“History shows that volatility and drawdowns are inherent in equity investing. It’s not uncommon to experience intra-year declines well over 10%, yet, more often than not, markets recover from those drawdowns within the calendar year. It’s therefore highly probable that exiting the market during periods of heightened volatility will result in investors missing the upside that inevitably materialises.”
A KNOWN UNKNOWN
Dittberner describes COVID-19 as a ‘known unknown’, a reference to former US Secretary of Defence, Donald Rumsfeld’s 2002 response about whether Iraq had been supplying weapons of mass destruction. In his response, Rumsfeld separated military intelligence into ‘known knowns’, describing things we know that we know. ‘Known unknowns’, referring to things we know we don’t know; and ‘unknown unknowns’, which are those things we don’t know that we don’t know.
Dittberner says, “COVID-19 is a known unknown because it isn’t possible yet to predict the true extent of its impact on the global economy and markets.” “Needless to say, trying to predict the future is a futile exercise. The Coronavirus is a black swan event that nobody could have foreseen. Market participants and economists alike, have been for some time trying to predict what will derail the global economic recovery and record-breaking financial markets.
Trade wars, debt, Brexit, geopolitical tensions were all among the suspects, yet no one foresaw a virus potentially doing the job. This is a great example of why forecasting is close to impossible. A far more efficient and effective approach is ensuring that we remain invested in high-quality businesses that can withstand the market volatility that ensues from the onset of unknown events.”
ACCEPT THE VOLATILITY
Accepting the volatility in markets will help investors maintain the perspective and fortitude required to stay the course through both good and bad times. The danger for investors lies in withdrawing from the market and missing out on the early, possibly rapid price recovery. Historical market data shows that periods of volatility and downturns are typically followed by enduring upward swings.
Furthermore, Dittberner points out that going back to the late 1800s, the S&P 500 Index has never yielded a period of negative real returns for investors who have remained invested for a 20-year period. These periods include both World Wars, the Great Depression and the Global Financial Crisis. “This highlights the power of remaining invested for the very long-term. We acknowledge that not all investors have a 20-year investment horizon, which is where effective asset allocation comes into play.” According to Dittberner, the strength of an investment portfolio’s returns is correlated to the quality of its underlying assets.
RETURNS ON CAPITAL
“When investing in a business, our philosophy seeks to identify companies that can generate superior returns on capital. This is typically achieved by companies that have high and sustainable margins. Alongside this, we aim to identify businesses that can grow to deploy capital at those higher rates of return.
“From a leverage perspective, we prefer lower debt levels. We acknowledge that some level of debt may be positive for certain companies, provided that there are sufficient earnings and cash to cover the interest and debt repayments multiple times. While we would expect to pay a higher price for these quality businesses given that they are superior to the market, we ensure that we do not overpay.” Dittberner concludes by saying that these fundamentals should stand a well constructed, diversified portfolio in good stead over the long term.
SEPARATING THE FACTS FROM THE HYPE
While previous viral outbreaks such as SARS and MERS also caused global panic, the proliferation of social media has increased the speed and breadth at which information (and misinformation) spreads around the world. The net result is that the typical panic that follows a viral outbreak has been significantly amplified this time around. Early in February, the World Health Organization (WHO) called the Coronavirus “a massive infodemic” due to the overabundance of both true and false information.
The narrative regarding COVID-19 has evolved with time. Following the initial panic at the beginning of the year, comparisons to the common flu and the 2003 SARS virus dominated headlines, with the main message being that people should stop overreacting as we’ve been through this before. However, just over a month later it became clear that the outbreak was far more serious than the common flu and SARS. As this reality settled in, the narrative evolved and China and the WHO were accused of underreporting statistics to cover up the true magnitude of this outbreak. This is a frightening possibility.
At this stage, it is important to remember that the narratives surrounding COVID-19 are exactly that - narratives. Therefore, it is far more prudent to remain calm, focus on the facts and prepare adequately for the risks that may present themselves. Right now, COVID-19 is one such risk and is unfortunately, what Donald Rumsfeld would have referred to as a ‘known unknown’ since we cannot predict the true extent of its impact on the global economy and markets.
AUTHOR: Andrew Dittberner, Chief investment officer, Old Mutual Wealth Private Client Securities.