Notes From a Chaotic Market
March 25, 2020
Tremendous financial market volatility continues. Last week (March 16-20), we also saw historically wide spreads in credit markets and liquidity dried up even in the market for government bonds. The highly unusual fixed income environment exacerbated equity volatility since fixed income markets are the building blocks for how we think about risk and return across all asset classes.
With the Fed taking decisive action this week, we may see some stabilizing in fixed income markets—at least for a time. However, we do not underestimate the scope of uncertainty from the economic and human impact from COVID-19, and believe we should be prepared for more market volatility ahead—perhaps steeper than anything we’ve yet experienced.
Given that, all we can ask ourselves each day is: How can we make good decisions for our clients in an environment that seems chaotic? For us, that means refocusing on the core tenets of our investment philosophy to guide rational decisions.
Like all good value-oriented investors, I have a copy of Ben Graham’s The Intelligent Investor on my desk. Over the past several weeks, I’ve been revisiting parts of chapter eight, which is where Graham introduces the concept of Mr. Market—that irrational business partner who offers to sell you a portion of his business every day, and you can choose to take that offer or not.
In today’s market environment, I’ve started thinking of Mr. Market as an AI-driven robot. This robot occasionally has software bugs that lead to irrational behavior in some parts of the market, causing massive selloffs in areas that have cascading effects. But eventually, the robot’s own AI software works out the bugs—it’s what you’d expect from a complex adaptive system. Or maybe an outside programmer, like the government, will intervene to accelerate the process of fixing the software, leading to a more rational environment. Mr. Market has gone haywire before—always for differing reasons from the time before—but we have always eventually returned to more orderly functioning markets. How long that takes is impossible to know with any certainty while it’s happening. But while we’re in it, we get to transact with Mr. Market at whatever prices he’s offering.
Which is why our steadfast discipline to our philosophy and process is so critical—now more than ever. We know that earnings for most companies will be impacted this year. But what about five years from now? We are performing scenario analysis on portfolio holdings and prospective investments, asking how operationally and financially leveraged they are to understand how much an earnings disruption may shave off from longer-term intrinsic value. And asking what normalized cash flow will look like in three or five years. And asking whether the company has the resources to weather a downturn in the economy or may experience a permanent change in demand patterns—or whether it has the balance sheet and business model to get through to the other side in better competitive positioning.
What we know now is, if our estimate of a company’s long-term intrinsic value is impacted 10%, but prices are trading down 30%-40% amid a chaotic environment, we are happy to buy those durable businesses that the market will more properly value in the long run. In fact, we may have opportunities to purchase businesses we’ve long admired—in many cases, exceptional businesses—at discounts that are rarely available.