PANDEMIC CONUNDRUM

Quarterly Letter

After a spectacularly COVID driven dive in March of this year, financial markets staged a rebound with almost the same intensity as the plunge that preceded it. In fact, if you were not paying attention from January to June, the market’s decline seems relatively benign compared to overwhelming impact of the crisis.

As the coronavirus dominates the news 24/7, most investors wonder whether markets are disconnected from the reality of what they hear and read in the mainstream media.

Anatomy for the rebound

Massive stimulus

While we think the rebound does reflect the fact that after the initial panic, investors concluded that “this too shall pass”, we believe the main reason is the amount of fiscal and monetary stimulus by governments and central banks worldwide. In other words, money printed out of thin air, will eventually end up in financial markets. Moreover, interest rates are expected to stay at historical lows for the foreseeable future, making fixed income instrument (especially government and high-grade corporate bonds) returns unappealing versus equities.

Extreme concentration

However, among equities, the rebound has been very uneven between sectors. We can actually divide equity performance into two groups: COVID “winners” and the others. Investors rewarded companies that enable remote working, shopping and stay-at-home activities by bidding up their stock prices. In turn, they punished traditional companies that rely on human contact to do business… except Tesla! So much so that new distortions are created in the markets. The extreme case is in the Russell 1000 Growth Index (representing, as the name shows, the 1000 biggest growth companies in the US), where 5 stocks now account for a record 37% of the entire index: Microsoft 10.4%, Apple 10.2%, Amazon 8.5%, Alphabet (Google) 4.5% and Facebook 3.8%. As a result, US stocks now account for 66% of the MSCI world index, versus 30% 3 decades ago. To put it in a different perspective, the table below shows the performance in US Dollars of the FANMAG stocks (Facebook, Amazon, Netflix, Microsoft, Apple and Google) versus the rest of the S&P 500:

 Gains/Annum (%) Year-to-Date (%)
 2014-12-31 to 2020-06-302019-12-31 to 2020-06-30
FANMAG27.3223.49
S&P 5007.43-5.5
S&P 494 (S&P500 ex FANMAG)4.22-11.3

Massive divergence in valuation

As you would expect, FANMAG and other technology stocks (commonly called growth stocks) should command higher valuations than traditional industrial stocks (called Value stocks). In fact, as we write, the median Price/Earnings (P/E) valuation for Growth stocks is 4 times the P/E for Value stocks (59.4x versus 15.8), according to Ned Davis Research. While it is true the FANMAG companies are extremely profitable and continue to grow at a good pace, the question we ask ourselves is: what is a reasonable premium to pay for growth? Everybody loves growth but at some point, valuation does matter. Geographic valuation is also becoming a concern. Thanks to the concentration effect dominated by FANMAG, US stocks are also much more expensive than they usually are relative to the rest of the world.

What ‘s next?

As the pandemic evolves, companies will have to adapt to new regulations and consumer behaviors. Until a vaccine discovery offers widespread immunity, life will not begin to normalize. In this environment, investing will require an ability to look beyond 2020. Weak companies will falter, and strong companies will flourish. Therefore, scrutinizing companies’ balance sheet and engaging with management will continue to be essential to our analysis.

What to do?

Investors should accept volatility as a defining feature of today’s market. Therefore, they should resist the urge of getting in and out of the markets. They should not allow the frequent sharp swings in either direction to derail their long-term strategic goals.

They should stay diversified and avoid the temptation to join the party created by the concentration effect on the FANMAG and related growth stocks. Do not envy your friends for owning Tesla, Zoom or other highflyers. (oh, we forgot to mention the most recent disaster on those POT (cannabis) stocks….) To paraphrase Charlie Munger, Warren Buffett’s partner, envy is a really stupid sin because it is the only one you could never possibly have any fun at. As with any other pandemic in history, this too shall pass.

Eventually, a vaccine will be discovered, and normal life will resume. We dare hope that with the medical and research progress made in the last 100 years, a vaccine is forthcoming sooner rather than later. As investors, we ought to have the ability to assess the intrinsic value of companies when things normalize, compare it to today’s price and make a decision as to whether we want to own them or not. That is what we endeavour to do at Claret.

Stay well and enjoy the rest of summer.

The Claret Team