Coronavirus – a sensible investment approach

Coronavirus – a sensible investment approach

As the world struggles to get to grips with the Wuhan coronavirus epidemic, what should investors make of the daily bombardment of negative news – with the outbreak currently showing no signs of abating? The reaction of global financial markets has been mixed: after an initial negative response, markets generally bounced back for a few weeks, but then plunged sharply over the past few days as the number of cases outside China surged.

The concerns that the impact of the Covid-19 virus will result in weak world economic data for at least the first half of 2020, centred around the impact on manufacturing supply lines becoming frozen – this is very real and paints a grim picture over the short term. These concerns are obvious, and the prices of financial assets have responded aggressively to the shock, with equity markets down over 10% across all major indices.

Of course, the averages mask extreme declines in individual shares, particularly those perceived to be more sensitive to the potentially negative spill-over of the virus. As we have come to see over many market cycles, if the impact of the virus isn’t permanent in nature and normality is restored in the economic cycle, the valuation of shares should decline, but not in a ‘destructive’ fashion.

The severe decline in prices would imply one of three scenarios:

  • Panic selling
  • An initial overvaluation of specific shares – so the external shock merely brought prices back to normality
  • Long-term damage to the economic cycle.

Our view is that the decline is a function of a combination of all three these scenarios. Despite the potentially negative impact of the virus on current economic activity, we believe the sudden sell-off suggests panic selling. Since we have long been cautious regarding the prospective returns of global equities, we believe that in certain sectors, the sell-off came from elevated valuations. As long-term active investors, these extreme price movements as a result of emotional selling create opportunities for us to take advantage of on behalf of our clients.

Buy and Hold

Importantly, our investment philosophy has been to hold higher quality assets for longer periods of time, benefitting as they respond to the attractive underlying economics. And although we have not increased our allocation to equities over this time, with clarity on the true impact of the virus on the global economy, comes the potential for us to seek out attractively priced, high-quality assets that don’t reflect the true nature of facts affecting them.

Intrinsic Value

At the risk of becoming a little technical, the true value of a business (known as its ‘intrinsic value’) is the present value of all free cash flows it will produce in the future, not just the cash it will produce in the next year or two. For a business that has long-term potential to grow its cash flows, what happens in the next year or two has only a small impact on its intrinsic value.

The economic and social disruption caused by the coronavirus will likely continue for many months. It can’t be dismissed as an aberration, and it is this unknown that has investors reeling. While we can’t say how this escalating health crisis will unfold, we can say that macro events, even ones as severe and scary as this one, don’t usually have a material long-term impact on the true value of high quality companies.

– Adapted with permission from Sanlam Private Wealth