more difficult to predict, in terms of how it will play out. As a novice in infectious diseases, here is what I know at the moment:

1. The virus (COVID-19) had its origins in China, though what caused it to spread into the human population is still unclear and rife with conspiracy theories. In an attempt to keep the populace from panicking and to give the impress of being in control, the Chinese government initially went into crisis mode, trying to control the information that is being made public and that has created both confusion and skepticism about official claims.
2. Within China, the virus has had its biggest impact in the Wuhan province, but it has affected other parts, though there is still not clear by how much or how many. The count, which is obviously a moving target, is that there are more than 80,000 cases of the virus, with more than 2700 fatalities so far. The latest reports from China is that new infections are falling, and if true, this would suggest that the spread is being controlled. 
3. The most immediate spread has been to the neighboring Asian countries, with Singapore being an early casualty and South Korea a recent-add on. It has jumped borders and is showing up in more distant parts of the world, mostly in occasional cases. Over the weekend, though, the Italian government set alarm bells ringing with an announcement of a large cluster of cases in the country, which suggests that earlier assessments that the virus was not easily communicable may need to be rethought, and it was this news that seems to have precipitated this week’s sell off. On February 25, the CDC warned Americans that the disease could make significant inroads in the United States and suggested that states prepare cautionary measures.
4. There is no cure or vaccine yet for the virus, but the mortality rate from the virus seems to vary across the population, with the very young and the very old being the most likely to die from it, and across geographies, with more deaths in Asia than in Europe or the United States. The overall mortality rate is low ( about 3%), but it is higher for people who are hospitalized with complications. 

In short, there is a lot more that we do not know about COVID-19, than we do, at least at the moment. While it has not been labeled a pandemic yet, it seems to have the potential to become one, and we do not yet have a clear idea of how quickly it will spread, how many people will be affected and what will push it into dormancy. It is also clear that much of this uncertainty will get resolved by real-time developments, not by collecting data or by listening to experts to tell us what will happen.

Get perspective
There is no denying that the last week has been a rocky one for investors, and a 1800-point drop for the Dow over two days (February 24 &25) is bound to add to the sense of foreboding. Since the first casualty of a crisis is perspective, it may be worth stepping back and looking at the market through wider lens. After the drop yesterday (February 24), the S&P 500 was at 3225.89, slightly above where it started this month (February 2020) at. In short, investors in the index were back where they were 18 trading days ago. Bringing in February 25 into the picture does put you below that level, but it still way above what it was a year ago:

In fact, extending the comparison to longer time periods only makes the hand wringing over the last week’s losses look even more absurd. This is both good and bad news. The good news is that, if you are a diversified investor, your portfolio should not look dramatically different from what it looked like at the start of the year and much, much healthier than it looked a year ago, five years ago or ten years ago. The bad news is that the big run-up in stocks over the last decade has left you exposed to more and bigger losses to come. The bottom line is that your concern should not be about the damage to your portfolio from the last week’s developments, but the damage that is yet to come.

Have a framework

With perspective in place, I am now in a position to look to the future, since that should govern how we react to last week’s developments. Given my investment philosophy of trusting fundamentals and value, I have to go back to my basic framework for valuation, which is to tie the value of an investment to its cashflows, growth and risk. When valuing the overall market, here is what it looks like:

With my value framework, the effects of the Corona Virus will play out in my forward-looking numbers in the following inputs:

1. Earnings Growth: Even at this early stage in this crisis, it is clear that the virus is having an effect on corporate operations. With some companies like hotels and airlines, the effect that the virus has had on global travel has clearly had an effect on revenues and operations, and it should come as no surprise that United Airlines announced, after close of trading on February 24, 2020, that it was withdrawing its guidance for revenues this year, as it was waiting for more information. With others, it is concern about supply chain disruptions, especially with Chinese facilities, and how this will affect operations in the rest of the world. The follow up question then becomes one of specifics:

• Drop in 2020 Earnings: This is the number that will reflect how you see Corona Virus affect the collective earnings on stocks in 2020. This will include not only earnings declines caused by lower revenues growth at companies like United Airlines, but also the earnings decline caused by higher costs faced by companies due to virus related problems (supply chain breakdowns). The wider the swath of companies that are affected, the bigger will be the earnings effect. As to how big this effect will be on overall earnings, we can only guess, given where we are in this process. To provide some perspective, the 2008 banking crisis caused an earnings implosion, with earnings dropping almost 40% in 2008, from 2007, but the World Trade Center attacks in September 2001 barely made an impact on overall S&P 500 earnings in the last quarter of 2001.
• Drop in long term Earnings: In previous crises, where consumers and workers stayed home, either for health reasons or because of fear, the business that was lost as a result of the peril was made up for, when it passed. If consumption is just deferred or delayed, the growth in subsequent quarters will be higher, to compensate for the lost business in the crisis quarter. If consumption is lost, the drop in earnings in the crisis quarter will never be made up. 

To illustrate the point, I look at how three different perspectives on growth will play out in growth rates, based upon how much of the drop in earnings this year is recovered over the following years:

Note that the first series is the unadjusted earnings, prior to the corona virus scare and that in all three of the scenarios, there is a drop in earnings of 5% in 2020, putting earnings well below expected values for 2020, but the difference arises in how earnings recover after that. If none of the drop in earnings in 2020 is recouped in the following years, the earnings in 2025 is 179.22, well below the pre-virus estimate of 199.28. If only half of the earnings drop is recouped, the earnings in 2025 is 189.41 and if all of the earnings drop is recouped, the earnings in 2025, even with the virus effect, matches up to the original estimates.

2. Cash Returned: In 2019, US companies returned 92.33% of earnings as cash to stockholders, with a big chunk (about 60%) coming from buybacks. That high number reflects not only the cash that many US companies had on hand, but a confidence that they could maintain earnings and continue to pay out cash flows. To the extent that this confidence is shaken by the virus, you may see a pull back in this number to perhaps something closer to the 85.24% that is the average for the last decade.

3. Risk and Discount Rates: Finally, the required return on stocks will be impacted, with one of the effects being explicit and visible in markets, in the form of the US treasury bond rate and the other being implicit, taking the form of an equity risk premium. If investors become more risk averse, they will demand a higher ERP, though as the fear factor fades, this number will fall back as well, but perhaps not to what it was prior to the crisis. The fact that the equity risk premium is already at the higher end of the historical norms, at about 5.50% on February 25, 2020, does indicate limits, but there could be a short-term jump in the number, at least until there is less uncertainty.

Using this framework on the S&P 500, you can see how each of these variables play out in value.

Download spreadsheet

I am not an expert on infectious diseases, and the health and economic impacts of this virus are likely to play out as developments in real time, requiring that I revisit this framework frequently. Based upon my estimates of how this virus will affect the numbers, the value that I get for the index is 3003, about 4.14% less than the index level of 3128.21 at the close of trading on February 25, 2020, which, in turn, represents a significant drop from the level of the index a week ago. To the question of whether a virus can cause this much damage to the markets, the answer is yes, though whether it is an overreaction or not will depend on how it plays out in the numbers. For the moment, though, if you are tempted to buy on what looks like a dip, I would suggest caution just as I would argue for slowing down to someone who wants to do the opposite and sell. As you look at my assumptions about how the virus will play out in earnings (both short term and long term), cash flows and risk premiums, some of you may disagree (and perhaps even strongly) and you can use this spreadsheet to arrive at your own valuation of the index, and use it to drive your actions. 

To thine own self, be true...

It is entirely possible that I am underestimating the impact of this virus on economic growth and earnings and that I should be panicking more, but it is also plausible that I am over adjusting my numbers too much. The bottom line with my calculations is that I am inclined to do very little, at the moment. I don’t feel the urge to buy the market, because there is a plausible case to be made that the adjustment in value, steep and sudden, was merited. I feel little need to sell either, because I don’t see an over valuation large enough to trigger action. As for whether I should be reducing my exposure to companies that are directly affected by the virus (hotels and airlines) and increasing my exposure to companies that are more insulated, I don’t believe there will be any segment of the market that is fully protected from the consequences, no matter how far you get from China and from travel-oriented companies. In fact, if there is a segment of the market where you are likely to see over reaction, it is likely to be in airline, travel and energy stocks, precisely because they are in the center of the storm. Do I now wish that I had bought Zoom before this crisis reached full blown status? Yes, but I am not sure buying it now will do much for me. I am loath to offer advice, but my only suggestion is that rather than listen to the experts on either side of this debate tell you what to do, you should make your own best judgments, recognizing that they can and will change as more facts emerge, and act accordingly.

YouTube Video


Spreadsheets

1. Spreadsheet to value Corona Virus Effects on S&P 500 (February 25, 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 Update VII: Market Multiples
8. A Viral Market Update VIII: Value vs Growth, Active vs Passive, Small Cap vs Large!
9. A Viral Market Update IX: A Do-it-Yourself S&P 500 Valuation
10. A Viral Market Update X: A Corporate Life Cycle Perspective
11. A Viral Market Update XI: The Flexibility Premium
12. A Viral Market Update XII: The Resilience of Private Risk Capital
13. A Viral Market Update XIII: The Strong (FANGAM) get Stronger!