How Do We Navigate This Unprecedented Market Environment?
How do we navigate this unprecedented market environment? While the circumstances of the Coronavirus/Oil War are extraordinary we are in the midst of a major crisis. Simply put, in a crisis there are certain actions we must adhere to as long-term investors until this crisis passes. We use historical precedents as a guideline, but every crisis is different. What isn’t different is how we approach them. This is not a time to be frequently trading long term positions locking in losses under irrational circumstances. Once the virus hysteria passes, events and gatherings return to normal, and fiscal stimulus is launched by the government the market will stabilize. The stock market rewards investors who are long term oriented. While others are selling their shares out of panic, it creates an opportunity for those who want to buy a stake in those companies with the mindset of a long-term part-owner. Stocks of great companies are selling off because the market is predicting that their earnings will be punished at least for this year, but their long-term business prospects remain the same. This is where mispricing occurs in the market. We do not know if this virus outbreak will worsen or accelerate before it subsides, but we do know it will subside.
It’s easy to be a long-term investor when the market is ratcheting higher with very little volatility which has been the case over the last few years (excluding December 2018). The difficult part comes when the markets begin to sell off for a public panic such as a virus outbreak. We are investors, not traders. We buy stakes in good companies, pay a reasonable price for our stake in said companies, and then let those businesses operate and compound our capital over time. This might seem simple but it’s important to understand what drives returns and why this is the most effective strategy for long term investors.
Equities are one of the best long-term investment vehicles, because they are the only asset class that continuously re-invests a portion of your capital. When you buy real estate or commodities such as gold and silver your capital is not automatically reinvested (assuming its value appreciates, or you earn rent, royalties, etc.). But rather a new opportunity must manually be found. Historically, this can be difficult over long periods of time as the competition of capitalism works its magic. When you own a high-quality company, this capital is typically being reinvested by experienced management teams who have expertise in their field with a history of operating businesses at the highest level. This capital reinvestment creates a ‘compounding’ effect over time which is the way that wealth is created.
Our investment philosophy centers around large-cap dividend paying equities. These companies pay out a portion of their capital as dividends to all of you, buyback shares if it makes sense at the time, and the rest of the money is reinvested back into the business. We anticipate that many of our companies with large amounts of excess cash were buying back stock last week as the market sold off dramatically. The portion that is reinvested back into the business will drive most of the company’s long-term return profiles. This is also why when we are assessing a company one of the most important questions that we ask is “Does this company have the opportunity to invest their capital in expenditures that will yield us high returns in the future?”. Low reinvestment opportunity is acceptable if the stock is trading at a lower multiple and the business is capital light. We hold several companies such as this and like them because of their predictability and reliable dividend payouts. This capital allocation dynamic is also why we love companies with strong balance sheets. Strong balance sheets are not only vital to ensure that a company can survive periods of stress but gives them the flexibility to invest when the time is right. This whole process does not happen in a span of days, weeks, or even months. This is a process that happens over years and decades and why keeping a long-term view can be one of the greatest advantages for an investor.
Now of course we will make tactical decisions when we feel it is appropriate both to capture returns to the upside but more importantly protect from risk to the downside. The reasons we typically tend to sell companies is if we think that company will suffer a long-term headwind, the stock becomes so overvalued that its future returns will be lowered, or we would like to reallocate the invested portion into a more attractive opportunity. This certainly does not mean that we will try to “time the market” by jumping in and out of cash. This strategy defeats the whole purpose of the previously mentioned advantages of equities. Add to the fact that doing this successfully over long periods of time is impossible. If knowing when to go to cash were as simple as it seems all investors would do it and the market would quickly erase this arbitrage. The chart below shows how trying to time the market can affect long term returns and over time investors return to rationality. It’s also important to keep in mind that most of the largest one-day returns come at the depths of market drawdowns as the market is reversing course.
If you sold your equities after the beginning of a market decline and went to cash for a year waiting for the noise to blow over, you would have greatly underperformed the market in the future.
The second chart below shows why this is. As quickly as the market can fall it usually rebounds even quicker. Therefore, missing the initial “bounce” from the bottom can have large effects on returns in the future.
I started my investment management career on June 23, 1986. Since that time I have experienced and survived each of the crisis’s highlighted in this chart. I learned a great deal from each of these situations and our investment management approach has proven itself in each crisis and will under the current one.
The final reason why keeping a long-term viewpoint is important is because it is too easy to be swept up in the short-term noise and put yourself on the sideline while other investors scoop up your shares at a good price. In the near term the Coronavirus feels like the end of the world and the perfect reason to go to cash and hide out. The media profits off this hysteria adding to the stigma which only makes things worse. The reality is that these events happen frequently. We are not saying that the Coronavirus will not influence the operation of companies and the economy as a whole. We just believe that this effect will be a short term, one-off scenario and companies will be able to cope. Does the possibility exist that the virus presents enough of a shock to the markets to cause a protracted downturn? Certainly, but right now with the info that we have available we believe that our companies will be able to weather the storm. In the long term it pays to be an optimist.
Past performance does not guarantee future returns.
So where do we go from here? We expect market volatility to likely persist until the end of the year. Eventually the market will finish shaking itself out and a bottom will be reached. Although we continue to think our companies are strong there will certainly be pockets of the market that experience permanent capital loss as the oil war being waged by the Russians and Saudis has created a scenario where many energy companies that have been irresponsible with their capital and balance sheets will be forced to deal with the consequences. Cruise lines and airlines that in recent years have bought back stock with excess cash rather than pay down their large amounts of debt will most likely find themselves in capital crunches as well. We do not own any of these companies. However, we will be closely monitoring this situation as it reverberates through both the equity and credit markets. The recent cancellations of major events and the slowdown of world travel certainly increase the probability of a recession in 2020 but it is still too early to confirm that. Even though we use these starting points to try to feel out a bottom, we cannot predict what will happen in the next month, six months, or next year. If we look a few years out, I would suspect that this sell off will have proved to be a great time to invest in strong companies.
Covington Investment Advisors, Inc. prepared this material for informational purposes only and is not an offer or solicitation to buy or sell. The information provided is for general guidance and is not a personal recommendation for any particular investor or client and does not take into account the financial, investment or other objectives or needs of a particular investor or client. Clients and investors should consider other factors in making their investment decision while taking into account the current market environment.
Covington Investment Advisors, Inc. uses reasonable efforts to obtain information from sources which it believes to be reliable. Any comments and opinions made in this correspondence are subject to change without notice. Past performance is no indication of future results.
