Greg Kolb, Chief Investment Officer for Perkins Investment Management*, reviews the state of markets in the wake of the coronavirus, and discusses why he thinks investors would do well to consider the functional challenges facing certain business models, and the reasonable upside scenario for certain beaten-up areas of the market.
*Perkins Investment Management is a subsidiary of Janus Henderson.
- The COVID-19 coronavirus will be with us for a lengthy period, warranting a significant adjustment in thinking about stock portfolios.
- In assessing reward-to-risk amid today’s confusion, it may be helpful to develop both a
realistic negative scenario and a more optimistic upside scenario, adapting both scenarios
to the current environment.
- While simply enduring the next several quarters will be difficult across a range of industries and some business models won’t function at all in this new environment, brighter days
likely still lie ahead in select areas of the market.
Often, it pays to chart a steady course in the stock market and not become too flustered, either positively or negatively, by current events. Stocks are long-duration assets, and corporations have generated significant growth in profits for a very long time, overcoming many obstacles along the way. However, a few months into the deepest economic slump in decades (it feels longer, right?), it is quickly becoming clear the new coronavirus represents more than a mere ‘bump in the road’. Barring a major medical advance soon – which we can hope for but should not count on – the situation today warrants a significant adjustment in thinking about stock portfolios.
The virus will be with us for a lengthy period. According to Dr Marc Lipsitch, an infectious disease epidemiologist at Harvard’s TH Chan School of Public Health, “Exactly how long remains to be seen. It’s going to be a matter of managing it over months to a couple of years. It’s not a matter of getting past the peak, as some people seem to believe.”1
Dr Lipsitch is co-author of a recent analysis from the Center for Infectious Disease Research and Policy at the University of Minnesota, which outlined several different scenarios for the future of the COVID-19 pandemic, one of which is reproduced in the chart below.2 The analysis suggests a series of incidence waves extending into 2021–22 that will likely require disease-mitigating measures to avoid overwhelming the health care system. Eventually, herd immunity may be reached once an estimated 60-70% of the population has been infected with the virus. In the meantime, vaccines take time to develop, and challenges are likely to arise. As the timeline for moving past the pandemic comes into better focus, it seems to stretch out. In my household there is a sense of foreboding as we look ahead to the new school year in the fall.
Exhibit 1: Possible pandemic wave scenario for COVID-19 – peaks and valleys
Source: Modified from the Center for Infectious Disease Research and Policy, University of Minnesota. Viewpoint, Part 1, 30 April 2020. The example provided is hypothetical and used for illustrative purposes only.
Stay-at-home and other COVID-19 disease mitigating measures — while perhaps warranted from a public health perspective — are ruining the economy. Unemployment has risen to Great Depression-era levels, retail sales and industrial production have suffered historic declines and economic anxiety has gripped both businesses and households, with confidence measures for both plunging. Many businesses are facing massive declines in revenue (falling 25–50% or more) and are simply not designed to operate profitably with such low capacity utilisation. High fixed costs and balance sheet leverage are multiplying the hit to bottom-line profits in many cases. Many public companies are abandoning their revenue and profit forecasts for the year, a clear acknowledgment of a very murky outlook.
Central governments have stepped into the void with massive quantities of money creation and deficit spending. Policymakers have moved quickly to attempt to avoid a deflationary collapse. Coupled with the beginnings of a ‘reopening’ strategy, the hope is to limit the worst of the damage and get the economy growing again. Looking forward, specifically on the fiscal side, many of the business and consumer aid packages are set to expire in the summer/autumn timeframe, creating an uncomfortable gap in economic support. In addition, we suspect that while in many cases people will want to get on with their lives, they will also strongly want to avoid disease. 2019 appears to have been a peak for corporate profits, which will take some time to achieve again.
Given all the moving parts, it strikes us as absurd to be working with point estimates of business value. We develop two distinct scenarios in our analysis of individual stocks — a realistic negative scenario and a more optimistic (but not blue sky) upside scenario — and find the approach helpful in assessing reward‑to‑risk amid today’s confusion. Our team of analysts and portfolio managers is adapting both scenarios to the new environment.
The degree of difficulty in simply enduring the next several quarters will be higher than ever before across a range of industries. Some business models that worked well just five months ago do not function at all in this new environment. Especially in economically sensitive and/or high social contact areas, companies will likely need the ability to be profitable at a much‑lower‑than‑2019 level of revenue for several years or else face reorganisation (for example, airlines or energy companies). Market darlings, including technology and various growth securities, will face the test of decoupling their revenues/profits from so many of their customers that are sustaining big hits or else risk seeing their valuation multiples decline, perhaps substantially (eg, many Nasdaq stocks).
Investors would do well to also remember the upside potential in equities. Many stocks are down meaningfully year‑to‑date and are recording subnormal levels of profits. While a reasonable upside scenario may be pushed a bit farther out than is typical, brighter days still likely lie ahead.
Stocks in beaten-up areas of the market could see significant growth in a reasonable longer-term scenario, in our view (eg, select financials and health care). There are also high quality franchises that are down more modest amounts and trading for mid-teens price-to-earnings ratios, which could potentially generate traditional equity-like rates of return (6–10% per year)3, an attractive level in a world of near-zero interest rates (eg, select consumer staples and out-of-favor technology stocks). While hunting for bargains, keep in mind the potential benefits of maintaining a diversified portfolio.
The gap between the new coronavirus’ coming and going is proving uncomfortably long. We can all hope for a great medical advancement or the virus to unexpectedly peter out. More practically, the sooner investors recognise the likely impacts on companies and stock portfolios, the better their investing results are likely to be.
- Roberts, Siobhan. “This Is the Future of the Pandemic.” The New York Times, 8 May 2020.
- COVID-19: The Center for Infectious Disease Research and Policy. Viewpoint, Part 1, 30 April 2020.
- The S&P 500® Index average annualised return from 30 December 1927 through to 19 May 2020 was 9.32%. Source: Bloomberg, total return data.