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.

 

banner

Most viewed in recent weeks

Welcome to Firstlinks Edition 383

One of the downsides of Donald Trump commanding the headlines is that we skim over other significant issues. For example, few Australians read the China Daily News or coverage of its contents, missing official statements that are terrifying hundreds of Australian producers. China says Australia will 'pay tremendously' for its recent lack of respect.

  • 12 November 2020

Five ways the Retirement Review points to new policies

The Retirement Income Review goes much further than an innocent-sounding 'fact base', and is sure to guide policies in the run up to the next election. It will change how we think about retirement incomes.

Graeme Shaw on why investing is at a pivotal moment

Company profits have not improved for many years but higher valuations have been driven by falling rates and excess liquidity. Conditions do not suit a value and contrarian manager but here are some opportunities.

Retirement Review gives strong views on hoarding of super

The Review includes some profound findings, most notable that retirement income should include drawing down far more capital. Expect post-retirement products to proliferate under a Retirement Income Covenant.

11 key findings on retirement dreams during the pandemic

A mid-pandemic survey of over 1,000 people near or in retirement found three in four are not confident how long their money will last. Only 18% felt their money was safe during a strong economic downturn.

Bank scorecard 2020: when will the mojo return?

Banks severely cut dividends in 2020 but are expected to improve payments in 2021. History provides clues to when the banks will return to their 2019 levels of profitability, but who is positioned the best?

Latest Updates

Retirement

Five ways the Retirement Review points to new policies

The Retirement Income Review goes much further than an innocent-sounding 'fact base', and is sure to guide policies in the run up to the next election. It will change how we think about retirement incomes.

Property

Steve Bennett on investing in direct property for the long term

As people stayed home during the pandemic, a bearish view swept over most property sectors, but many have thrived and prices have recovered rapidly. The best opportunities are in long leases with quality tenants.

Retirement

Retirement Review gives strong views on hoarding of super

The Review includes some profound findings, most notable that retirement income should include drawing down far more capital. Expect post-retirement products to proliferate under a Retirement Income Covenant.

Superannuation

Paul Keating on why super relies on “not draining the bath”

Paul Keating is the champion of compulsory superannuation as the central means of funding retirement. In the wake of the Retirement Income Review, he is at his passionate best defending the system, with Leigh Sales.

Latest from Morningstar

Is your portfolio too heavy on technology stocks?

Investors with heavy allocations to a broad US index should check how much is exposed to tech stocks, especially when valuations look a bit steep. It might be time to reallocate to other sectors or styles.

Investment strategies

Beware of burning down the barn to bury the debt

At some point, policymakers will turn to the task of deleveraging, to work off massive debt burdens built up during the pandemic. Australia is already ticking the boxes on many policies used in the past.

Superannuation

New bankruptcy rules may have a domino impact on SMSF pensions

During COVID, bankruptcy rules have allowed small businesses to trade while insolvent. It may mean an SMSF is hit by the collapse of a business leaving trustees struggling to meet their own legal obligations.

Sponsors

Alliances

© 2020 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.
Any general advice or class service prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, has been prepared by without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG) for more information. 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.