U.S. Equities: February 24th to February 28th, 2020

Nowhere does history indulge in repetitions so often or so uniformly as in Wall Street. When you read contemporary

accounts of booms or panics, the one thing that strikes you most forcibly is how little either stock speculation or stock

speculators today differ from yesterday. The game does not change and neither does human nature.

Edwin Lefevre, Reminiscences of a Stock Operator, 1923

What a week. Not so long ago there didn’t seem to

be overly compelling reasons for why prices

shouldn’t rise. Yes, there wasn’t an irrational greed

or exuberance evident in markets, but overheated

tech stocks and options activity suggested that

investors were more far more optimistic than

pessimistic. But no longer do people seem worried

about missing opportunities, they seem worried

about losing permanent capital. Whilst it is fair to

say that investors didn’t see their glass completely

full when we were at all-time highs, it feels like

they see it completely empty now. The S&P 500

lost 4.42% on Thursday, the biggest fall in over

eight years. Since the high on February 19th the

S&P 500 lost over 12% in six trading sessions- which makes it the fastest correction in history.

It has been said that, when things are going well, investors timelines move out to infinity- both on a position and a

portfolio basis. A company’s valuation is justified by growth rates that extend to the distant future, and the level of

risk in a portfolio is justified by a timeline that can ride out any short-term volatility. Unfortunately, as Charlie

Munger advises, ‘Invert, always invert’, and so, when things go badly quickly, everyone’s time horizons change to the

next 24 hours. This has obvious effects on perceived

valuations and selling. When time horizons invert so

quickly, investors telescope their minds to focus on the

shortest time-period possible (that is dominated by noise)

and where bad emotional decisions have the highest

probability of occurring.

Aravis Research

US Equity Market Weekly Note 24th – 28th February

Sam Wood, CFA

In this note we cover:

A summary of U.S. equity markets last week.

An overview of how fundamentals could be impacted and what that means for valuation.

Buffett’s annual letter and lessons it can give investors with long time horizons.

Index Week % Change

S&P 500 -11.49%

Russell 2500 Growth -10.65%

Russell Mid Cap Growth -10.46%

Market Prices: Week 24th - 28th Feb

Some of the most severe days since the Financial

crisis also demonstrated a big divide among the

stocks feeling the most pain. Investors dumped

risky stocks at a crazy pace and ran towards

anything that looked remotely safe. This activity

has put some of the drivers of the S&P 500’s past

returns under the spotlight. In theory, the way to

increase return is to bear more risk (the reason

why the capital market line slopes upward and

to the right- investors have to be offered higher

expected returns to make riskier investments).

Essentially, financial theory assumes investors are always risk averse. But investors attitudes towards risk in real life

isn’t a constant- in the recent past investors have embraced risk to increase returns. Dependable returns from risky

investments are an oxymoron. A lot of securities therefore carried a risk premium that was inadequate

compensation for the risk actually present. Last week’s price action, albeit extreme, reminded investors that more

risk doesn’t always equal more return and can mean losing money.

There is one small piece of good news- for net savers this

rout is a good thing. Unless you have to sell, lower prices

are better. For anyone with a time horizon longer than

right now, the sell-off can be an opportunity. The table on

the right shows the benefit of longer time-horizons and is a

good reminder of how extreme movements in price get

averaged out over time. It demonstrates the ‘happy

medium’ rather than the daily reality- which is often more

driven by emotion, urgency and sentiment. There are

plenty of cliché’s to fall back on in response to the type of drawdowns we saw last week, including Buffet’s advice to

be ‘fearful when others are greedy and greedy when others are fearful’, but my favourite remains, “the stock market

is the only place where things go on sale and people run for the exits.”

Fundamentals or Fear?

One of the foremost authorities

on equity valuation, Aswath

Damodaran, released a blog post

last week attempting to provide a

fair value for the S&P 500 index

based on adjusting some key

inputs in response to the

Coronavirus. Whilst in theory the

market’s price movements are

tied to the market’s discounting of

corporate, economic and

geopolitical events, it is clear that

markets also often move on many things other than fundamental information. Outside of that noise, Damodaran

looked at the S&P’s cashflows, growth, and perceived risk to attempt to provide a rough valuation of where the

index should be when incorporating more negative fundamental information than what was priced in before the

virus hit. Whilst Goldman Sachs has revised its forecast for earnings growth from 7% to 0% in 20201, Damodaran is

more aggressive and has forecasted for corporate earnings to shrink 5%2. A 5% decline in earnings growth in 2020, a

1 https://edition.cnn.com/2020/02/27/investing/earnings-coronavirus/index.html 2 http://aswathdamodaran.blogspot.com/2020/02/a-viral-market-meltdown-fear-or.html

Time Frame Positive Negative

Daily 56.0% 44.0%

1 Year 75.4% 24.6%

5 Years 87.8% 12.2%

10 Years 94.7% 5.3%

20 Years 100.0% 0.0%

S&P 500: 1926 - 2020

Inputs

Pre Corona Virus

(01/02/2020)

Post Corona Virus

(27/02/20)

Expected growth in earnings next year 5.52% -5.00%

Expected earnings growth rate in yrs 2-5 3.36% 4.80%

Current long-term risk free rate 1.51% 1.19%

Expected long-term growth rate (after year 5) 1.51% 1.19%

Base yr. earnings for index $163.00 $163.00

Expected earnings in 2025 $199.28 $189.01

Equity risk premium 5.13% 5.50%

Intrinsic present value of index $3,225.29 $2,920.31

Current level of index $3,225.52 $2,978.76

Index % under or over valued 0.01% 1.96%

Aswath Damodaran S&P 500 Valuation Calculator

Correction Period # Days S&P High S&P Low % Decline

2020: Feb 19 - Feb 28 7 3394 2954 -12.96%

2019: Jul 26 - Aug 5 10 3028 2822 -6.80%

2019: May 1 - Jun 3 33 2954 2729 -7.62%

2018: Sep 21 - Dec 26 96 2941 2347 -20.20%

2018: Jan 26 - Feb 9 14 2873 2533 -11.83%

2016: Aug 15 - Nov 4 81 2194 2084 -5.01%

2016: Jun 8 - Jun 27 19 2121 1992 -6.08%

2015/6: Nov 3 - Feb 11 100 2116 1810 -14.46%

2015: May 20 - Aug 24 96 2135 1867 -12.55%

S&P 500 Corrections >5% since 2015 (to 28/2/2020)

jump in the equity risk premium, and a decline in the risk-free rate/long-term growth rate spits out a price of

$2,920.31- still 1.96% lower than the closing price of the S&P 500 of $2,9778.76 on 27th of February. Entering

Goldman Sachs 0% earnings growth (and keeping expected earnings growth in years 2-5 at 4.8%) the model provides

a price of $3,074.01- over 3% above where we are today (27th Feb). Clearly, this is an exercise which has many

moving parts, but it can help to understand the market’s expectations for earnings growth and how badly it is

expected to be impacted by Coronavirus. Understanding the market’s expectations in terms of valuation can at least

help inform our own opinion of whether fear or fundamentals are being priced in.

Buffett’s Annual Letter

Warren Buffett’s annual letter to shareholders regarding the performance of Berkshire Hathaway included some

coincidental, but convenient, sound bites in response to the market volatility last week. As a reminder from our note

on Buffett’s alpha a couple of weeks ago, Berkshire Hathaway has outperformed the S&P 500 by 10.3% per annum

since 1965 and has the highest Sharpe ratio (risk-adjusted returns) of any U.S. stock in that same time period3. As a

holding company for many different businesses, and equity stakes in far more, BRK represents the management

approach and investment criteria of the best investor in recent decades. That investment criteria is remarkably

simple, “…we constantly seek to buy new businesses that meet three criteria. First, they must earn good returns on

the net tangible capital required in their operation. Second, they must be run by able and honest managers. Finally,

they must be available at a sensible price.”4 This combination is very similar to Joel Greenblatt’s ‘Magic Formula’- a

simple rules-based ranking of stocks based on their earnings yield (a measure of value) and their ROIC (return on

invested capital) which has gained some traction as a market-beating strategy over the long run. But the important

point is that the capital invested in companies that meet his criteria, on aggregate, will earn rates of return on their

retained earnings that exceed the opportunity cost of investing that capital elsewhere. As Buffett puts it, “It is

certain that Berkshire’s rewards from our many equity holdings will manifest themselves in a highly irregular

manner. Periodically, there will be losses, sometimes company-specific, sometimes linked to stock-market swoons.

At other times…our gain will be outsized. Overall, the retained earnings of our investees are certain to be of major

importance in the growth of Berkshire’s value.”5

Buffett’s letters are always a good read when short term uncertainty hits. It can be very tempting to focus on day-to-

day price movements and extrapolate sensationalist headlines as reasons to believe this is ‘the big one’. Buffett

reminds us, “Anything can happen to stock prices tomorrow. Occasionally, there will be major drops in the market,

perhaps of 50% magnitude or even greater.”6 However, because Buffett is focused on the ability of his equity

investments to earn returns on their retained earnings over the long-run- rather than price movements- he reminds

us of the benefits of thinking of equities as ownership in a business, rather than speculation on price appreciation.

On a weighted basis, BRK’s equity holdings earn 20% on their invested capital, a return which Buffett compares to

the 2.5% or less currently offered on 30-year U.S Treasury bonds. For these reasons he reassures his readers that

equities are “the much better long-term choice for the individual who does not use borrowed money and who can

control his or her emotions.”7

Controlling ones emotions seems like sage advice during weeks like last week. As we discussed above, after hitting

all-time highs on the 19th February, the market’s emotions certainly seem to have done a very quick 180. As Howard

Marks puts it, “The mood

swings of the securities

markets resemble the

movement of a pendulum.

Although the midpoint of its

arc best describes the location

3 Andrea Frazzini, David Kabiller, CFA & Lasse Heje Pedersen, Buffett’s Alpha, Financial Analysts Journal Volume 74, 2018, p.39 4 Warren Buffett, Berkshire Hathaway Annual Investor Letter 2019, p.4 5 Ibid., p.5 6 Ibid., p.11 7 Ibid.

$10k investment in the S&P 500: Jan 4,

1999 to Dec 31, 2018 Dollar value Annualized performance

Fully invested $29,845 5.62%

Missed 10 best days $14,895 2.01%

Missed 20 best days $9,359 -0.33%

Missed 30 best days $6,213 -4.20%

**Source: JP Morgan**

of the pendulum ‘on average’ it actually spends little of its time there. Instead, it is almost swinging toward or away

from the extremes of its arc. But whenever the pendulum is near either extreme, it is inevitable that it will move

back toward the midpoint sooner or later.”8 Timing markets is near impossible, and despite the temptation of

jumping in and out based on which way the pendulum is swinging, Peter Lynch’s adage of ‘time in the market is

more important than timing the market’ is sensible advice. The importance of staying invested, and therefore

capturing 100% of the forthcoming good days, makes a significant impact on performance over the long run.

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8 Howard Marks, Memo to Oaktree Clients: The Happy Medium, July 2004 p. 1