Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 355

Too many unknowns: hope isn't an investment thesis

Over the next several weeks, investors will experience horrendous macroeconomic data. For instance, based on initial jobless claims data, more jobs were lost in the US in four weeks recently than were created during the entirety of the now-ended 11-year business cycle. So yes, economic data will get worse, but it may not matter to capital markets because this is a market known.

Markets factor in expectations

Markets are a discounting mechanism of ‘known knowns’ and the weighted probabilities of many ‘known unknowns.’ And an upcoming earnings recession won’t surprise markets any more than terrible labour data will.

Two known unknowns are the pace of the economic recovery and the path of post-recession earnings. Since the March 2020 lows, US equities have retraced over half of their losses. Stated another way, in the face of the worst recession of our lifetimes, equity valuations are down only to June 2019 levels. Over the past few weeks, investors have increasingly assigned a higher probability to a shorter-than-anticipated recession and a stronger acceleration in profits.

We’re not epidemiologists, so we won’t opine on the infection curve or the risks of a second wave, though we certainly hope for the best. But as they say, hope isn’t an investment thesis.

Regardless of when the virus peaks or the economy reopens, life will be different. Politicians, the media and investment strategists and economists (but not us!) have equated the world’s efforts to contain COVID-19 with fighting a war. While it may feel that way with everyone pulling together (thank you to the brave health workers and first responders!), pandemics alter long-term behaviour differently than wars.

The catalysts that generally drive V-shaped postwar recoveries are very different from pandemic-driven ones. In short, precautionary savings by both consumers and businesses create different economic and inflation environments than those previously observed in postwar economies.

The scramble into new capital raisings 

A market known unknown, if you will, that we want to explore further is the likely earnings dilution resulting from future equity capital having to be raised.

During periods of economic strength, many corporations take advantage of all available levers to maximise their appeal to equity investors. Part of the reason for this is that the wrong incentive structure is in place for many corporate leaders. Over the past decade, working capital has been the priority for most CEOs, and lower balance sheet quality has been the lever. That dynamic has been on display more in the recent past than in any other period of recorded history. Exhibit 1 details the steady increase of billions of dollars’ worth of shares repurchased in the S&P 500 Index.

This isn’t new information, so we highlight 2008. As the fat tail risk of the GFC faded, emphasis turned from maintaining liquidity towards recapitalisation. That recapitalisation came via the equity market and at the expense of shareholders who suffered substantial dilution on a per-share basis.

Today, CEOs and CFOs — particularly those of companies that might not be able to carry on — are scrambling to secure liquidity. Profit maximisation is no longer the priority. Survival is the goal, as meeting next month’s debt maturity is all that matters. Balance sheets are now the focus, unlike in the past dozen years.

However, the nature of this recession is different from that of 2008, and not only because the recession is driven by a pandemic. The 2008 meltdown was driven by an overleveraged financial sector. However, this time around, banks and real estate investment trusts (REITs) weren’t the entities that extended balance sheet leverage to unsustainable levels in order to repurchase stock.

Instead it was every corporate sector but financials. And a fresh wave of recapitalisations is likely just getting started. There’s already been equity issuance by leisure and professional services companies in the US and Europe.

Too many unknowns for recovery conviction

None of us can guess what the duration of this recession will be, nor can we tell how strong the recovery will be. Yet many seem to believe they have sufficient visibility into any such recovery’s many known unknowns to make the high-conviction call that the recovery will be strong. We wish we had such conviction, but we don’t, and we don’t think you should either.

Instead of trying to make those calls, we’ve chosen to invest carefully, owning assets of enterprises for which the growth of working capital isn’t dependent on externalities such as financing, recognising that you can’t plan perfectly for black swan events such as the one we’re experiencing.

 

Robert M. Almeida Jr. is a Portfolio Manager and Global Investment Strategist, and Erik Weisman, Ph.D. is a Portfolio Manager and Chief Economist at MFS Investment Management. The comments, opinions and analysis are for general information purposes only and are not investment advice or a complete analysis of every material fact regarding any investment. Comments, opinions and analysis are rendered as of the date given and may change without notice due to market conditions and other factors. This article is issued in Australia by MFS International Australia Pty Ltd (ABN 68 607 579 537, AFSL 485343), a sponsor of Firstlinks.

For more articles and papers from MFS, please click here.

 

RELATED ARTICLES

The iron law of building wealth

The bright outlook for Australian fixed income

3 investment themes for 2023

banner

Most viewed in recent weeks

An important Foxtel announcement...

News Corp's plans to sell Foxtel are surprising in that streaming assets Kayo, Binge and Hubbl look likely to go with it. This and recent events in the US show the bind that legacy TV businesses find themselves in.

Welcome to Firstlinks Edition 575 with weekend update

A new study has found Australians far outlive people in other English-speaking countries. We live four years longer than the average American and two years more than the average Briton, and some of the reasons why may surprise you.

  • 29 August 2024

The challenges of building a portfolio from scratch

It surprises me how often individual investors and even seasoned financial professionals don’t know the basics of building an investment portfolio. Here is a guide to do just that, as well as the challenges involved.

Creating a bulletproof investment portfolio

Is it possible to build a portfolio that performs well in any economic environment? So-called 'All Weather' portfolios have become more prominent of late, and this looks at what these portfolios are and their pros and cons.

Welcome to Firstlinks Edition 578 with weekend update

The number of high-net-worth individuals in Australia has increased by almost 9% over the past year, and they now own $3.3 trillion in investable assets. A new report reveals how the wealthy are investing their money.

  • 19 September 2024

Why I'm a perma-bull on stocks

Investors overestimate the risk of owning stocks and underestimate the risk of not owning them. In the long run, shares crush other major asset classes, yet it’s one thing to understand this, it’s another to being able to execute on it.

Latest Updates

Investing

Where to find good investment writing and advice

Investors are exposed to so much information that it’s often hard to filter the good from the bad. This looks at how to tell the difference between the two and the best sources of investment writing and advice.

Investment strategies

Are demographics destiny for the stock market?

Demographics influence economies and stock markets, but other factors like technology and policy can overshadow their impact. Diversifying across income-producing assets can help mitigate demographic-driven challenges and build wealth.

Shares

Are we reaching the end of Transurban's gravy train?

You can only push monopoly power so far before it triggers a backlash. Transurban might have finally pushed too far, raising big questions for investors.

The dawn of wicked asset classes

Collectables and other non-traditional assets often rally late in the cycle. But you should only buy them with a clear purpose and with money you can afford to lose.

Property

This property valuation metric needs a rethink

Capitalisation rates, commonly known as ‘cap rates’, are a fundamental metric in Australian property investing.  However, this seemingly simple and ubiquitous measure can be far more complex to use when comparing different types of properties.

Superannuation

Improving access to account-based pensions

Research suggests that 50,000 Australians who are retiring over the next year may not be able to access an account-based pension because they do not meet minimum application requirements of their super fund.

Do sanctions work?

Sanctions are losing effectiveness due to increasing economic polarisation, with many countries increasingly circumventing restrictions. Examples include China, Iran and Russia, whose industries have adapted despite sanctions.

Sponsors

Alliances

© 2024 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.