It’s the end of Q1 2020 and all hell has broken loose. The Covid-19 pandemic, not to mention the oil fiasco, has brought havoc to the health of our people, our economy, and our markets. Our prayer in all of this is for safety, peace, and clarity.
Our portfolios have done their jobs vs. their respective benchmarks, and we think the structure of our approach lends itself to keeping advisors off of the hot seat. Today’s note is less about why and more about what. Its purpose – a foundational level understanding of your portfolio and investing in stocks in general. As Tim Urban often says at Wait But Why, growing branches is impossible without a trunk. That’s the purpose of the note today. Short, simple, trunk-building discussion from the ground up.
The next few weeks and months may get ugly, and we will touch on thoughts around what that could mean and how we are prepping. But today, a root level understanding should give you confidence in the future and serve as a reminder of how powerful time is. Time is an asset you have more of than you think. Now, let’s zoom out.
What is a stock?
A stock is a claim on expected future cash flows from a business. It’s that simple. That future cash flow is long-term….very long term, think decades. That last part is important, we will revisit in a second.
Return on a Stock/Investment
Again working from simplicity…we aren’t discussing dividends, just the basic concept that a stock is nothing more than a claim on very long-term future cash flows. How can that generate return? As John Hussman described in the snippet below, price paid dictates a lot of the actual return earned…
Source: Hussman Funds
Aptus note: a stock is not a claim on a single payment, but a claim on a series of future payments. So the math gets trickier but takes us to our ultimate point – the price you pay for future cash flows has a whole lot to do with the investment’s return.
Take another look at those rates of return and think about why that matters. How future cash flows are valued today has a significant impact on future returns. To be intentionally repetitive, VALUATIONS MATTER.
To summarize what we’re about to say –
Your return from a stock is based on the future cash flows, and today’s price. We aren’t concerned about the disruption of near term cash flows, but we are concerned about valuations continuing to fall across the board. Short-term cash flow disruption means next to nothing on the value of your claim on future cash flows. The valuations investors are willing to pay for those claims has our attention as it matters, and we want to protect against it and provide capital to deploy if it occurs.
Remember, we’d much rather pay $20 vs $80 for the same future cash flow, just look at the difference in return above. That’s the silver lining of falling valuations. That’s why we hedge the way we do…we want to have cash on hand to deploy when valuations get reset as they have recently and may continue to do so.
What’s Happening in Today’s Market
We use this phrase often: “We want to understand potential returns and the risks associated with them.” As we noted in the past, we entered 2020 where potential returns had more risk associated with them than we’d like. Or, to think of it at the root level, claims on future cash flows were being priced too high. Investors weren’t demanding enough of potential returns and assumed the associated risk was low.
Covid-19, the oil shock, etc has caused investors to lower the price they are willing to pay. Investors are now demanding much higher returns moving forward. The flip side of that means they are willing to pay much lower prices.
That’s what we are seeing. The price investors are willing to pay is dropping. It’s not just happening to stocks, it’s happening to every other asset that’s not government bonds.
Let’s tie all this into what matters – your portfolios.
Your portfolios hold claims on long-term expected future cash flows – stocks. Yes, you own bonds most likely, which are different securities, but we’re focused on stocks in this note.
Think about those future cash flows sequentially, one after the other. Remember when we said long term? Well, this line of cash flows goes out decades. You own claims on those.
Here’s what we know. The near-term economic and earnings numbers are going to be bad, really bad. The good news is, totally removing the closest one or two cash flows in a line that stretches decades, really doesn’t matter. A stock is not priced on next quarter’s cash flow, it’s priced based on what it is; a claim on long-term future cash flows.
Here’s what we don’t know.
- The length and severity of Covid-19’s impact
- How the price investors are willing to pay for claims on future cash flows due to uncertainty will change
Here’s what we are doing about it.
We are entering Q2 more defensively positioned than ever, across the board. The amount of uncertainty in the markets calls for it. We appreciate all the actions of the Fed to support markets, but we need to see more hard data on our ability to contain Covid-19 and the economic fall out before our opinion changes on that.
We will remain hedged, and continue to take hedged profits when available, towards ongoing risk management and buying additional shares at lower prices.
Closing on a High Note
There’s still risk in this market, no question, but we think less than there was. In addition, the drivers of your returns are the claims on decades of future cash flows. Near-term uncertainty won’t change that. If the price investors are willing to pay for those claims continues to drop, it will be nice to have hedges in place, which you do. We’ll repeat what we said in our last note, despite the negative news stream, this sentiment has not changed:
We believe it may get worse before it gets better and containing Covid-19 should be the top priority across the globe. While we recognize that, it’s also important to recognize the massive stimulus coming out of Washington, the swiftness of this decline, and the amount of resources and energy devoted towards preparing and finding a vaccine. We’re long the human ability to get through this and believe the current crisis could turn into the buying opportunity of a lifetime. And we’ve designed our hedging to create a helpful flexibility to take advantage of opportunities as they come.
This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy.
Investing involves risk. Principal loss is possible. Investing in ETFs is subject to additional risks that do not apply to conventional mutual funds, including the risks that the market price of the shares may trade at a discount to its net asset value (NAV), an active secondary market may not develop or be maintained, or trading may be halted by the exchange in which they trade, which may impact a fund’s ability to sell its shares. Shares of any ETF are bought and sold at Market Price (not NAV) and are not individually redeemed from the fund. Brokerage commissions will reduce returns. Market returns are based on the midpoint of the bid/ask spread at 4:00pm Eastern Time (when NAV is normally determined for most ETFs), and do not represent the returns you would receive if you traded shares at other times. Diversification is not a guarantee of performance and may not protect against loss of investment principal. ACA-20-81.