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Much has been written about the emotional cycle of fear and greed in investing. Both panic and excessive optimism can create extraordinary opportunities for those who can afford to be patient and lean against prevailing sentiment. But investors don't merely buy high and sell low because they are fickle, irrational creatures. While some may indeed fit that description, for many it's simply a case of having spare cash to invest when times are good and the need to call on that money unexpectedly when times are hard. Writing from London, Ben Preston, from our offshore partner, Orbis, discusses how this dynamic is playing out during COVID-19.
Travel restrictions and widespread social distancing measures have ushered in some of the toughest times in many years, triggering an economic shutdown that affects nearly everyone. Small businesses have been hit particularly hard, and for many people faced with job losses, ill health or self-isolation, conditions have become very tight very quickly.
As is their nasty habit, financial markets are piling on the misery just when it is least welcome. Many individuals now find themselves forced to sell some of their stock market investments to meet urgent short-term needs. But a much bigger wave of forced selling has come from professional investors who were aggressively positioned for perpetually good times. Their strategy of borrowing at low rates to juice returns on the assumption of low volatility, rising asset prices and endless liquidity, has suddenly come to a crashing halt.
...As a firm, we have gone to great lengths to prepare for moments like this long before they arrive...
In nearly two decades at Orbis, this is the third major bear market that I've seen. Of all the lessons I've learned, the single most important one is to stay relentlessly focused on the long term. It also happens to be the easiest thing to say when everything is going well - and the hardest thing to actually do when it really matters.
As a firm, we have gone to great lengths to prepare for moments like this long before they arrive. This has included things like partnering with like-minded clients who are also patient and unlikely to panic, maintaining a global footprint, developing a robust business continuity framework, and eschewing quick profit-enhancing wins like stock-lending (and the counterparty risk that comes with it). Most importantly, the firm is privately owned by those who are best placed to understand and support our contrarian investment philosophy.
What we are focusing on
In the current environment, we are broadly focused on two key questions:
- How will our existing holdings be affected by a prolonged period of intense economic hardship?
- What new opportunities will stand out as exceptional bargains when we are looking back and writing to you five or 10 years from now?
As to the first question, it is comforting to know that there are already many companies with solid balance sheets and bright long-term outlooks in the portfolio - and the sell-off has only made their valuations more compelling.
One example is UnitedHealth Group, the strongest and best-capitalised managed care organisation in the US. Investors are fearful that insurance claims will skyrocket as the pandemic spreads. Like other health insurers, the company annually reprices its policies - which are sold mainly to large employers - thereby insulating it from higher costs, except for a small lag. In fact, there may even be scope to reduce costs if elective procedures and non-essential hospital visits are deferred.
...there are already many companies with solid balance sheets and bright long-term outlooks in the portfolio...
Our stress testing concludes that, even in a severely adverse scenario, the hit to the company will be equivalent to about 25% of last year's earnings, before returning to (and growing from) prior levels. With the shares experiencing a drop of 30% to their mid-month lows and now trading at 15 times earnings, we think the market has been far too pessimistic.
A second example is BMW. While the pandemic has understandably put a halt to luxury car sales in many markets, shares of major automobile manufacturers were already deeply out of favour thanks to existential concerns about electrification, ride sharing and autonomous vehicles. With BMW, we think both the long- and short-term fears are more than priced into the stock at current levels. Unlike business or holiday travel, you can't put off buying a replacement car forever, so we are confident that pent-up demand will ultimately drive healthy future sales - we just don't know exactly when. If, as seems likely, there is a prolonged preference for private over public transport or ride sharing, the current turmoil may even benefit BMW in the long term.
...bear markets are exciting times for long-term investors who can keep their focus...
As a conservative, family-controlled company with an excellent track record of profitability, BMW has successfully navigated short-term profit pressure - and disruptive technological forces - on more than a few occasions in nearly a century of making cars. With a robust balance sheet and a compelling selection of new electric models in the pipeline, we are excited about BMW's ability to overcome the challenges it is currently facing.
Meanwhile, its shares are available for purchase at less than four times our conservative assessment of "normal" earnings and a 40% discount to the book value of its tangible assets. In volatile markets, cheap shares can always get cheaper, but such valuations make it clear why bear markets are such exciting times for long-term investors who can keep their focus.
As to our second question, experience has made me mindful that big global events can often accelerate societal change. "Never let a crisis go to waste" is the mantra of many an astute politician. Caught in the here and now of the crisis, big structural changes can sneak by unnoticed. In the dotcom bust of 2000-01, while investors were preoccupied with the "New vs Old Economy" debate, the really big change that dominated the following decade was China quietly joining the World Trade Organization and ushering in a natural resource bonanza in the decade that followed. Similarly, in the aftermath of the global financial crisis, instead of debating whether or not to wade back into banks or stick with something more defensive, the more insightful investors were following the advent of the smartphone, which enabled entirely new business models to emerge and dominate in the 2010s.
The importance of lateral thinking
As bottom-up stockpickers, we rarely allow ourselves to try to guess what the next big thing will be. But the lesson of these historical episodes is that it does pay to think laterally and beyond the knee-jerk questions. What is quietly happening off to the side while everyone is debating the fate of travel companies and makers of toilet paper and hand sanitiser?
One possibility we'd offer would be climate change. We'd like to believe that the pandemic will prompt greater cooperation on other challenges facing the human race. If so, one such beneficiary might be Vestas Wind Systems, the world's largest manufacturer of wind turbines. Our research suggests that not only is wind power environmentally favourable today, it is also economically superior - beating fossil fuels in cost-effectiveness for the first time in history.
As electricity demand grows in the decades ahead, there is both the room and the need for renewable power such as wind to grow approximately eightfold. Vestas, as the industry leader in both profitability and market share, appears to have a particularly bright future. But it too sold off by 30% over a few weeks despite no change, or perhaps even a marginal improvement, in its long-term prospects.
We realise that it is almost impossible to turn away from the noise when it feels like the world is crashing down around you, but it is absolutely critical for success in investing. Far more importantly, though, we wish the very best to you and your loved ones at what is an exceptionally challenging time for many families across the globe. Not only is the pandemic creating extraordinary stresses on our economies, financial markets and our normal ways of life, but far more importantly, it is also having a devastating impact on far too many human lives.
Please stay safe - and focused on the long term.
Author: Ben Preston - Allan Gray
