We have been hit about as hard as anyone in this decline because we have been overweight in higher beta names (i.e., those that are more volatile than the S&P 500) believing (correctly) that since the financial crisis people have been risk- and volatility-phobic and that perceived risk has consistently been greater than real risk. Going into 2020, I thought that economic risk was low and that if the market was going to decline it would be because of either geopolitical events or some exogenous shock to global aggregate demand or aggregate supply. We got that exogenous event in the form of a global pandemic that took stocks from all-time highs to a bear market decline of over 30% in the shortest time in history. As is typical in these sorts of egregious declines, we are down a lot more than the market.
In times such as this, I am reminded of what Keynes wrote to his board when he was managing money during the 1937 market collapse. As you may know, in addition to being the most influential economist of the 20th century, Keynes was also an outstanding investor. The board had been urging him to sell as the market went down and he refused. He told them that it was “the duty of every serious investor to suffer grievous losses with great equanimity.” He went on to note that their advice to increase his selling as stocks went down, if practiced by everyone, would be economically disastrous for the country. It would also mean, he went on to point out, that he would own little or no stock when the market bottomed, whereas his strategy involved being fully invested when stocks were cheap and the market was at its lows.
The market’s behavior since the current low of 2191 on March 23 gives a good indication that this recovery from the inevitable recession now underway will follow the pattern of every other recovery since at least 1973-74. The stocks that have led since the bottom have been low PE/cyclical names with operating or financial leverage, viz., the exact names that were clobbered the most in the decline. Those names were also the worst performers when recession fears were high — fall of 2018, first six weeks of 2016 — yet where no recession materialized. And they gained the most when those fears proved unfounded. The reason why is fairly straightforward: Prices and valuations are highly sensitive to the marginal return on invested capital and to business risk. When the economy is declining, or there are fears that it will, valuations on those companies whose return on invested capital (ROIC) is most sensitive to economic change (mostly traditional cyclicals) will decline more than those that are more resistant such as consumer staples, utilities, bond proxies, and many recurring revenue businesses. Companies with high debt leverage and economic sensitivity fare the worst as the market discounts the possibility they will experience financial distress. When the market sees a recovery, the exact reverse occurs, which is what we saw in the week ending April 10, one of strongest weeks in market history.
It appears that most equity strategists think that the March 23 low may be “retested” in the coming weeks as the global economic shutdown drags on. If so, last week’s leaders, and our Strategies, will also likely lag, although perhaps not as much as they did during the initial collapse. I am agnostic on that as my ability to forecast the market’s short-term path rounds to zero. So does everyone else’s, by the way.
Listening to the financial commentators on CNBC and elsewhere, I hear many, if not most, of them advising investors to use the decline to “upgrade” their portfolios. They say to “buy quality names on sale,” but avoid or reduce exposure to names that are riskier. Typical issues in the quality bucket include companies such as Alphabet, Disney, Nike, Amazon, Facebook, Procter & Gamble, and Clorox. Now these are all very fine companies and we own several of them. I think, though, that a portfolio comprised of all “quality” names, names that have been among the best performers in this dramatic decline, will almost certainly be a portfolio that underperforms the market as the economy and the market recover. In big market declines, the prices of stocks fall more rapidly than long-term business values. We try to use these opportunities to “upgrade” our portfolios as well, by which we mean replace names that have held up reasonably well with those whose price declines now offer much greater long-term upside when the economy comes back.
Sir John Templeton advocated buying at the point of maximum pessimism. The problem is that point is only known in retrospect. There is much pessimism and little optimism evident now, and it is impossible to tell if stocks have declined enough to discount what the future holds with regard to the economic damage that the pandemic will inflict. In October 2008, Warren Buffett wrote an op-ed saying he was buying US stocks and urging others to do so as well. A few years later he was asked how he knew that was the time to buy. He said he did not know the time, but he did know the price at which stocks were a bargain. They were a bargain then and, in my opinion, they are a bargain now, albeit not as great a bargain as they were a few weeks ago. The market may have bottomed at an intraday low of 2191 on March 23 or it may not have. I do believe that shares bought at these prices will prove to be quite rewarding over the next few years, and perhaps a lot sooner. If you missed the other 4 great buying opportunities, the 5th one is now front and center.
Bill Miller, CFA
April 13, 2020
S&P 500 2761
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The views expressed in this report reflect those of Miller Value Partners portfolio manager(s) as of the date of the report. Any views are subject to change at any time based on market or other conditions, and Miller Value Partners disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results. Content may not be reprinted, republished or used in any manner without written consent from Miller Value Partners.
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