As states continue their gradual reopening, the economy is thus far demonstrating its resiliency, at least with respect to the job market. While there are signs that the economic freefall may be leveling out, we still can’t know how quickly it will recover to pre-pandemic levels. The COVID virus is still lingering, and we don’t know if predictions of a second wave will come true or not. And, if they do, what will the response be – another complete shutdown or just a partial one – and how will that impact the economy? And how will that impact portfolio values?
The stock market is also showing its resiliency, having recovered nearly all of its losses in the sharpest stock rally in history. But, in the face of all this uncertainty, investors are still nervous, wondering how they should react to a stock market rallying with 40 million Americans still collecting unemployment benefits. They want to participate in this stock market recovery, but they’re not sure how. What if the economy slips again? How should they look at stock prices? What if it takes longer for company earnings to recover?
In the end, it comes down to the age-old question of how we should be valuing stocks, regardless of the circumstances. By its very nature, investing must assume that bad things can happen that adversely impact stock prices. The probability of economic shocks must also be built into the equation. We can’t know when they will happen, but we know that they will. So, how should investors cope with that? What should they be thinking about when investing in stocks in this environment?
How Many Building Blocks is That Stock Worth?
First, investors should understand that the fundamental nature of investing is simply deferring consumption – choosing not to spend money today with the expectation of having more money to spend later. So, to determine how much you should spend on a stock today, you would add up what you expect to receive on that investment in the future, and that would represent the current value of that investment.
A simple way to think about this is to imagine yourself playing with ten building blocks. Each of the blocks represents what you receive in the future. In the case of a stock, each block represents one year of earnings the company generates. If you line up the ten blocks in a row, you have a sense of the total income you would receive by deferring consumption today. You could spend your blocks today, or you can invest them and receive them back in increments over the next ten years in the form of earnings.
So, if you were to value a company, you could start by stacking those blocks on top of one another and ask yourself whether it is worth that total investment today. Or, is there something about the company or the industry or the economic outlook that might cause you to think you might not receive all ten blocks back in the future. In other words, you think it’s possible the company could come up short with its earnings due to circumstances beyond its control. That’s OK because, if you still think it’s a great company, it could still be a great investment. All you need to do is hold on to a few blocks and invest the rest. That way, you don’t pay more for the stock than it is worth today and in the future.
It’s Hard to Lose When You Pay Less Than What the Stock is Worth
That is the way to manage your risk on the front end and protect your portfolio from shocks. If you find a company that, in your assessment, has the capability of returning ten blocks over ten years and you want to protect against the unexpected shock, you hand over seven or maybe six blocks now. If something bad happens and you only receive the six or seven blocks in the future, you haven’t lost anything – except perhaps the time value of money. But if the company performs as expected, and you receive the ten blocks the company was expected to generate, you come out way ahead without taking unnecessary risk. That’s what it means to buy stocks at a discount.
You might be thinking that if it were that easy, why doesn’t everyone do it. Obviously, I’ve oversimplified the concept. But the theory is sound, and it can work in practice. There’s a lot that goes into determining the value of a company’s stock today versus what the company can be expected to earn in the future. If you have a process to assess companies based on stringent criteria, as we do, you can find the few companies, out of thousands of publicly traded companies, with the potential to deliver the full ten blocks while handing over just six or seven blocks to own the stock. In other words, you buy the stock at a discount of one-third to half of its intrinsic value, thereby limiting your downside risk while reaping the rewards of their full upside potential.
