History provides a crucial insight regarding market crises: they are inevitable, painful, and ultimately surmountable.
Shelby M.C. Davis
Introduction: Price dislocations that occur during times of market crisis often create some of the best investment opportunities for value investors. Disciplined value investors will have cash available in their portfolios to take advantage of these opportunities and an ability to ignore short-term volatility. Finding investment opportunities in crisis requires discipline and patience, but as the chart from Capital Group shows, the average bull market total return is much larger (+279%) and much longer (72 months) than the average bear market.
Over the past 70 years, there have been seven significant market crashes, resulting in a new bear market approximately every ten years. This year’s market crash was on schedule, ending the ten-year bull market that began in 2010. US stock indices hit their lowest point around the 23rd March 2020. Like previous market crashes, this one was abrupt and induced fear in market participants who indiscriminately sold equities and moved their portfolios into bonds and cash.
The speed at which short-term market panic has been able to spread has accelerated due to the availability of 24/7 news and social media. This year’s geopolitical tension and upcoming election created even more uncertainty, leading investors to reduce their equity investments further.
Historical data shows the market rewards investors for looking beyond short-term volatility created during times of crisis. Investors can take three actions to find investment opportunities in a crisis: (i) Do not panic, (ii) Upgrade the portfolio, and (iii) Invest in sectors that benefit from a recovery.
Figure 1. Capital Group Economics Data.
Three actions to find investment opportunities in a crisis:
Do not panic: The most robust evidence against panicking comes from previous crisis periods. Historical data shows that investors who look past the short-term volatility and remain focused on the long-term picture have often been rewarded for their patience, with the highest stock market returns often realised immediately after the market trough. In the short-term, COVID-19 has brought record-high unemployment and a tragic human cost. However, much of the slowdown in global economies was induced by government lockdowns as opposed to fundamental weakness in business operations. If business fundamentals remain strong through this period of slowdown, then a ‘U’ shaped recovery in the economy is possible. Uncertainty in the stock market has increased due to society-level groupthink supported by 24/7 news and social media circulating ‘expert’ opinions, including those stating the COVID-19 pandemic will never end. During crisis periods, society-level groupthink tends to focus on how this crisis is different, rather than the similarities with previous crises. The most important common denominator across all previous crises is that they all ended. Therefore the idea that this current crisis will not end is improbable. Once economies recover, some things will change, but the situation will normalise. For example, after September 11th enhanced security was introduced at airports, therefore after COVID-19 it is not unlikely that vaccination records will be required for long-haul travel. Assessing when the recovery might happen is challenging and requires looking at the depth of disruption across each sector in the economy. Health metrics (rate of infection, geographic distribution, testing capacity) also provide clues to the timing of recovery. McKinsey’s latest estimates indicate a long hard road to recovery with China returning to pre-crisis levels by Q2 2021, the US by Q1 2023, and the EU by Q3 2023.
Upgrade the portfolio: Crisis is an opportunity to upgrade the portfolio towards businesses that will rebound strongly once economies recover, and business that have a strong balance sheet to survive through the current period. Upgrading requires making hard decisions to sell overvalued lower quality businesses and buy businesses that have become undervalued, with comparably better long-term prospects. Investors can deploy cash reserves into businesses that have been tracked for some time, and whose stock price has become attractive. When deciding which investments to make, investors should not be anchored to keeping businesses in their existing portfolio or to their investment cost. Investors should perform an unbiased review of a broader universe of potential investments, seeking to invest in overall better-quality businesses.
Invest in sectors that benefit from a recovery: Sectors which look to benefit from the return of consumer spending, whenever it materialises, include payments (Visa, Mastercard), established consumer brands (Starbucks, Disney), animal health and pet care (Elanco, Trupanion), alcoholic beverages (Diageo, Budweiser), and gaming (Sony). Berkshire Hathaway is potentially an attractive investment, as the share price now reflects a suitable entry point. With a c.$128bn cash balance ready to be invested, Berkshire is likely receiving introductions to several attractive and proprietary investment opportunities. There are several great technology and e-commerce businesses whose user bases have grown through the COVID-19 pandemic. However, share prices for technology businesses have outpaced the broader market meaning many good quality businesses are currently overvalued. Opportunities may also arise from businesses that address the challenges of integrating public health measures, and ultimately aid economic recovery (3M). Investors should be careful when assessing businesses in sectors facing the deepest economic disruption. These sectors include hospitality, commercial aerospace, oil and gas, insurance, and discretionary retailing. Some businesses that fall within these sectors may continue to deliver good dividends. Other businesses may appear cheap after stock prices have fallen dramatically, however, turn out to be ‘value traps’ in significantly challenged sectors that have now become even more challenging.
Conclusion: Historical data shows in times of crisis, patient investors who look-through short-term volatility are rewarded. Since 1950, returns from the average bull market have been approximately 8.5x greater in magnitude than the average bear market loss. Moreover, the highest returns have often been realised immediately after the market trough. Therefore, during times of crisis it is important to stay invested and upgrade investment portfolios. Investors should seek to invest in quality businesses that can use their balance sheets to survive short-term declines in revenues, and whose earnings will benefit from an economic recovery.
Stock mentioned: Visa, Mastercard, Elanco, Trupanion, Starbucks, Disney, Diageo, Budweiser, Sony, 3M, Berkshire Hathaway