How to be on the correct side of COVID-19 stock market crash?

On November 17, 2019, a 55-year-old man in the Hubei province was tested positive for COVID-19, a disease caused by a novel coronavirus. His positive result started a series of events that led to lockdown in 50 countries and the biggest stock market crash of the 21st...

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On November 17, 2019, a 55-year-old man in the Hubei province was tested positive for COVID-19, a disease caused by a novel coronavirus. His positive result started a series of events that led to lockdown in 50 countries and the biggest stock market crash of the 21st century. Nothing can prepare us for a pandemic, but we can adapt our portfolio and lifestyle to changing times. Below are the three things you can do to prepare yourself. On November 17, 2019, a 55-year-old man in the Hubei province was tested positive for COVID-19, a disease caused by a novel coronavirus. His positive result started a series of events that led to lockdown in a dozen countries and the biggest stock market crash of the decade. Nothing can prepare us for a pandemic, but we can adapt our portfolio and lifestyle to changing times. Below are the three things you can do to prepare yourself.

Embrace for impact

Investors usually overestimate their risk tolerance. In a falling market, I would recommend deleveraging your portfolio and investing only the capital that you can live without for the next ten years. Another good discipline is to review your holdings timely and identify weaknesses within your portfolio. Stocks you do not want in your portfolio are cyclical companies. Cyclical companies (i.e. Airlines, Hotels, Financial Services and Natural Resources) are the worst hit since the outbreak of COVID-19. Defensive stocks (i.e. Retail, Utilities and Healthcare) are more desirable during the current crisis as they provide essential goods and services for the economy to function properly. Ideally, you should create a watchlist of fundamentally strong defensive companies that you would like to buy.

A balanced All-Weather portfolio

Great portfolios are created by fine-tuning the balance between long term financial objectives and risk tolerance levels. One such great portfolio is the All-Weather Portfolio.   All-Weather portfolio is the creation of Ray Dalio, the founder of Bridgewater Associates, one of the biggest hedge funds in the world. According to Mr Dalio, there are only four scenarios that can affect the value of your investments. They are as follows:1. Inflation – The increase in the price of goods and services or rising prices2. Deflation – The decrease in the price of goods and services or falling prices3. Rising economic growth – Flourishing economy or higher than expected economic growth4. Declining economic growth – Shrinking economy or lower than expected economic growth

Ray Dalio suggested constructing a portfolio with assets that would perform well in each of the above scenarios. The result is a diversified portfolio of Stocks, Bonds and Commodities. Performance of All-Weather portfolio in previous financial crashes:

  • Great Depression – when back-tested during the Great Depression, the all-weather portfolio was shown to have lost just 20.55% while the S&P 500 lost 64.4%.
  • In 1973 and 2002, when S&P suffered some of the worst losses, the all-weather portfolio made money.

Do not time the market but look for clues

I wish I had a magic bullet to protect your investments from market crashes. I don’t. But I want to help you protect your investments. COVID-19 has changed our perception of market volatility, but there are a few things we can look for to prepare ourselves.
Daily infection rate or growth factor of daily new cases: Growth factor is the factor by which the daily new cases number multiplies itself over time. A growth factor of 1.07 means the daily new case is growing by 7%. More than 1 indicates signs of increase, whereas less than one indicates decreasing levels. If the number stays below 1 for an extended period and continue to move towards 0, then there is a high likelihood that the market will improve. During the SARS crisis in 2003, the stock market bottomed a week after the daily infection rate topped out.

Fear Index: The current epidemic is anything like before, but there will be indications of revival. Stock market declines often coincide with VIX index spikes. Previous outbreaks of SARS in 2002-03 pushed VIX to 41. Global Financial Crash in 2008 spiked VIX to 79. As of March 24, 2020, VIX, is at 55. Before buying any stock, I would expect VIX to fall considerably. No one can predict when the market would bottom, but you can look for clues to give yourself a head start in building a better portfolio.

Key to better portfolio performance

The All-Weather Portfolio consists of 30% Stock, 40% Long Term Bonds, 15% Intermediate-Term Bonds, 7.5% Commodities and 7.5% Gold. The portfolio maximises diversification, minimises volatility and improves performance.  Higher allocation of bond in the portfolio is to balance the volatility from Stock and Commodities as bonds are negatively correlated to stocks. Timing the market is fool’s errand. Buying when the valuations are right is key to better portfolio performance.

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How to value companies with Benjamin Graham Formula?

How much is the company worth? Shall I buy shares now or shall I wait? If you do not know how to value the company correctly, you could make a costly mistake on your investment. Valuing a company is not an exact science Generally, the value is calculated using past...

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How much is the company worth? Shall I buy shares now or shall I wait? If you do not know how to value the company correctly, you could make a costly mistake on your investment.

Valuing a company is not an exact science

Generally, the value is calculated using past data from the balance sheet and future assumptions of the broader economy. Investors analyse a stock with a different outlook, which results in different prices. To value the company correctly, investors should give greater emphasis on previous information and rely less on their instincts.

There is no absolute value

Different valuation models explore different scenarios, resulting in different prices. Because Benjamin Graham formula looks into earnings only, it is ideal to value defensive companies. The recipe will not be useful to identify growth companies.

Therefore, if you want to find growth firms, you should use a different method.

The original Benjamin Graham Formula is incomplete

The original formula to find the value of the company was:

V = EPS x (8.5 + 2g)

where;

V= Expected value per share of the firm

EPS (Earnings per share) = the company’s last 12-month earnings per share

8.5 = P/E (Price to Earnings) ratio for a no-growth company g = long term growth rate of the company (7-10 years)

The original formula doesn’t take into account capital expenditures (i.e. money spent by businesses to maintain fixed assets and equipment). An illustration will help you understand.

Let’s assume there are two firms (Digital Media Co. and Construction Co.). They both have earnings of £1,000,000, but Digital Media Co. has a capital expenditure of £200,000 whereas Construction Co. has a capital expenditure of £800,000. Please see the comparison below:

 
  Digital Media Co. Construction Co.
Capital Expenditure £200,000 £800,000
Earnings £1,000,000 £1,000,000
Total Number of Shares 10,000 10,000
EPS (Earnings/Shares) 10 10
Growth 10% 10%

Value of Share (BG

Formula)

£106 £106

According to Benjamin Graham Formula, both companies are equally valued, making it difficult to choose the right stock. Assuming all else the same, Digital Media Co. is a better proposition than Construction Co.

The second issue with the original formula is that it ignores how much the firm is leveraged (i.e. Financed by debt). An illustration will help you understand.

Let’s assume we have two firms (Lehman Bros Co. and Microsoft Co.). They both have earnings of £5,000,000, but Lehmann Bros Co. has a total debt of £1,000,000 whereas Microsoft Co. has only £200,000 liability like below.

  Lehman Bros Co. Microsoft Co.
Total Debt £1,000,000 £200,000
Earnings £5,000,000 £5,000,000
Total Number of Shares 10,000 10,000
EPS (Earnings/Shares) £50 £50
Growth 10% 10%

Value of Share (BG

Formula)

£530 £530

Based on Benjamin Graham formula alone you will be tempted to buy the highly geared Lehman Bros.

The third issue with the original formula is that it was based on 1962 AAA corporate bond rates. To adjust the formula to today’s bond rates, we can adjust Graham’s formula to:

Where,

IV =           [EPS x (8.5 + 2g) x 4.4] / Y

V= Expected value per share of the firm

EPS (Earnings per share) = the company’s last 12-month earnings per share

8.5 = P/E (Price to Earnings) ratio for a no-growth company g = long term growth rate of the company (7-10 years)

4.4 = the average yield of AAA corporate bond in 1962 when the model has introduced Y = the current yield on AAA corporate bonds

10 Point Filter Method

To discover remarkable companies using the revised Benjamin Graham Formula, I would recommend the 10-point filter method.

The 10-point filter to find remarkable firms are:

  • Filter shares that have high-profit margins
  • Has market capitalisation more than $500 million
  • Current assets should be twice the current liabilities
  • Long-term debt should not exceed the net current assets
  • Regular dividend payments
  • The minimum increase of at least one-third in per-share earnings
  • Current share price should not be more than ten times the average earnings of the past three years
  • Current share price should not be more than 1.5 times the book value
  • Regular earnings growth yearly
  • Buying Level: the intrinsic value of the share using the revised Benjamin Graham Formula

Limitations of the revised formula:

  • Companies that have missed dividend payments recently will be not selected
  • Some reliable companies that have low-profit margins will be excluded from the final list
  • Firms that might have missed earnings growth due to the economic downturn will also be

Like any method, care should be taken on how you use them and your risk appetite. If you want to invest long term in defensive sectors, then I would recommend Benjamin Graham Formula with the 10 point filter method.

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