How We’re Thinking About Coronavirus

25 February 2020 | by Sean Stannard-Stockton, CFA

When various world news breaks that seems scary for the market, the main way we process this information is the degree to which we think it allows us to accurately change our forecasts about the future. Something that is only a modest driver of market returns, but very certain how it will impact things will be quickly incorporated into our forecasts and thus our portfolio will change to reflect the news. But many big events have extremely uncertain impacts on the market and thus while they may matter a lot, they may not be actionable from the standpoint of making investment decisions.

In order to generate investment performance that is better than the market, we must be able to make better forecasts than other investors. When we buy or hold a stock, it is because we believe that the set of forecasts about the company’s future cash flows that other investors are using in valuing the company are too pessimistic. That’s what it means for a stock to be “cheap”. If we’re right and the cash generated by the company is closer to our forecasts than the market’s forecasts, the stock will rise faster than the market over time.

So in making decisions about how to incorporate any new bit of information we come across into our portfolio management decisions, it always boils down to the question “how does this information change our long term forecasts of company cash earnings?”

For the last month or so, the market has seemingly been “ignoring” the risk of Coronavirus. And then over the last two days, global markets have fallen sharply. We believe the explanation for this is that the market was never ignoring Coronavirus in the first place. But investors had limited confidence that the virus would materially reduce economic growth or corporate profits outside of China. With the outbreak of the virus over the weekend in Italy and the Center for Disease Control warning Americans today to prepare for the virus to spread in the US, investors have suddenly re-calibrated their expectations and now appear to be assuming that the economic impact of the virus will be at least somewhat severe and/or prolonged.

But while it is perfectly reasonable to be concerned about the long-term economic impact of the virus, it is also perfectly reasonable to recognize that the virus may have little to no economic impact beyond 2020. Right at this moment in time, after such a sharp drop in the stock market, it is hard to believe that this might all fade in economic importance over time. But it is notable that in fact this is exactly what has happened with almost all past global virus outbreaks.

Here’s David Quammen, the author of “Spillover: Animal Infections and the Next Human Pandemic” writing in the New York Times:

“[This outbreak is] possibly even more dangerous to humans than the other coronaviruses. I say “possibly” because so far, not only do we not know how dangerous it is, we can’t know. Outbreaks of new viral diseases are like the steel balls in a pinball machine: You can slap your flippers at them, rock the machine on its legs and bonk the balls to the jittery rings, but where they end up dropping depends on 11 levels of chance as well as on anything you do.

Nobody knows where the pinball will go… Six months from today, Wuhan pneumonia may be receding into memory. Or not.”

This lack of conviction in making a prediction feels to the lay person like a sign the expert doesn’t know what they’re talking about. But in fact, research on decision making and forecasting demonstrate that the best forecasters are those who understand the limits of their ability to predict the future.

While Coronavirus feels very new and different, Quammen goes on to point out this isn’t the case:

“This Wuhan emergency is no novel event. It’s part of a sequence of related contingencies that stretches back into the past and will stretch forward into the future… The list of such viruses emerging into humans sounds like a grim drumbeat: Machupo, Bolivia, 1961; Marburg, Germany, 1967; Ebola, Zaire and Sudan, 1976; H.I.V., recognized in New York and California, 1981; a form of Hanta (now known as Sin Nombre), southwestern United States, 1993; Hendra, Australia, 1994; bird flu, Hong Kong, 1997; Nipah, Malaysia, 1998; West Nile, New York, 1999; SARS, China, 2002-3; MERS, Saudi Arabia, 2012; Ebola again, West Africa, 2014. And that’s just a selection. Now we have nCoV-2019, the latest thump on the drum.”

Ebola, Bird Flu, West Nile, SARS, MERS… each of these outbreaks were seen, rightly so, at the time that they were spreading to present very serious global risks. But in each case, from an economic perspective, these outbreaks have all “receded into memory” as Quammen points out may well happen with Coronavirus. Or not.

It is that “or not” that is so worrisome. It is that “or not” that is causing the stock market to plummet. It is that “or not” that is causing people to stockpile food and face masks. It is that “or not” that makes all of us worry.

But the world is full of “or nots”. Maybe a war will break out with Iran. Maybe the political party you support won’t win the next election. Maybe China will go into a deep recession for reasons entirely unrelated to Coronavirus.

In a world where every sensible person knows that there is simply a deluge of possible disasters always just over the horizon, while at the same time so many of these risks never come to pass, what are we to do?

The key is to recognize that many of the most important things that occur in the world are not forecastable. Even if they are forecastable, you need to be able to also forecast how they will impact the economy and in particular the cash earnings of the specific companies in which you are invested.

Lots of stuff matters. But only those things that matter and are forecastable are actionable in a way that can make investors money. So what can we forecast about the impact of Coronavirus on economic activity? Well we know that economic activity in China has slowed dramatically. In the last month. Starbucks, Apple, hotels and automakers have all closed many of their locations in China. There is no doubt at all that this will negatively impact their cash earnings this quarter.

But what about next quarter? Until yesterday, the market was assuming that the negative impact would be temporary. And indeed Apple announced today that they re-opening 70% of their stores in China while automakers have begun re-opening their Chinese factories.

So what matters and is actionable for investors right now is recognizing that earnings reports for many companies that sell into China are going to be terrible this quarter. But surprisingly this doesn’t actually change the value of the stock market by all that much. This short term economic damage has been known for at least the last few weeks and the market mostly ignored it because the value of a stock is based on how much cash earnings it will generate over the long term, not how much a company makes in any given quarter.

The fact is that the US stock market is only going to generate cash earnings of about 4% of the value of the market in 2020. This is the long-term average rate of cash earnings. So if the market collectively earned zero in 2020, but in 2021 and beyond it earned the same amount as it would have if Coronavirus had not occurred, then the value of the market should drop about 4%.

So what matters is not whether the virus spreads in the EU or in the US, or if Chinese based companies go back to work this week or next month or this summer. What matters is if the Coronavirus fades in its economic relevance over the course of time as all past virus outbreaks have, or if this outbreak is somehow different and the global economy grinds to a halt.

I wish I could tell you the latter outcome was impossible. But Coronavirus could be with us for a long time. Or not. It simply isn’t forecastable, which is exactly what the most informed experts on global pandemics will tell you. But this is true about so many important things. We can’t forecast the economy very well, indeed even the Federal Reserve board with all their PhDs and access to unlimited data and resources find forecasting the economy beyond six months to a year to be nearly impossible.

The reason stocks have generated returns of about 9% per year while government bonds have earned returns of less than half that level is because bonds are far, far more forecastable than stocks. The stock market earns higher returns because owning stocks requires that you accept uncertainty. It isn’t fun. We try our hardest to identify ways to better forecast the future. But we also accept that a high level of uncertainty is the price of earning the long-term rewards of the stock market.

The market falls by 5% or more, as it has this week, about three times a year. It falls by 10% or more about once a year. And it falls by 20% or more about once every seven years. If the market continues to decline until it drops by 10% or even 20%, this shouldn’t be surprising. It won’t be fun, but it is just part of investing.

We’ll continue to monitor the news about Coronavirus and we’ll continually update our own forecasts about how our portfolio holdings’ cash earnings will play out this year and well into the future. We’ll take action when we recognize that something important has occurred, that is forecastable, and which we believe other investors are missing.

But in all likelihood, the economic impact of Coronavirus will fade over time, just as it did for every one of the virus outbreaks of the past.

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