The goal of this commentary is to assess the potential magnitude of the decline of the aggregate value of companies caused by the epidemic. We’ll use a basic quantitative valuation model and assess the impacts on the results of the model of various assumptions. If this sounds a bit nerdy, it is – but perhaps some nerdiness is useful at a time when nearly all the analyses I see in the press are vague and emotional. Before going into analytics, I again want to restate the disclaimer I made in last week’s commentary. The analysis of the Coronavirus on the stock market is trivial relative to the effect on lives, health, and social welfare. But we need to do our job, which is to try to make sense of the impacts on the portfolios of our clients.
Fundamental versus current market valuation
Our focus is on the fundamental valuation of the stock market, which is a matter of analytical opinion, and is based on estimates of various economic data. During most times, the current market values of stocks are a good approximation of that ethereal fundamental value, but during times of market panic, market values can diverge widely. How do we know the two values have diverged? The current market value has increased on this Friday morning by 1.2% during the 15 minutes it took to write the first paragraph (after falling by 3% in the previous hour) – the sharpness of those movements is obviously not related to anyone’s estimate of fundamental valuation. However, when a crisis is over – crises never last forever – the market movements settle down and the two valuations converge again.
The model and assumptions
To get an assessment of how fundamental valuations might be affected by the epidemic, I created a simple valuation model focused on earnings, future growth, and the reasonable expectation of returns in the equity market. Academic students of finance are well acquainted with models like these. The purpose of the model is not to predict whether stocks are currently overvalued or undervalued, but to see how changes in the factors of the model impact fundamental valuation. I calibrated the model such that the forward price-earnings ratio was in the 18s, which is what it was on February 20, the day before the news of the Coronavirus started consistently impacting the current market values.
To assess the impact, I focused on two questions – what will be the degree of impact of the epidemic on corporate operating earnings and how long will that impact last? I assumed for 2020 corporate operating earnings will go to zero because I wanted to see a worst-case scenario. How radical of an assumption is that? The biggest decline in earnings in the past 80 years was the financial crisis of 2008, when operating earnings fell by 40%. I’m assuming the decline would be more than double of that drop!
The more critical question is how long will the impact last? For now, I’ll assume a year. Ask yourself a question – your true fundamental belief – do you think that as we stand in March 2021, we will still be feeling the day-to-day impacts of the epidemic? Will schools still be closing? Will global commerce still be curtailed? Will Coronavirus be the lead story on every newscast? My true belief is no. In general, when people are in the middle of any crisis, they often correctly acknowledge the current depth of the predicament, and then incorrectly linearly project the current impacts into the future, without
accounting for the fact that there are very smart and experienced experts working on solving the problem. Time and time again – 9/11, the aforementioned 2008 financial crisis, the Greek debt crisis of 2011 – society overestimates the length of time that a crisis will last.
The effects on the model
Given that analysis, I presumed that while 2020 earnings will go to zero, 2021 earnings will return to 2019 levels. Again, using the last recession as a guide, 2009 earnings started to grow, and by 2010, they were back to their pre-recession levels.
Before debating the efficacy of the assumptions, let’s see what the impact on fundamental valuation is. In the model, fundamental valuation declines by only 5%. Why is the effect so little? Because the vast majority of the valuation of a company is not next year’s earnings, or even the next few years of earnings, but the long-term stream of earnings.
Obviously, there are countless scenarios that can play out, and changes to the assumptions impact the valuation in predictable ways. Suppose that 1) the earnings decline is only 50% in 2020 (still more than the drop in the recession) and the impact on earnings lasts for two years instead of one year – then the decline in valuation is still only 5%. Perhaps you’re more pessimistic than I am, and you believe that there will be zero earnings for two years, then the change in valuation will be 10%.
As I’m writing this Friday morning, the actual change in current market valuation since February 20 is 14%. From our perspective, the 14% decline in stock values can be considered an overreaction, but as we’ve seen with other crises, such declines are understandable with the tremendous amount of uncertainty. We wouldn’t say it’s a “buying opportunity” because buying opportunities suggest short-term results, and in a crisis, no one can predict short-term results (if someone tells you they can, they’re lying). And one thing is certain, the volatility we’ve seen the past few weeks will likely continue for the next few months. But from a long-term perspective, the impact of the epidemic does not suggest a change to long-term investment strategy.
I truly would like to hear from you. While not unprecedented, the current level of volatility is atypical. It’s nice to lead an investment advisory business in a year like last year, when equity returns in the high 20s and above average bond returns make us look good. But I believe we truly add value during times like these. So, if you have questions, drop me an email – firstname.lastname@example.org. I can’t promise you’ll like the answers, but they will be direct and honest.