Nishlen Govender, Portfolio Manager, Citadel
With over 100 million cases of COVID-19 and 2.2 million deaths globally since the start of the pandemic, its impact cannot be underestimated. The COVID-19 crisis has rocked economies around the world, resulting in rampant unemployment, massive shocks to businesses and households left in turmoil. Yet in the midst of this, equity markets are at an all-time high. So are stock markets overvalued, or are we facing another market bubble?
Examining the stock market and the true worth of financial assets
Equity markets are simply a collection of companies listed on stock exchanges around the world. In South Africa this includes retailers like Mr Price and Woolworths, banks such as FNB and Standard Bank, and restaurants like Spur. Globally, large companies established in various markets are also listed, such as Nike, Microsoft, Booking.com and Walmart.
The majority of these companies sell to and service the public in some way, and are operating in the very same economies that are being ravaged. Additionally, their employees are being affected by the virus every day in the form of lockdowns, social distancing and the upheaval of families via death or contraction of the virus.
Yet if all this is true, how can these companies be thriving with share prices at all-time highs? The idea seems like an oxymoron, giving rise to the perception that equity markets are overvalued. But are they? The answer is not necessarily simple and goes back to the question of how to determine fair value.
How do we value a financial asset?
One of the most relatable ways of understanding the fair value of financial assets is by examining the value of a property. For example, how much is your home worth to you? The answer often relates to the value of properties around you. However, you would also often adjust that value based on additions you have made to your property relative to your neigbours. This includes items such as pools, air-conditioning, a pizza oven etc. This is considered a relative valuation – the price of something relative to something similar.
You can do a similar assessment with companies and achieve a fair value for a share in a company (and thus the market). However, the key issue lies in finding companies that are as similar to each other as houses in a neighbourhood. Consider a company such as Apple – can you find a company that sells a similar range of products to compare to? Samsung may appear an obvious choice considering the competition between Apple and Samsung devices. However, consider that Samsung also sells an array of other products while Apple controls its own operating system, iOS, and you can see that making a relative valuation from a company perspective is difficult.
For this reason, investment professionals defer to a process known as the discounted cash flow (DCF) analysis, which attempts to find the present value of a future stream of cash flows. To understand what this means, consider the process in the context of your home again. If you had to rent your home to another family, what would the new value of your property be? It is no longer just the value associated with selling the property in the future – you now have to consider the impact of a recurring stream of rent. If you have a fixed-term lease and plan to sell the property at the end of the lease, then you need to determine the value today of those cash flows, as well as the value, today, of selling the house at the end of the lease term.
The DCF analysis offers the ability to find the present value of future cash flows, thus providing a future value. Importantly, however, like any framework or formula, your inputs and assumptions are crucial to the output. In the case of DCF, the key variables that affect the value you would pay for a financial asset is the growth in cash flows over time and the final or terminal value. In the case of renting your home, the level of rent is crucial, as well as potential escalations in that rent and the final selling price for your house. The model is also malleable: you could add the risk that your renter may default on their rent, that there may be property damage that you would have to pay for, and so on. The list is truly endless.
You can think of a company like Apple in a similar way. Apple is not just worth its current stock of inventory, properties and equipment – its worth is also based on the company’s ability to produce products and services that will be consumed in the future. To perform a discounted cash flow analysis, investors need to consider and forecast a variety of factors related to a company’s prospects.
However, there are four key levers that determine a significant part of a company’s value, namely:
- Sales or revenue: how the company makes money
- Margins: how much profit a company makes from US$1 of revenue
- Reinvestment: how much the company needs to invest in capital to fund the assets (such equipment or inventory) in order to generate revenue
- The cost of capital: the return that you, as an investor, require from the business.
Understanding these factors and valuing that stream of cash flows into the future then allows us to determine the value of Apple and other stocks. But unlike our property example, it is crucial to understand that investment views differ widely, as it’s challenging to predict future profit and cash flows. For instance, what will Apple look like in 10 years? Will the iPhone still be popular? Will Apple have found a different growth lever to pull? Each analyst and portfolio manager will have their own opinion of a company’s prospects and will thus determine their own value of a stock.
Are all equities expensive?
If we try to incorporate our pandemic view into the framework for understanding company valuations, we can now determine whether we are in a bubble. Given the pandemic’s effect on economies, we would expect revenue growth and margins to be down for major companies. However, significant stimulus has allowed those who are unemployed to continue to “earn” and spend despite the virus. It has also supported many companies that have received stimulus support directly, boosting both revenue and profits.
In addition, it is worth noting that companies and individuals have loans to pay. Just like a defaulting renter in your property, companies and individuals could default on their loans, which in turn would reduce the value of companies. This has mostly been avoided through more stimulus, as central banks around the world have lowered interest rates and thus reduced the interest burden on loans. In fact, interest rates are so low that those less affected by the pandemic (both companies and individuals) could lever up and take on more debt, providing even more capital to spend in the economy.
Ultimately then, simply because the market goes up, it does not mean that equities are overvalued (or in a bubble) – despite what the underlying economy is telling you. Although discussed briefly, it is clear that the environment for companies has been far more nuanced since the pandemic started given stimulus efforts by governments and central banks.
As long as equities are offering value at a particular price or level, the risk of a bubble is lessened. In the current environment, we believe that the market might see a correction, but we do not expect it would result in a wholesale crack across all stocks.
This nuance is crucial as the support provided is record-setting and is a vital offset to the extreme downside of the pandemic. So, while equities may seem like they’re in a bubble, we believe that there is support for equity valuations at these levels, especially if we consider the development and roll-out of vaccines. We therefore don’t expect a severe market crash – the kind that often follows an equity bubble. Rather, we expect equities to be supported in the near term.
Crucially, however, views on financial markets and particularly equities can shift quickly as events change on the ground. As a result, the framework explored above is an iterative and ongoing process.
Thus, while we believe that equities will be supported in the near term, we do expect market volatility as investors grapple with the ever-changing global narrative.