Summary: Recently, on CNBC’s The Exchange, Kelly Evans and I discussed the impact of the coronavirus on global markets and how investors can manage their way through the crisis. You can see a video clip of our conversation by clicking this link. For a more technical version, you can read about the contagion models that epidemiologists use in my next post.
Note: my old friend Bill Griffith, who anchored Closing Bell with Kelly, once told me she is the smartest journalist he has ever worked with. After working with her many times, I can’t disagree. Check out Kelly’s show at 1PM ET – you won’t be disappointed.)
To be honest, the coronavirus parameters are not good. It started in China, one of the most densely populated countries on earth. And the incubation period of approximately two weeks is long enough to allow an infected person to travel great distances and infect many people before they even know they have it. But there are two important additional control variables in play with the coronavirus:
- On the negative side, local officials clearly covered up information about the outbreak during the crucial first days, allowing it to infect many more people.
- On the (medically) positive side, the authoritarian nature of the Chinese government allowed Xi Jinping to take more aggressive actions to contain the spread of the disease than would be possible in many places. At one point more than 150 millions people were under geographical lockdown. These actions, while draconian, likely bought those of us outside China valuable time to prepare for our turn in the barrel.
- Note: Now that the flow of new cases in China has leveled off and been overtaken by new cases elsewhere, there is a pointless blame game raging in the media being played by both Chinese and American authorities. I find it a waste of time and will not be commenting on it. We have more serious issues to handle today.
My first point to Kelly was that we are all scared by the coronavirus because nobody knows what’s going to happen and that when we are scared, we make dumb mistakes. So, let’s take a minute to separate the fear and ignorance from the fundamentals.
Remember the Fundamentals
As for the fundamentals, we know that the closed stores and shut-down factories in China are going to have a huge impact on economic activity in China in the coming weeks, months, and quarters. And it will have a meaningful impact in other countries on the performance of companies that are directly impacted by the virus inside China, (e.g., Starbucks’ store closings), companies affected by supply chain blockages (AirPod parts for Apple, components for Honda and Nissan), and companies in other countries where the coronavirus will spread. But we also know that the epidemic will most likely be a short-term headline, that the Chinese central bank has backed a truck up to Chinese banks so they can shovel liquidity where it is needed, and that the Chinese government is one of the few in the world that can quarantine a city of 6 million people with a phone call.
Stocks are Long-Duration Assets
When you buy a stock, the price you pay buys its entire stream of future free cash flow. Unlike a bond, there is no maturity date when you get your money back. And unlike a bond, a stock’s cash distributions, either as dividends or stock buybacks, grow over time–at least you hope they will. That means the duration of a stock–roughly the number of years of a company’s free cash flow you would have to collect in order for the present value of those collections to equal half of today’s stock price–is much larger than the duration of a long-term Treasury bond. Duration is a good measure of the sensitivity of an asset’s price to a change in the interest rate used to discount future cash flow. Technically, it is the fulcrum–the point on the teeter-totter where is just balances–of the stream of future cash flows, translated into present values. For example, the price of an asset with a duration equal to ten (say, a ten year zero-coupon Treasury bond) will fall by ten percent if interest rates rise by one percentage point. The duration of a typical bond fund today is 5-7 years; the duration of the 10-year Treasury bond is a little over 9 years. But the duration of the S&P 400 non-financials is more than 40 years, which explains the extreme sensitivity of stock prices to changes in interest rates.
More simply, stocks last a long time so whatever happens to this year’s profits doesn’t matter much as long as it doesn’t affect expected profits in later years. For a decent estimate of how much you can use the dividend yield. If a company pays a $2 annual dividend and its stock is selling for $100 per share (2% dividend yield) you are only going to get back $2 of your $100 in the first year, so the other $98 much be the value of everything that happens after year 1.
The caveat, of course, is that this is only true if whatever happens this year doesn’t push the company into insolvency and kill it, which is especially relevant for highly-levered companies. But for strong companies it gives investors an opportunity to buy shares at a discount when other people freak out about what is likely to be a short-term problem.
Examples include Starbucks (SBK) and its Chinese competitor, Luckin Coffee (LK). Both companies closed all their stores; both will survive and thrive. Another is Alibaba (BABA), perhaps China’s top world-class company. The same goes for Apple, Microsoft and Amazon. All were hit by the coronavirus fears; all will still be around after the flu has been tamed.
Of course, all of this assumes that you either have nerves of steel or a medicine cabinet full of beta blockers, so you don’t freak out too. This is a time to be cautious, not aggressive.
JR
