Permanent Change Vs. Long-Term Fundamentals

As the COVID-19 virus continues spreading globally and within the US, uncertainty about the economic impact is roiling markets. Add to that Saudi Arabia’s opening salvo in an oil price war with Russia that sent crude prices to $32, and we are getting market volatility not seen since the post-Lehman failure days in 2008.

Given the steep volatility (which we’ve experienced periodically in our careers) predicated on fears of a true pandemic (a much rarer occurrence), how are we thinking about portfolios? It is difficult to know how the coronavirus plays out in the months to come. Therefore, as we always do, we are thinking about how fundamentals for portfolio companies will look five years from now, and whether that changes our estimates of intrinsic value.

This isn’t a Pollyanna-ish approach that ignores near-term events. We recognize that a lot can happen over the next five years that can impact cash flows. What we are asking is, what about this pandemic can permanently change an industry or a company’s long-term fundamentals?

Energy is an industry that has had some fundamental challenges heading into recent volatility. Energy demand fell thanks to COVID-19, but the threat of a production glut as Russia and Saudi Arabia attempt to undercut each other led to another massive selloff.

Cruise lines are an area that may look very different in five years (an area where we have no exposure in our Large Cap strategy). Also, as we grapple with supply disruptions, manufacturers are likely to reassess whether they need more redundancy in the supply chain. China has become a major player in intermediate goods, driving down costs for finished goods and benefiting both manufacturers and consumers, but the coronavirus may have exposed a flaw in that strategy. Questions we are asking: Are manufacturers overly reliant on China and will they seek more redundancy in the supply chain? If so, can potentially higher costs get passed along, or will that impact margins in some permanent way for certain companies?

Ultimately, we think it likely that earnings across a range of companies will be impacted in 2020. But most of our estimates of intrinsic value are based on what our portfolio companies will be worth in 2025. And for the vast majority of them, we see little changed from that five-year estimate—apart from the stock price. What’s more, our discipline has taught us to take prudent advantage of indiscriminate sell-offs to upgrade the portfolio. We are finding we don’t have to go very far out the quality curve to get stocks at attractive valuations without having to make a bet on coronavirus duration.