COVID-19: Disaster or Opportunity?
In June 1944 General Eisenhower marched into a conference room at army HQ in Malta. A ring of ashen faces stared from around the table.
Days before, the Allies had stormed the beaches of Normandy. Enthusiasm for D-Day’s success was now giving way to dismay over the present reality: tens of thousands of Allied troops were bogged down in the hedgerows of France. They were struggling to move, coordinate, and reorganize. The Allies were sitting ducks and the Germans knew it. Intelligence suggested that the Germans were preparing yet another Blitzkeig -- a violent, lightning-quick show of force intended to devastate the Allies’ in mind and body.
As General Eisenhower peered around, he declared: “The present situation is to be regarded as opportunity for us and not disaster. There will be only cheerful faces at this conference table.”
The difference between an opportunity and a disaster is a state of mind. Eisenhower knew fearful, timid thinking would not get the job done. Fear closes our minds and narrows our vision. In Dune Frank Herbert aptly called fear “the mind-killer”.
Like Eisenhower, Winston Churchill built his career by turning obstacles into opportunities. He famously advised that leaders “never waste a good crisis.”
The present COVID-19 crisis is decidedly not “good”, but Churchill’s sentiments still apply. We regard the market’s tumble as an opportunity to seize, not a disaster to fear.
When markets are volatile, we focus on the fundamental principles of investing:
be greedy when others are fearful
grasp the obvious rather than the esoteric (or, keep it simple)
Where’s the Value?
When markets move fast, it’s important to keep the big picture in focus. Fear narrows investment horizons. When markets fall, investors naturally narrow their focus from years to days. We gain an immense advantage by resisting this urge. Simple theses make it easy to see the value in our holdings.
Take Berkshire Hathaway, for example, which published its annual report last week. At a high level, Berkshire is the sum of two parts: insurance and industrials.
Berkshire’s insurance segment is worth at least book value, or $160 per class B share. Book value is a proxy for liquidation value and gives no credit for Berkshire’s world-class underwriting or capital allocation. Berkshire’s industrial segment is a collection of above-average businesses and is worth at least the market’s median price (14x pre-tax) or $140 per class B share.
Together, these sum to $300. Friday (2/28), Berkshire stock traded $200. If Berkshire can compound its intrinsic value at just 7% annually for the next five years -- well below its recent record -- its intrinsic value will be above $400 in five years, double Friday’s market quotation.
Or consider Bank of America, which announced last June it would buy back $30 billion of stock by July. At its current price ($28) that amounts to 12% of its market cap. Bank of America also pays a 2.5% dividend, bringing its total yield to 14.5%.
Wells Fargo is similarly buying back $23 billion of stock by July, 9.5% of its market cap. it also pays a 5% dividend for a 14.5% total yield. The lower prices go, the more attractive these repurchases become.
Quantifying COVID-19
COVID-19 will impact each of these businesses in some way. While the affects may be profound, I think we can all agree they will be temporary.
The real question then becomes, how much should stocks fall given a temporary decline in earnings? Without a crystal ball we have no chance at precision, but we can make an educated guess.
A stock should be worth the present value of the business’s future cash flows. So, lets consider a simple hypothetical stock which:
Produces $10 of earnings each year for 10 years
Trades at 10x earnings after the 10 years
The present value of these earnings is $157.83 using a 10% discount rate. That’s what this stock should be worth (i.e. its “intrinsic value”).
Now let’s assume COVID-19 knocks out the first year of earnings entirely. How much is the stock worth? $148.74, 5.8% less. What if it loses two entire years of earnings? Its present value is $140.48, 11.0% less.
The market was down 12% at Friday’s (2/28) close and 15% at Friday morning’s low, which means investors think the S&P 500 will lose over two years of earnings (relative to prior expectations). That didn’t even happen in 2008/09.
Markets Will Fluctuate
Laurence Sloan’s 1927 book Security Speculation -- The Dazzling Adventure recounts an anecdote about J.P. Morgan.
History has it that a young man once found himself in the immediate presence of the late Mr. J. P. Morgan. Seeking to improve the golden moment, he ventured to inquire Mr. Morgan’s opinion as to the future course of the stock market. The alleged reply has become classic: “Young man, I believe the market is going to fluctuate.”
Mr. Morgan’s insight is as profound as it is banal. Markets have always and will always fluctuate because human emotion is destined to oscillate between fear and greed. Stock prices tend to oscillate wider than their underlying businesses, which presents opportunity.
Author and Wall Street Journal columnist Jason Zweig once wrote:
From financial history and from my own experience, I long ago concluded that regression to the mean is the most powerful law in financial physics: Periods of above-average performance are inevitably followed by below-average returns, and bad times inevitably set the stage for surprisingly good performance.
Reversion to the mean is a tale as old as time. The Roman poet Horace, writing around 40 BC said, “Many shall be restored that now are fallen and many shall fall that now are in honor.”
Newspaper headlines are almost always negative, and have been since Gutenberg fired up his printing press. But society has marched forward, through wars, epidemics, and natural disasters.
Pundits like to advise you wait for “clarity” to invest. But clarity never comes. The world jumps straight to the next worry. By the time fears subside, prices have risen. As Warren Buffett says, “You pay a very high price in the stock market for a cheery consensus.”
We don’t know where markets will be in a week, a month, or a year. But we do know that the world will march forward over time. And we know that buying good businesses at low prices produces wealth over decades.
If you expect to be a net buyer of equities over time, like we do, then you benefit from lower prices and should regard the present situation as an opportunity and not a disaster.
Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.