As the effects of COVID-19 continue to rip through societies and economies, Trevor Green explains why adding uncertainty on top of uncertainty is never a good investment strategy. He outlines three critical, but simple, rules for navigating the current equity market.
4 minute read
Investors often confuse risk and uncertainty. These words, contrary to popular belief, are not synonyms. The subtle, but significant, difference between their meanings, pointed out by economists John Maynard Keynes and Frank Knight as early as the 1920s, reveals the gap between what is knowable and what isn’t; what can be foreseen and what can’t. Or, as Donald Rumsfeld put it, known unknowns and unknown unknowns.
COVID-19 has increased both risk and uncertainty, which presents a thorny challenge for investors
The importance of this distinction comes down to control. You can control – or at least account for – risks; you cannot control uncertainty. COVID-19 has increased both risk and uncertainty, which presents a thorny challenge for investors. But interrogating the two in more detail, and being able to distinguish between them, should guide us toward sensible and grounded decisions. It is at times like these that we must focus on what is controllable and knowable, avoiding full-blown uncertainty at all costs.
Let’s start with the big picture. Most economic models, linear in nature, are not well equipped to ascertain the full extent of COVID-19. Most variables they try to capture not only address specific factors in siloed isolation, they also rely on the modelling of our human response to the global pandemic. That is driven by fear and wholly unpredictable.
Economics provides one useful concept for framing the situation we find ourselves in, namely the ‘wealth effect’
However, economics provides one useful concept for framing the situation we find ourselves in, namely the ‘wealth effect’. This idea – that people spend more as the value of their assets rise – offers us a way of moving from the fiercely uncertain into the realm of the more predictable. It is, for example, inevitable that the global economy will enter a recession. Unemployment will rise, and a negative wealth climate will likely follow. The stock market could remain volatile for a prolonged period relative to recent history as investors struggle to come to terms with the economic downtown. These are things we know; their respective lengths and durations are less clear and will depend on the scientific and political response.
As an equity investor, I don’t lay any claim to be able to predict the scale of the recession or the potential speed of recovery. Instead, I continually look to expand my bucket of knowable risks and opportunities. To not approach investing in this way would be akin to adding uncertainty on top of an already uncertain situation. In order to help guide my thinking, I have broken the current investment challenge down into three simple rules:
- Think long term: Identify structural versus temporary changes.
- Use volatility to invest in strong companies at attractive prices.
- Treat COVID-19 as a litmus test for companies.
Think long term
One way of removing an element of uncertainty is to focus investment decisions on the long term as the immediate term has become nigh on impossible to gauge. As the wealth effect, which has been a steady and reliable ballast to markets over the last decade, goes into reverse, strong discounter brands that sell low ticket items should benefit. Faced with unemployment, the threat of it, or loss of earnings, many individuals will look to eke out savings wherever they can. Price comparators, with recognisable brands, could also do well in this environment as consumers become more price conscious and use their time at home to scour for savings on utilities and car insurance (among other things).
Irrespective of the state of the economy, pest control and hygiene products will always be in demand
On the other hand, and irrespective of the state of the economy, pest control and hygiene products will always be in demand. Even as COVID-19 subsides, this will not change. Other long-term impacts to consider are structural changes to the travel industry. Travel operators will have to be alive to changing consumer attitudes toward being in crowded spaces for long periods of time.
Similarly, the commercial office sector will likely see a reduction in demand globally as companies recognise the efficiency and cost savings of their employees working from home. We have spoken to several UK companies who are already reviewing the amount of office space they need. It seems the momentum for businesses and consumers to do more online will only gather pace, whether shifting to the cloud, general shopping habits or personnel-based learning and development.
Use volatility to your advantage
Equity markets are generally efficient, but in times of extreme stress the reverse is true. Though it has become an investment cliché to say so, volatility creates opportunity. As an investor you are always looking for attractive entry points into preferred companies. Events like COVID-19 crate such conditions. Many quality UK and global franchise businesses, that have long been on our radar but were too expensive before this crisis, have come into range. These are companies that have strong brands, are experiencing structural growth and whose price-to-earnings multiples now look favourable.
A strong franchise business pre-COVID should remain one afterwards
Famed investor Robert Arnold once said: “In investing, what is comfortable is rarely profitable.” The prescience of this should not be lost on anyone. Increasing exposure to retail will feel uncomfortable right now. However, a strong franchise business pre-COVID should remain one afterwards. Waiting until they are back up and running and open for trading is the comfortable thing to do, yet its share price (having risen) will also reflect that level of comfort.
COVID-19 as a litmus test
They say it is only when you apply pressure to something that you really find out what it is made of. How companies respond in a crisis tells us far more than any report and account ever will.
Over the last decade or so, some aspects of the investment profession have been arbitraged away by algorithms. Corporate releases on profits and earnings are ingested into computerised models, spitting out quantitative analysis of the health of a company. This can all be done in a matter of seconds. The informational value of this data is limited, however, without qualitative analysis; not just of specific companies, but of structural industry trends and fundamental shifts in business models.
COVID-19 offers us a glimpse inside companies that in normal circumstances would be unimaginable
Meeting company management can provide active managers with a critical edge, but we must also look for other ways to find out more about the inner workings and health of the companies we invest in (or are watching closely). COVID-19 presents one of those rare opportunities. It offers us a glimpse inside companies that in normal circumstances would be unimaginable. How prepared for a crisis were they? How adaptable are they? Did they move quickly to ensure the safety of their staff, their suppliers and their customers? What does their response say about their culture? Have they been investing in areas not immediately obvious through their financial reports?
The answers to all these questions reveal a lot of worthwhile information – particularly in relation to ESG factors. Strong brands can increase their reputation and market standing for the way they handle a crisis and there are numerous examples of companies doing positive things to support the NHS and other key workers in this time of need.
Good companies will still be good businesses on the other side
Warren Buffet is famed for many quotes. Perhaps the most apt in the current situation is: “The best thing that happens to us is when a great company gets into temporary trouble.” Amid all the uncertainty, one thing we can still be certain of is that good companies, with good values and cultures, strong management and balance sheets, will still be good businesses on the other side.