This is a time for cool heads, and calm thinking. Our view is that market selloffs, like the one we are witnessing now, actually present opportunities for investors. If they don’t need the capital that they have already allocated, then why extract it at a time of maximum fear? And, if they are fortunate enough to be able to invest additional capital, then history has shown that buying after precipitous price declines has proven to be the right move – not selling.
In that spirit of calm thinking, let us reflect on a fascinating insight from a recently published piece from our CROCI research team. Put simply, they argue that, of the two fundamental drivers of stock prices – earnings, and the rate at which they are discounted – people make the mistake of overestimating the extent to which short term changes in earnings can cause stock prices to decline. Or, to put it another way, the majority of a stock’s value comes from long-run earnings, and not from what investors believe will happen to earnings over the next year or two.
This is best demonstrated by example. So, first, for context, look at Figure One, which shows the nominal earnings per share of the S&P 500 over the last 25 years or so. There are two key messages here. First, that, as bad as it ever got over that period (and we have noted the two main sell-offs – the dot.com bubble , and the Financial Crisis), earnings never dropped by more than 50% (and yes, that is a lot, but the relevancy of that number will become apparent in a moment). Second, note that both times earnings fully recovered, and more, and likely faster than many investors at the time would have assumed.
Figure One: The Nominal Earnings Per Share of the S&P 500 (1995 -2020)
Source: Bloomberg Finance L.P. Data as available on 12 March 2020. Each year represents an average of prior four quarters. May not be indicative of future results.
Now, armed with that information, consider Figure Two, and focus initially on column 2 under Scenario B. What this demonstrates is that, from an earnings perspective alone, if investors today believed that the next two years were going to be as bad as those experienced during the Financial Crisis (i.e. a decline in earnings of -50%), then the market should have dropped by around only -5%. Furthermore, it shows, under column 5, that even if investors believed the next two years were going to be dramatically worse than 2008, and lead to the total elimination of all S&P earnings, then the impact that would have on the market would be just -9%. The message of course is that the biggest chunk of value in owning the S&P, or indeed in any individual stock, comes from the present value of its long-term earnings, not from any knee-jerk gyrations in the next year or two. A crucial message during these turbulent times.
So, if we know how much markets should be impacted from earnings, how do we rationalize how much they have been impacted (the S&P is down around -25% year-to-date (YTD) at the time of writing). The answer of course comes from that second factor that I alluded to earlier – the rate at which these earnings are discounted to today’s values, or the so-called “discount rate,” or “required rate of return.” And, as Figure Two also amply demonstrates, it is a jump in this factor that really has the ability to reset prices (compare columns 2 and 4 for example, or columns 5 and 7 where the only thing that is changing is the discount rate).
Figure Two: Scenarios showing the impact on prices from the changes in earnings and discount rates
A repeat of 2008 with a 50% fall in EPS for 2 years
Worse than 2008 with no EPS for 2 years
|Long term Earnings||100||100||100||100||100||100||100|
|Earnings Estimates for 2020 & 2021||100||50||50||50||0||0||0|
Source: DWS, CROCI. The table shows price changes that different earnings and discount rate scenarios should mathematically produce. Data as available on 16 March 2020. May not be indicative of future results.
The CROCI team has an expression for the discount rate – they call it the “dark side of valuation.” Why? First, because it involves behavioral aspects of market analysis that are hard to quantify, and, frankly, require investors to admit to a certain degree of irrationality. But, second – and crucially as we witness world events today – because they attribute much of the change in discount rates simply to investor fear.
However, the CROCI team end their report on an optimistic note:
“Eventually, fear passes. At the peak of fear, the marginal seller has already sold. Everything looks dark. This pandemic could trigger another financial crisis, and drag down entire economies. But, as ugly as the situation may be, we believe there is simply too much value at the moment to ignore. This is what attracts contrarian deep value investors who are looking at the bigger picture, and are not frightened by ugly situations.”
That sounds to me like a recipe for controlling your fear factor, and letting a cool head, and a calm mind help you to see today’s markets in a very different light.
CROCI® is a registered trade mark of DWS Group in certain jurisdictions. The CROCI® strategy is supplied by the CROCI® Investment Strategy and Valuation Group, a unit within the DWS Group, through a licensing arrangement with the fund’s Advisor. DWS Group reserves all of its registered and unregistered trade mark rights.
Assumptions, estimates and opinions contained in this document constitute our judgment as of the date of the document and are subject to change without notice. Any projections are based on a number of assumptions as to market conditions and there can be no guarantee that any projected results will be achieved.
CROCI DWS Group’s proprietary equity valuation process. DWS Investment Management Americas, Inc. (“DIMA” or the “Advisor”) intends to utilize the CROCI team’s proprietary investment valuation process and indices to develop and manage investment strategies.