Nobody knows – Tony Rich

The song title for this note is inspired by Howard Marks’ latest memo to his clients, entitled ‘Nobody Knows II’.

For those who don’t know Mr. Marks, he is the co-founder of Oaktree Capital Management and is widely recognised as one of the world’s most successful investors. Indeed, Warren Buffett once remarked that ‘when I see memos from Howard Marks in my mail, they’re the first thing I open and read. I always learn something…’

So, what can we learn from Marks’ latest update? As you might expect, Marks does address the coronavirus and draws many of the same conclusions we do. Whilst noting the WHO’s upgrading of the risk to ‘very high’, he also notes that the rate of new cases in China has declined substantially. Indeed, we also know that the number of active cases in China (i.e. those that became infected minus those that have recovered or resulted in death) have fallen quite sharply since the peak in mid-February.

However, whilst this is encouraging, the number of new cases is clearly expanding outside of China and, as testing becomes more prevalent, numbers are likely to grow and by some estimates a significant percentage of the world will be affected by the virus. From an economic perspective, Marks notes that the initial concern, over supply chain challenges and Chinese economic contraction, has expanded to concerns about demand and recession in the West.

We are already seeing clear evidence of consumers postponing consumption and this reflexive, self-fulfilling behaviour is likely to result in significant economic contraction. Of course, as Marks notes, we are dealing with a high degree of uncertainty and, unfortunately, there is ‘no such thing as a reliable statement regarding the implications
of the virus’.

It is perhaps Marks’ comments on investor reaction that are most instructive. He notes that in the “real world, things generally fluctuate between ‘pretty good’ and ‘not so hot’. But in the world of investing, perception often swings from ‘flawless’ to ‘hopeless’.” This is a valuable insight, investor emotions tends to swing to extremes. For example, valuations are often described as cheap or expensive, rarely described as reasonable.

Right now, the commentary seems to be skewing towards dire outcomes and this is particularly reflected in the move in ‘safe-haven’ assets. In his note, Marks notes that ‘how can it be anything but a manifestation of extreme fear to make an investment that guarantees a return of 1.1% a year for the next ten years? And consider that question in the light of a 2.0% dividend yield on the S&P 500, or perhaps its earnings yield of almost 6.0%’.

The 1.1% Marks is referring to was the yield on the US 10 year Treasury bond, at the time of writing this is now 0.45%! I should note that Marks is not making a comment that equities are especially cheap and in the note he remarks that they are ‘fairly valued’ and that stocks could well continue to go down.

However, let’s just stand back and think about the difference between the earnings yield and bond yield. Marks notes the c.6.0% earnings yield based on forecasts, if we assume no earnings growth this year that number falls to c.5.0% for the S&P 500 and c.5.5% for the world equity market. Whilst we need to make assumptions about the path of earnings, the earnings yield is a reasonable estimate of potential after inflation returns. So we might get 5.0-6.0% average annual real returns from equities from today, over the long run. Whereas, if we invest in government bonds or cash in most countries, we are looking at negative after inflation returns out to 30 years!

This is amazing really. Even if we just look at the dividend yield, ignoring the retained earnings that allow companies to re-invest and grow, we see the dividend yield on the world equity market is 2.4%. The dividend yield (which will grow) is materially higher than government bond yields in the developed world, with German yields negative (before inflation!) out to 30 years. As Marks notes this has to be a ‘manifestation of extreme fear’. How else does it make sense?

Perhaps earnings will fall this year and dividends will be cut but it is highly unlikely that the virus outbreak will permanently impair future growth and mathematically the impact of a decline in one year’s earnings/cash flow actually has very little impact on the value of assets.

Think about it this way. If you had a rental property giving you a yield of 5.0-6.0% and your tenants didn’t pay you for a few months or even a year, how would this impact the value of the property? It wouldn’t really, because you still have an asset that will produce cash flow for a very long time and losing one year’s cash flow, whilst unpleasant, really doesn’t impact the value of the asset.

This same logic holds true for the equity market, so we should expect cash producing assets to eventually recover from recent weakness. As Marks notes, this is not to say markets won’t or can’t fall further. They may very well do and we expect heightened volatility for some time. As we said in our last note, it is also important to emphasise the awful human impact of this tragedy. It is deeply troubling. However, we are tasked with managing our clients’ irreplaceable capital and we have to look at events through this lens.

In doing so, we have to focus on what we can know and recognise that nobody truly knows how the situation will evolve. We absolutely know that the global economy will suffer a serious setback this year and this will materially impact corporate profits.

However, we also know that significant fear and concern is being priced into certain assets and, provided future economic growth is not materially impaired, long term investors in equity assets should significantly outperform those invested in cash and bonds. In no way do we wish to down play the severity of the outbreak and we recognise how unsettling volatility can be. Nevertheless, we would like to stress that we believe investors will be compensated for having to withstand this volatility and now is a very important time to remember that our investment time horizon should be measured in years, not days, weeks or months.

As ever, please do not hesitate to contact us with any questions.

Ian Quigley
T: +353 1 2600080
E: ian.quigley@brewin.ie

www.brewin.ie

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Past performance is not reliable guide to future.
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Our investment may be affected by changes in currency.
Any income you get from this investment my go down as well as up.