by futurist Richard Worzel, C.F.A.
What are stocks worth in the face of the emerging Covid-19 pandemic?
Nothing. Zero. Nada. Bupkis, Rien.
But how can that be? Just a month ago, stock markets were worth many trillions of dollars. All that value can’t just vanish. Can it?
My answer comes from the fundamental principle of the stock market: a stock is a fractional share of a business, and therefore shares in the value of the company.
What are companies worth today?
Companies are worth what they can produce and sell. But more than that, companies can only produce and sell things as part of a global, interdependent chain. For instance, looking at one, small strand of this chain, farmers produce and sell food. Shippers take that food to processors. Processors, like millers, butchers, and refiners, transform it into food that gets put on tables for people to eat. Restaurants serve that food to people who want the luxury of having someone else prepare, cook, and serve their food rather than doing it themselves.
But if people don’t or can’t leave their homes to go to restaurants, the restaurants go bankrupt and stop buying foods (as well as table linen, cutlery, glasses, stoves, alcohol, and many other things). That means processors stop processing food, and go bankrupt. Then, as processors stop buying the food that shippers transport, shippers stop buying the food to transport as the shippers go bankrupt.
And if farmers can’t sell their food to shippers – well, they can eat the food themselves, but their standard of living plummets to levels not seen since for centuries.
In that environment, farmers don’t have the money to buy clothes – they have to make them themselves. They can’t buy tractors, or seed, or fertilizer. They also can’t pay interest on bank loans, so banks foreclose on those loans, and the farm gets taken away.
But now the banks have a problem, because there’s no one to buy the all foreclosed farms, and the bank winds up with a shipload of bad loans, so the bank starts to teeter on the brink of bankruptcy.
And if a bank starts to look shaky, people suddenly realize their life savings are there, and rush to the bank to demand their money, starting a run on the bank. And since banks only ever have a small fraction of the deposits on their books available in cash, they can’t pay out all of their depositors at the same time, so the bank closes. And once one bank closes, people with deposits at other banks get scared, and rush to withdraw their money from their banks, so those banks close. That starts a domino effect, with one bankruptcy knocking down the next.
This is a drastic oversimplification of an enormously complex mechanism, but it’s intended as an illustration. The Covid-19 virus is threatening the entire structure of our economy, and everything associated with it, including stocks, because people cannot gather, cannot go out in public, and their demand for goods and services dries up.
And that leads back to stock valuations being zero.
“Stay Home!”
In the present environment, we are facing an enormous degree of uncertainty about what will happen to the economy. We don’t know how long it will be before life can “return to normal”, or even if it ever will. We don’t know how many people will be infected, and how many people will die. And we are not entirely sure how to keep from being infected, although we have better, and steadily improving, ideas about that.
Right now, at least in countries like Italy and America (and I lump those two countries together on purpose), governments are saying: Stay home. Don’t go out. Don’t go to restaurants. Don’t go shopping for clothes or cars or toys or anything except the bare necessities of life. And that will tip the first dominos over.
Some companies will initially do well in this situation. Amazon comes to mind because of its online ordering & home delivery, as well as supermarkets, and telecommunications companies who supply Internet service. But how long will they thrive if their customers can’t go to work, can’t earn money, can’t pay their rent or mortgages, and therefore eventually can’t buy anything?
Clearly, some people have money saved, and those people will be okay – for a while. But today’s society is vastly interconnected, and ultimately you can’t eat money.
How Do You Value a Stock?
So now, what’s a stock worth? A share of stock represents a fraction of the ownership of the underlying company. If you own that share, it delivers value in two ways: through the dividends paid while you own it, and through the price that someone else will pay to buy it from you.
Modern stock valuation theory was laid out by pioneers like Benjamin Graham and David Dodd in their seminal book, Security Analysis, written in 1934. This approach says the proper way to value a stock is to look at the future stream of dividends, and discount them to a present value[1]– that is, a lump sum that you would be willing to pay today to receive that stream of future dividends.
This ignores the amount some future buyer might pay for your stock share. It assumes they would pay a lump sum they thought fair in order to receive the remaining stream of dividends[2]at the time they bought it. It is, in other words, a continuation of value due to the future stream of dividends.
So, what is the outlook for the future dividend streams of the companies listed on the various global stock markets?
We don’t know. We don’t know if they will earn any profits, and therefore we don’t know if they will be able to pay any dividends.
Now, the difference between an investor and a speculator is that an investor values stocks on the basis of what is known, what is reasonably projected, and what can be analyzed. A speculator bets based on guesses about what mighthappen, and typically assumes that an investor is wrong in their analysis of a stock’s value.
So, right now, in the simplified world that I described above, an investor says, “This is not a reasonable world. There is no reasonable basis for valuing future dividend streams. Therefore, I’m unwilling to pay anything for stocks. Their value is zero until I have information that I can use to come to reasonable estimates.”
In other words, stocks have no value.
But don’t take my word for it.
I have a friend who was one of the canniest pension fund investors that I know. (He’s retired, and only manages his own investments now.) He anticipated (and his clients profited from) the tech crash of 2001. He anticipated and profited from the housing collapse and stock market crash of 2008. He wasn’t always right about every stock he bought or sold, but the overall results were consistently above the market averages. He is a classic example of a competent, knowledgeable investor in the traditional sense of the word.
I recently exchanged emails with him about the current situation, commenting that I thought there might be some attractive bargains in the market, and that I was tempted to start nibbling at some of them. And here (lightly edited to remove personal information) is what he said:
Before the coronavirus hit, my model indicated that the US stock market was 35% overvalued. Now that it is down 35%, you might think that I would jump in. Not yet. My model assumed “everything being equal”, but things are no longer equal. Also, markets tend to go from extreme overvaluation to extreme undervaluation.
Earnings are going to collapse. For how long?
As I think I mentioned at our last lunch, the greatest risk to the economy was not personal debt, which is a worry, nor banks, because they were the last battle, but rather corporate balance sheets. Since the Great Recession, US corporations have loaded up their balance sheets with debt. Most of this debt was used to buy back stock, not to build their companies. It was a Ponzi Scheme to pump up the price of stocks to enrich the large shareholders and more specifically, the option holders. Even the huge tax cuts given to corporations by Trump went into stock buy-backs. The largest demand for stocks over this time was corporate stock buy-backs.
Even though interest rates on this debt is relatively low, interest still has to be paid and maturities have to be made. Any prolonged drop in corporate cash flows will see a lot of big and small companies forced into chapter 11. Forget the R word, this is a recipe for depression.
Trump has been bankrupt 6 times, now he is bankrupting the US. $1 trillion deficit in 2019, $1 trillion deficit in 2020, and now add on an additional $2 trillion to fight the coronavirus slowdown and then add in the lost tax revenues from the slowdown…well it gets ugly pretty fast.
The EU is in worse shape. No one really knows about China, as they lie.
So no, I have not yet started buying.
My assessment as an investor, then, matches his: There is no rational basis for assigning stocks any value at all.
But That’s Absurd
Yes, it is. There are rational ways of evaluating the future of the economy, business, and the virus based on similar events in the past. Let’s use one of the worst examples of an earlier infection as a case study: The Black Death pandemic, which swept through Europe from 1347 to 1351.
The Black Death was a bubonic plague caused by bacteria and transmitted either by aerosol (droplets thrown into the air by sneezing or coughing) or the bites of rats or fleas that carried the bacterium. There were no reliable censuses then, but estimates of the death caused by the Black Death run from 30% to 60% of European population. It was a horrible catastrophe.
But European economies recovered, the population grew back, and eventually lead to the prosperous Europe of today. There is life after disaster.
More than that, the Black Death broke the hold of the feudal economic system, in which the vast majority of people were serfs, and effectively owned (or at least controlled) by an aristocracy, and that paved the way for the emergence of a middle class of independent farmers, merchants, and businessmen, and therefore, modern society and economies.
But putting aside the human cost in lives, the economic cost was enormous. When you lose 30-60% of the population, your economy collapses, and the survivors are left to pick up the pieces.
It Won’t Be That Bad
This is not the Black Death, and we know much more about what causes – and cures – diseases now than we did in the 14thCentury. But right now, we don’t know how bad it will be, and hence what it will do to our economies.
Therefore, there is no rational basis for an investor to value stocks.
If you want to speculate that stocks will be worth something, you are probably right. And if you pick the right stocks, the stocks of companies that will survive this catastrophe and eventually prosper, you have the potential to make enormous amounts of money. But you will be guessing – speculating – rather than investing.
How to Speculate Successfully
If I knew which companies are going to do well, I wouldn’t tell anyone until I’d bought all I could afford of such companies myself. Why drive up the price before I buy? (And no, that isn’t insider trading. First, I have no inside knowledge beyond my own analysis. And second, I don’t advise people on investments for a living anymore, although I did at one stage of my career.)
But let’s think through what are the characteristics of a company that is likely to survive this period, and thrive later on.
The companies you would want to speculate on would be financially stable, and able to absorb a big financial hit without going bankrupt. Hence, look for companies with strong balance sheets, and relatively little debt.
The companies you want would be in industries that will thrive if, as, and when life returns to something like normal. They would sell basics, like food, shelter, or clothing, or luxuries that people will choose as soon as they have some discretionary income, like entertainment. Movies did very well in the Great Depression of the 1930s, for instance, in part because they offered a distraction for the harsh realities of life at that time.
But most importantly, the companies you want have something that is very difficult to define: competent, imaginative, far-sighted leadership. Executives that inspire and enable their people rather than bully them. Those that can study the future, and come up with a plan to, in the words of Wayne Gretzky, “skate to where the puck is going to be”, and profit from that foresight. Good companies pick up market share in bad times, leading to bigger profits during recovery.
Finding such companies is a fine art that successful investors must develop and work at.
So, What Should You Do Now?
I’ve been through, and watched, around eight to ten economic and stock market cycles, including at least four end-of-the-world scenarios. I started watching the economy and the stock market when I was a student in high school, interested even then in stocks and apparently having a talent for economics[3]. And as I said in an earlier blog, the end-of-the-world happens regularly in the stock market, yet there is always tomorrow.
So although I can say that I’ve seen this movie before, it had different plot twists, and may have a different ending. But I can tell you that there is one rule that rises above all others at this stage in an economy, and a stock market cycle: The Golden Rule. The Golden Rule (in the stock market and the economy) is very simple: He (or she) who has the gold, makes the rules.
What you want to hold right now is cash. Period.
Cash can be in several different forms, but essentially you want assets that are absolutely secure, liquid, and immediately available.
And, unfortunately, the traditional “gold standard” of safe investments, being U.S. government bonds and treasury bills, might not be as safe this time around. But I’ll cover that in another blog, later this week.
© Copyright, IF Research, March 2020
Blogs in this Series:
Part 1: What Are Stocks Worth?
Part 2: What Will Happen to Businesses?
Part 3: Bankruptcies, Panics, and Opportunities: The Virus & the Economy
Part 4: What Will Happen to Governments?
Part 5: Reset or Reboot? The Virus & Society
[1] As a simple illustration, how much would you be willing to pay today to receive $105 one year from now? If you could put your money in the bank and receive 5% interest per year, then $100 today would produce $105 in one year’s time. Hence, the present value of $105 one year from now would be $100 today.
[2] This opens up another can of worms with questions like: What is the value of a company, like Amazon, that doesn’t pay a dividend? The Graham answer is: the present value of the future dividends you expect they will pay. If they don’t pay any dividends, then there is norational way to value the shares of such companies. But that’s an entirely different subject.
[3] I got a grade of 100% on my high school economics course, and my teacher apologized, saying he wasn’t allowed to give me a higher mark.
