Famous Last Predictions
We’ve been having several conversations with investors/market participants over the past few weeks on how they’ve been allocating their investments. It seems to be quite a dichotomy of thinking, with some investors mostly- or fully-invested and others still holding large amounts of cash. The cash holders seem to be, as can be gleaned from conversations, terrified of another potential correction/crash. This cash holding observation is backed up by data showing that banks are having seen current accounts increase by trillions since the coronavirus[1]. Now, never ones to market-time we are almost always 90% to 100% invested, and that also reflects in our client portfolios. However, given the dichotomy, we thought we’d look through the fear and concerns that people have to see if we’re missing something. We are also going to, for fun, step out onto a ledge and make some predictions which we put in writing so you can laud us as gurus when they come true or laugh at us when they go wrong. If you have strong-counter points, please email us – we love being proven wrong. Also we’d love to take credit for all the ideas below, but as usual, we’re not that smart and these are amalgamations from our original thinking, our observations, and writings/podcasts of other investors we follow.
Fear 1: The Election
We don’t even have to say which country’s election for you to know what we’re talking about. Now, the given fears are a few. One is the unknown – we don’t know the election result so that puts people at unease. But you have to remember this is a known unknown (risk we are aware of but can’t predict the outcome of). For what it’s worth, according to Nate Silver’s FiveThirtyEight probability is that Trump will take a beating and the senate is likely to go to the Democrats.[2] Now, again, none of this is guaranteed, and thus the known unknown label. We know that known unknowns may cause corrections, but are unlikely to cause large crashes – and given the chart we sent out a few weeks ago (see again below) it doesn’t seem that US elections in general have anything but a positive impact on stock markets no matter who wins.
The other risks related to the election include President Trump not willing to accept the outcome of the election and triggering some sort of constitutional crisis. While we are not going to be the ones to try and predict what a genuinely unpredictable man will do, we do take some solace in the fact that a fear of the current US President triggering a constitutional crisis has been a fear from before he took office, and it has yet to manifest (or at least effect the market negatively in any significant way). The last fear, which we think is the biggest risk is that if the Presidency goes to one party but the senate goes to the other (listen to this podcast for more on this topic). This could delay or hamper any fiscal stimulus that’s required to keep the economy on its adrenaline, but considering how much pressure the legislature will be under to keep pumping up the economy and helping those most affected by the consequences of the virus, it’s likely that the stimulus will eventually pass. Now if the Democrats do win there could be some medium-term risks with regards to higher corporate taxes and antitrust actions against big tech, but until the economy is on stronger feet we don’t think the Democrats would do much too rock the boat. Our Prediction: The most frightening thing about this election will be the circus that was the presidential debate.
Fear 2: The Virus
We don’t even have to say which virus for you to know what we’re talking about. Now, certainly we are still somewhere in the middle of our battle with the Covid-19 (to show you how much weight you should put behind our predictions – we thought in March we’d have a vaccine by now). This has led to a subdued demand in anything but online services. Now as long as this virus continues to be at the forefront of our lives we think this demand will remain subdued. However, with the virus, most people would concede it’s a matter of time before we are over it, what we don’t know is the full extent of the economic fallout, especially with regards to corporate defaults, making this another known unknown. We do expect there to be some defaults, but with interest rates around the world at record lows, it does seem easier to refinance deals (just a few months ago a junk bond was priced below 3%[3]!!!) as August saw record high-yield issuances.
Actually, on the contrary to the doom and gloom about the virus we’ve noticed a lot of pent-up demand. We’re hearing about this around the world with smartphone sales rising rapidly ahead of the holiday season in India due to pent-up-demand,[4] August home sales at 11 month highs in Singapore,[5] packed restaurants globally, and commodity producers telling us they’re seeing a fresh wave of demand from material producers who are already prepping for 2021 demand. Anecdotally, we did a staycation in Sentosa a few weeks ago, and all the rooms in our hotel were sold out (and there was no pricing discount) and our friends in Europe and US all tell us they can’t wait to start traveling again. Our Prediction: As soon as there’s a vaccine widely available, you’re going to see a consumption boom like no other (can anyone say roaring 2020s?).
Fear 3: The Valuations
There is no doubt that valuation of the best growth companies look stretched. We’re talking 10,15,30x revenues and on occasion even 140x annual recurring revenues (ehm... Snowflake). There is no one serious who will tell you that valuations aren’t at least a bit aggressive. The fear here is that there will be a wave of multiple compression (where the market just stops paying high multiples), which is what happened to end the dot-com boom. Now there’s a lot to say about the difference between the current market environment and the dot-com boom. But there are two main differences that we see. The first, is that during the early 2000s, as Lyn Alden Schwartzer points out in this article, US interest rates were closer to 6% and equity risk premiums were at a record low in comparison, making it an easy switch for investors from overvalued stocks to high risk-free returns. Secondly, as many on FinTwit have pointed out is that high-flying companies today are much better quality than say a Pets.com. So if margin compression does happen, the growth might make up for it. Let’s take an example. Say you value a company at 10x Price/Sales, and all of a sudden the market decides to only pay 8X for it, all things being equal, a company’s valuation should drop by 20%. However, say the company is growing its revenues at 25%, then your valuation should stay stable. See the table below to see what we mean.
So essentially, the quality of the growth and the rate of that growth provides you with a buffer against margin compression. Companies which have quality business with high-growth recurring revenue provides you with a margin of safety of sorts (pretty sure Benjamin Graham is turning in his grave).
In a nutshell, we do think out of the risks mentioned, margin compression is the one that we think most about. However we don’t think it’s 2000-01. That said, a large spike in interest rates would make us think twice about paying high-multiples, however considering the Fed’s commentary on how long they are going to keep rates where they are, we don’t think this is going to happen for quite a while. If it does happen, growth rates should buoy most good businesses. Our Prediction: Margin compression is a risk, but is unlikely to happen broadly unless interest rates increase significantly, which is many years away.
So there you have it, our predictions – or we should say famous last predictions. As usual though, we always have some portion of our clients’ portfolios positioned as a buffer in case we are wrong, as anyone should to protect against their cognitive bias. We hope this post has been helpful to think through the risks ahead of you. Happy investing!
[1] https://www.cnbc.com/2020/06/21/banks-have-grown-by-2-trillion-in-deposits-since-coronavirus-first-hit.html
[2] https://projects.fivethirtyeight.com/2020-election-forecast/senate/
[3] https://wolfstreet.com/2020/09/11/junk-bond-frenzy-sets-records-as-everyone-tries-to-front-run-the-fed/
[4] https://telecom.economictimes.indiatimes.com/news/pent-up-demand-sparks-smartphone-sales-growth-in-india/78545648
[5] https://www.businesstimes.com.sg/real-estate/august-new-home-sales-surge-to-11-month-high-on-pent-up-demand