This week's interesting finds

EdgePoint: Second-level thinking in periods of market extremes
Portfolio manager Andrew Pastor and analyst Sydney Van Vierzen discuss why using second-level thinking to choose 'non-obvious' survivors is especially important during periods of market extremes. To illustrate, they break down three examples from the EdgePoint Canadian Portfolio.

Charts that caught the eye of the investment team
With everyone crowding into the growth/tech trade the five largest stocks in the S&P 500, Microsoft, Amazon, Apple, Google, and Facebook, now represent more than 20% of the entire index. The last time the top 5 were this concentrated was in 1970!

A tale of two investors
While it can be tempting to sell in the midst of a downturn, investors who hold their investments historically see much greater returns. To see how this plays out, let's rewind to the Global Financial Crisis. Here are two hypothetical investors, Sharon and Barbara, both start out with a $1000 investment at the market peak. After the decline, Sharon reacts emotionally as the market declines. Her $1000 is now worth $432 at the bottom and Sharon sells. She later rebuys once the market rebounds to the previous peak. After 7 years Sharon has $531. Barbara reacts rationally despite the downturn and stays invested.  At the end of 7 years, Barbara has $ 1,232.

This week's dilemma

This week's interesting finds

Thoughts from the investment team 
Is the 40-year bull market in bonds over? Yields have officially hit the lower bound. In Germany for example, yields are flat year-to-date despite experiencing one of the worst economic shocks since WW2. German bond yields should be falling based on the deflation in the system. Here is the 10-year German treasury.

The crowd's stampede into "quality" or safety investments has made them very expensive while value has bounced. This trend is even more pronounced in Europe.

As long-only funds crowd into the “safe” trades, they are avoiding the undervalued stocks that stand to gain. Since the lows, in March most long-only funds have had a hard time beating their benchmark.

History shows that investors who are crowding into today’s crowded “safe” trades may also pay an opportunity cost by avoiding the undervalued stocks that stand to gain the most when the unwinding of “safe” strategies begins.

Large-cap stocks in the lowest quintile of beta are trading at historic high valuations.

Electric Vehicle penetration in China is back to pre-2018 levels
Perhaps it’s a function of the +60% drop in sales.   In a tough economy, people will not pay up for an EV. Car sales in China have recovered, but down 33% in the first week of April vs last year.

Howard Marks Memo: Knowledge of the Future
In this week’s memo, Howard Marks discusses the notion of making informed guesses regarding the future and shares questions about re-opening the U.S. economy. He also reviews the latest Federal Reserve moves to help the economy combat the coronavirus.

This week's interesting finds

We have met the enemy and it is us
The average investor continues to lag the performance of all major asset classes year after year. What causes this? Unfortunately, investors tend to jump in and out of their investments at precisely the wrong times. They pile into funds that have been performing well and redeem at the first sign of underperformance. Buying high and selling low eventually leads to this behavior gap. 

Relative valuations

Who cares what Mr. Market thinks
If you own a restaurant on a beach and the weather forecast shows a hurricane approaching, are you going to rush to sell the restaurant before the hurricane hits? Are you going to lower the selling price because you know the hurricane is going to hit and you are going to lose a few days or possibly weeks of business? Of course not! So why would you do the same with stocks?

The intrinsic value of the restaurant is not going to be impacted by the coming hurricane. Yes, they will lose business, and will probably have to repair some damage.  Of course, there is a possibility that it wipes out the whole beachside town and it takes years to rebuild. But most market exogenous events in the past ten or twenty years weren't of the magnitude to destroy everything (in aggregate) for years.

We have to understand that regardless of what the 'market' is looking at, or what the pundits say on TV, a business is simply worth the present value of all future cash flows.

Here's the illustrative model. Let's say the market has an EPS of $10/year, and the discount rate is 4%. In this table, I just took the earnings for the next 10 years and discounted it back to the present at 4%, and then added a residual value at year 10 based on a 25x P/E ratio (or 4% discount rate), and discounted that back to the present and added them together. Of course, this would give the market a present value of 250.

Let's say that the economy is wiped out for a whole year, and the S&P companies make no money for a whole year. 

First Year Earnings $0.00 Instead of $10.00

The intrinsic value of the market would go down less than 4%. With zero earnings for 4 years, the intrinsic value would go down by about 15%.

Zero Earnings for First Four Years

So, with the market where it is right now, it is like the market is discounting no earnings for more than four years!

The above tables clearly show that there is a negative impact on intrinsic value by even temporary business interruptions. But the magnitude is not nearly as much as the market usually moves.

We all had the same thoughts every time something happens. We all see some permanent negative change that explains a lower stock market. For example, after 9/11, the thought was that the world would never be the same, and that increased security measures will permanently reduce global growth potential and profitability.

Again, the market makes the news, and the market creates the explanations, not the other way around. We all try to model the facts to explain what is going on in the market to maintain the two illusions that 1. the market is always right, and 2. that we know what's going on. We wrap the market volatility tightly into these rational-sounding wrappers, pleased at having figured it out, secure in the knowledge that we know what's going on.

Stay home

Much needed humor 

This week's interesting finds

2020 Q1 EdgePoint commentary

In this quarter’s equity and fixed-income commentaries, we address the gravity of the responsibility you have entrusted us with. We know that you have a similar responsibility to your own clients. For the first time, we have also recorded a podcast of the commentaries.

Equity commentary: We understand the gravity of our responsibility to you – 1st quarter, 2020

Fixed-income commentary: Glass half full – 1st quarter, 2020

Which way now?
In the last six weeks the markets have seen the best of times and the worst of times:

• From February 19 to March 23, the U.S. stock market saw the quickest meltdown in history, for a loss of 33.9% on the S&P 500. Then its 17.5% gain from Tuesday through Thursday of last week made for the best three-day stretch since the 1930s.
• Of the 21 trading days between February 27 and March 27, a total of 18 days saw moves in the S&P 500 of more than 2%: eleven down and seven up. They included the biggest daily percentage gain since 1933 and the second-biggest percentage loss since 1940 (exceeded only by Black Monday in 1987).
• From March 9 through March 20, issuing a new investment-grade bond seemed inconceivable. Then, as our trader Justin Quaglia points out, last week’s news of the government’s rescue package enabled 49 companies to issue $107 billion of IG bonds. That made it the biggest week for issuance on record; In fact, there was more issuance last week than in nine of the 12 months in 2019.
• Finally, on March 26, Justin wrote, “It’s hard to believe I used the words ‘panic’ and ‘FOMO’ within two weeks of each other.”

Looking at the above, it’s important to note the degree to which people (and thus markets) seem to think long-term phenomena can change in the short run. 

A chart that may prove useful:

On average the market bottoms 5 months before the recessions ends, and rallies 26% before the recession is officially over.

The Craziest Month in Stock Market History

But enough of the numbers and charts.  The thing that made March 2020 especially insane for most investors was the constant news coverage and speed at which everything was happening.

The entire month was an onslaught of information, fear, and uncertainty.  And to top it all off, we spent most of this month physically separated from each other, sitting within the same 4 walls every day.

So no matter how crazy this month was for you, the most important thing to remember is that…it ended. 

Market volatility may not go away anytime soon, but the important thing to remember is that investing isn’t about a single decision, but a collection of decisions over a lifetime. The biggest important thing is to make sure that you live to invest another day.  A lot of the very basic stupid mistakes are the most important things to avoid.

Family's lockdown adaptation of Les Misérables song goes viral
A family from Kent who shared a video of their living room performance of a lockdown-themed adaptation of a Les Misérables song has become a sensation online. Ben and Danielle Marsh and their four children changed the lyrics of One Day More to reflect common complaints during the COVID-19 lockdown. They say the video, which has gone viral, was intended to give friends and family a laugh during this stressful time.

How to stay creative and keep your family sane during the lockdown
British art and textiles teacher Andria Zafirakou won the 2018 Global Teacher Prize and has two teenage daughters. Here she gives some practical tips – from giving your children time to transition to homeschooling, to creative ideas – for navigating staying at home together. Parents can encourage creativity. Here are just a couple from the list. 

• Asking questions: Creativity is all about questioning: How can I? Why should it? What would happen if? How can I make this, or how can I change this? It’s about making sure that children are always being asked those questions.
• Keeping everything: Do not chuck anything away. Keep a bag with all the egg boxes and toilet rolls in a corner, because that’s going to be a mine of incredible craft-making materials.
• Giving them time: The beauty is that the parents are in control of the time, for once. So you can give your child two hours to get on with a wonderful creative task, and they wouldn’t have that in school.
• Thinking outside the paintbox: Creativity is not just about arts and crafts, it’s also about the kitchen. What kind of lunch can they make for you while you’re working?