Extreme uncertainty produces extreme opportunities
May 13, 2020
The novel coronavirus pandemic has been an enormous human tragedy and its ultimate impact on the global economy remains impossible to predict. For many companies, the damage is likely to be severe, perhaps permanent, and this has been justifiably reflected in depressed share prices. But a key lesson from previous crashes is that periods of extreme uncertainty can also produce extreme opportunities for active stock selection to add value.
As miserable as it may feel today, the current opportunity set in global equities may be the most appealing in decades for patient, long-term investors. The remarkable events of recent months reignited several multi-year trends that have combined to drive the valuation gap between the cheapest and the most expensive stocks globally to an extreme not seen in at least 30 years.
These related trends have been evident across style, geography and size. Following a short-lived reversal in the latter half of 2019, growth stocks reasserted their decade-plus dominance, outperforming value stocks by 15 per cent over the first four months of 2020. They have now outperformed their cheaper peers by 30 per cent since the start of last year. From a geographic perspective, the U.S. market outperformed both developed markets outside the U.S. and emerging markets by approximately eight per cent year to date and by 20 per cent since the start of 2019. Lastly, from a size perspective, large-cap stocks continued to dominate smaller-caps by a wide margin in most markets globally, but especially in the U.S.
A common thread running through all of these trends has been an insatiable investor appetite for certainty and stability at almost any price. The flip side of this has been a desire to avoid cyclical and other less-predictable businesses, no matter how compelling their valuations and longer-term fundamentals. While this has generally been true of the market environment for some time, it became even more pronounced with the flight to safety that commenced as the pandemic began to spread rapidly earlier this year.
To use a specific stock as an illustration, BMW was down 50 per cent for the year in mid-March. While the price has since recovered somewhat, it remains cheaper than it was during the darkest days of the global financial crisis at about four times a conservative assessment of normal earnings and at approximately half its book value. There is no question that the crisis has created great uncertainty for the auto industry, on top of pre-existing concerns about electrification, ridesharing and autonomous vehicles, but the market’s reaction still appears excessive.
After all, BMW has successfully navigated short-term pressure and disruptive technological forces on more than a few occasions in nearly a century of making cars. With a premium brand and significant cash on its balance sheet, BMW should not only survive a prolonged shutdown, but could emerge stronger than many of its less conservatively capitalized peers, setting it up nicely to earn well in excess of its cost of capital over the long term.
It is easy to lose that long-term perspective in the midst of a crisis. Indeed, there were also plenty of reasons to be fearful at BMW’s low in 2009. But investors able to look through the short-term noise were rewarded as its share price ultimately appreciated more than 500 per cent to its 2015 high—more than triple the MSCI world index’s return over that period. Of course, BMW is just one example, but it is representative of many other stocks from that period that proved to be extraordinary bargains in the fullness of time.
Only time will tell how the current situation will play out. The impact of the pandemic could turn out to be far worse than even the most extreme stress tests suggest, but at half of book value, the range of outcomes for BMW and many other companies trading at similarly depressed valuations, appears skewed to the upside.
That is why it is so important for investors to remain focused on the relationship between share prices and the long-term intrinsic value of the businesses that they represent. It is the easiest thing to say when everything is going well . . . and the hardest thing to do when it really matters.