31 March, 2020

The Gap Between Price and Value Widens When Uncertainty is High

In the of my Saturday morning, I sit reflecting upon the changes to our lives both big and small. For many of us, a laptop and an internet connection are enough for us to work from anywhere. A chair and desk are scarcely required. For so many others, especially those in the service and hospitality industry, COVID-19 has had an immediate and profound impact on their lives. My spouse and I were speaking to our friends, a young couple who recently had to close their restaurant and let go of staff. They did not know how long this pandemic would last and could not afford to keep paying their staff for what might be months. This is not the story of just one restaurant, one business, but of tens of thousands of businesses in the services sector across Canada, and it’s affecting a significant portion of our working population.

 

Those who work in the oil sector are also affected. The sector has struggled since 2014 when oil prices fell from a high of over USD $100 per barrel – the first oil price shock – only to get walloped again in early March. Slower global demand for oil and supply-chain disruptions will hit the industrial sector, which could lead to a period of unprecedented decline in economic activity. The rippling impact of this global pandemic and seized economies from Asia to Europe to North America will be significant, although I expect brief, in the grand scheme of things. Still, it will not diminish the emotional toll on people. When the official numbers come out, we will likely see Canada’s unemployment rate at about 10%, although economists predict it is headed even higher.

 

You may be thinking at this point, “this sounds like the Great Financial Crisis of 2008 all over again”. Will banks and other financial institutions fail? Are my investments safe? These are the questions my mother-in-law asked me this week. Although, I admit, I was not entirely successful in allaying her fears and preventing her from withdrawing a large sum of cash from the bank and “stuffing it in her mattress”, perhaps I will be more successful with you.

 

Let’s begin.

 

Fiscal and monetary authorities around the world have proactively moved at unprecedented speeds to smooth out the imbalances being caused by the demand shock of COVID-19 and prevent it from spiraling into something far worse.

 

Let’s separate the actions of fiscal and monetary authorities so we can understand them better.

 

Monetary authorities are the central banks around the world - like the Bank of Canada or the U.S. Federal Reserve. They are responsible for setting interest rates and managing our economy to ensure that it isn’t running too hot or too cold, just like the porridge in Goldilocks and the Three Bears. They also play an important role as the lender of last resort, which helps ensure the stability of our financial system. The latter is an important role, more so since 2008.

 

The Great Financial Crisis started as a typical recession caused by a bubble bursting. In this case, it was residential real estate, and it significantly damaged those who took on too much risk and leverage. However, this “typical” recession quickly devolved into a financial crisis when investment bank, Lehman Brothers, went bankrupt due to its significant holdings in “sub-prime mortgages”, which became illiquid and, therefore, difficult to value. When Lehman collapsed, the fallout cascaded across the global financial industry. It took a while, but central banks figured out that they could stabilize investment banks and other financial institutions by buying these assets at steep discounts and, therefore, injecting liquidity into these institutions. In other words, central banks took the risky and illiquid sub-prime mortgages off the banks’ books and gave them treasury bills in exchange, a liquid asset backed by the government so that these businesses could continue to operate. Letting them fail would have threatened the survival of the entire financial system. Today, central banks around the world are doing the same thing, being the lenders of last resort and buying up illiquid assets, so that there will not be another Lehman event and the financial system will not be part of the problem. In doing so, central banks have issued an amazing amount of debt, over $5 trillion USD at last count. This coordinated and rapid response is the reason why we do not expect our financial institutions to be in jeopardy. Central banks are doing everything within their capabilities to ensure that this recession does not devolve into a financial crisis. How we will pay for all this debt going forward is a question for another day.

 

Fiscal authorities are our elected governments and they are the ones who determine tax rates, public spending, etc. Globally, our elected officials have been busy, too. Governments are enacting measures to address the “negative demand shock”, which is economist-speak for “we aren’t spending money on goods and services while we are practicing social distancing in our homes.” The Canadian government has committed $107 billion to date in new spending support and tax deferrals in response to COVID-19, effectively providing a “bridge” to those affected by this crisis. This week, the government also expanded the wage subsidies for businesses from 10% to 75%. It will apply to small and large businesses, as well as to charities and non-profits, and should help alleviate some of the strain on Canadians and help companies retain staff.

 

A summary of our government’s overall response can be found here. Provincial and local governments are providing additional support.

 

The intent of this bridge is that the people affected by this crisis will be able to pay their rent, utility bills and buy groceries. This ensures the crisis does not devolve into something even more serious and buys us time until we can begin reducing our social distancing, thereby, ensuring that we have a rapid recovery to economic growth.

 

I want to reiterate: the fiscal and monetary responses are extremely proactive. I never expected to see the playbook for Global Financial Crisis being pulled out again in my lifetime, but here we are. The silver lining is that all the learnings from the last crisis are being applied at astonishing speed. From the start of the Global Financial Crisis, it took a year for monetary authorities to figure out how to fix the plumbing of the financial system and during that time there was a lot pain and angst. I am much more confident today that we have the plumbing figured out, that our financial system is robust and that we will not have a banking crisis.

 

Looking Ahead

 

Based on the market actions of last week, which were strongly positive after Monday, the financial press declared this bear market dead. My team and I are not so easily convinced. In my letter last week, I summarized the four phases of a bear market, as written by John Rekenthaler of Morningstar. I believe that we are still in the panic stage. During times of great uncertainty, these are normal market fluctuations. Risky assets will rise rapidly off the bottom, only to fall again and test their previous lows as the flood of bad news starts coming in. So, don’t be surprised when we see this played out multiple times in the coming weeks. It is normal. The fluctuations that we have seen so far are caused by the great uncertainty of the dual economic impact from COVID-19 and the oil shock. It is extremely difficult to model the risks when you don’t know the probabilities of the possible outcomes. Market participants have acted mostly rationally, in the face of uncertainty, but in doing so have created significant dislocations between price and value.

 

To quote Aswath Damodaran, Stern Business School Professor of Finance, and author of Musings on Markets Blog, a personal favourite:

 

“Price and value are two terms that get used interchangeably in both academia and practice, but with very different drivers and implications. As we watch stock indices around the world gain and lose trillions each day, it is worth remembering that markets are pricing mechanisms, not value mechanisms, or as Ben Graham would put it, they are voting machines, not weighting machines, at least in the short term.”

 

To give this some context, I was speaking to the lead portfolio manager of Counsel Global Real Estate, Corrado Russo. Yes, we have the same unusual first name, but that’s another story. He was telling me that in the chaos of last week’s market turbulence, you could have bought Boardwalk REIT, Canada’s largest owner of multi-family residential properties, which has a fair market value of ~$6 billion, for the bargain basement price equivalent of $800 million. The market is riddled with such examples. I’m not recommending that one go out and buy Boardwalk or any other individual security, but just drawing the example of how wide the dislocations between price and value can be when uncertainty is this high.

 

Professor Damodaran writes; “Prices of stocks can move towards infinity or towards zero, depending on where mood and momentum take them. Value, on the other hand, has both upper and lower bounds, with both bounds being set by expected cash flows, growth and risk. The upper bound is set by those who are more optimistic about a stock and what they forecast the fundamentals to be (high cash flows, high growth and low risk) and the lower bound by those who are most pessimistic about that same stock, in terms of future expectations or liquidation value. It is true that reasonable investors can disagree about where these bounds lie, but they should not disagree about the existence of these bounds. It is possible, for some stocks, especially early in the life cycle and with substantial uncertainty about the future, for the lower bound on value to be zero, but stocks collectively cannot have that lower bound. For equities collectively to be worth nothing, you would require an apocalyptic scenario, one in which there is little point thinking about investments anyway.”

 

I mentioned it earlier, but it bears repeating - it is unknown exactly how long this shut down will last, but we fully expect the economic and financial numbers from Q1 2020 to be ugly and Q2 will be even uglier. However, we will start to see a recovery at some point going forward. Whether this recovery will be “L”, “V” or “U” shaped is difficult to assess. I honestly do not think that the recovery will be “L” shaped (i.e.: economic depression), which would mean that the economy would remain in a malaise for years. I think I have made my case against that outcome even if my mother-in-law doesn’t believe it! The question of whether this will be a “V” or “U”-shaped recovery remains. Right now, we think it’s too early to be able to answer that question.

 

Rather, we are focussing our time looking for emerging signs that extreme social distancing is “flattening the curve”. Although we feel that developed economies have the resources and infrastructure to deal with the impacts of COVID-19, we have great concern for emerging market countries. Although not yet fully impacted, many lack the resources and infrastructure to test large numbers of people. We are actively monitoring the developments. Our hope is that there is a vaccine or seasonality to the virus which will spare emerging market countries and their people from the worst outcomes of this virus.

 

What This Means to Our Portfolios

 

As I review this week’s buys and sells across our mandates, I see that our investment specialists are active. They are selectively adding to existing names and purchasing new names where they see significant dislocations between price and value. For our part, our Portfolio Management Team is active in assessing the current sentiment and valuations of the respective currencies and asset classes that we invest in and developing scenarios and plans to take advantage of the current market environment. We collectively believe that the ability to look beyond the current noise and be disciplined is what differentiates a speculator from an investor. It isn’t in times of bull markets where investors demonstrate their value. After all, a rising tide raises all ships. As Warren Buffet aptly said: “Only when the tide goes out do you discover who's been swimming naked”. Perhaps we looked silly to some who saw us as wearing wetsuits and water wings as markets marched forward in 2017–2019, but we believe in building resiliency in our portfolios to weather any storm.

 

As I said last week – and I truly mean it – we know this bear market state is jarring and highly disconcerting. While we are not without emotion for the gravity of this crisis, we want to assure you that we are, and have always been, measured and deliberate when it comes to managing your money. To do so effectively, we know that now is the time when we must have courage, conviction and, most of all, patience. Today’s decisions will drive many years of future returns.

 

In closing, whatever the future brings, along with our sub-advisors, will continue to monitor and evaluate markets daily and make adjustments accordingly. We continue to see the benefits of our portfolio construction and the diversification of our investment strategies. Our downside protection strategies have proven to be effective in reducing some of the worst of this bear market.

 

Final Thoughts

 

I would be remiss if I did not acknowledge our health care and social service workers who are taking care of our sick and most vulnerable. While I sit in the comfort and safety of my home, they are on the front lines, putting in long stressful hours day in and day out, putting themselves at risk for contracting COVID-19. I am deeply thankful for their service. Let’s think of their service and sacrifice when we become frustrated by our current situation. Our sacrifice is nothing compared to theirs. The best way we can honour them is doing everything we can to minimize the transmission of COVID-19 so that they can get back to their families and lives. Until next week, stay safe and be well.

 

Corrado Tiralongo

Chief Investment Officer