A few days ago, I finally had the chance to read Warren Buffett's latest shareholder letter. It contained a good reminder of a key reason we buy and hold stocks of great companies -- to go along for the ride as successful enterprises re-invest profits in their key businesses to expand upon already existing profitability, in turn generating compounding wealth for patient shareholders. The letter was written in February before the full picture of COVID-19 emerged. I didn't get to it till recently in part because of trying to respond to the investing challenges posed by the pandemic. Arrival Capital attempted to protect clients first by ensuring there was enough cash to cushion accounts against a severe economic downturn and to provide capital to take advantage of emerging opportunities, and, second, to remove from client accounts stocks in companies that were so adversely affected by the outbreak that their long-term profitability and even survival were realistically threatened. But after raising cash and removing impaired companies from client portfolios, the true work of investing goes on, which is to maintain and add to a diversified portfolio of profitable companies that are priced below what they will be worth in the future because of reinvesting in their businesses as well as paying dividends over that time.
Another useful insight comes from Professor Jeremy Siegel of Wharton. Early on in this crisis, Professor Siegel observed that the basis for valuing profitable companies at least in part is the price to earnings ratio (P/E ratio) of a given company and that the "E" stands for earnings expected for a given year. Thus, a company selling at a P/E ratio of 20 entails investors multiplying 20 years of expected earnings to come up with a value. Siegel pointed out that should a company's annual earnings be wiped out for an entire year because of the pandemic, and would then bounce back, then the P/E ratio of a company should decline to, say, 19 times earnings, which would warrant just a 5% decline in a company's stock price. Even a two-year wipeout of earnings would bring a P/E ratio down to 18, for a 10% decline. At the recent low in March, stocks declined by 35% and are still down almost 20% today.
The point is not to in any way to minimize the enormous impact that COVID-19 has had on society as a whole and the business and investment world. For everyone alive on the planet, this truly is a time like no other and special precautions must be taken in many areas of our lives, including in our investment approach.
But timeless insights about investing and creating wealth do not go out the window because we are now living in perilous times. Uncertainty about the ultimate resolution of the pandemic, likely by some combination of vaccine or treatment, and social distancing and other preventative measures permanently adopted by society, is not a prescription to abandon investing in the best combination of businesses we can find that will get to the other side of this crisis and resume their profitable future path, because of the enduring values in their brands, know-how and assets.
Investing is at its most powerful when you can identify undervalued companies that can grow their businesses (sometimes by disrupting the existing business world) well into the future in a way underappreciated by the investment community, which is often buffeted by short-term noise and temporary disruptions. COVID-19 is obviously more than noise and probably longer than temporary, but life will return to what will likely be a "new normal." Unfortunately, some businesses do not have the resources to survive unscathed by the COVID-19 crisis. Other businesses will be fundamentally transformed. Some will take advantage of the changing social landscape and grow stronger. The great thing about being an investor at this time, especially one with the resources and cash to take advantage of the changes, is you can tailor your portfolio to meet the times, except of course for those investors wedded only to investing in pre-set indices like the S&P 500, which up to now has been a decent proxy for stocks as a whole, but now contains a host of companies that will be severely challenged by changing circumstances. The question is why buy an index of stocks that undoubtedly contains many that simply are not built for this unique period. The answer is that you do not have to. Index investing may no longer be the safe or prudent thing to do for investors with meaningful assets and a chance to diversify among industries not facing difficult longer term challenges.
Arrival Capital continues its search for undervalued investments that can be placed in diversified client portfolios that can stand the test of even the most trying times. What's more, we try to know the person or people behind every portfolio to see where they are in their own lives and let those circumstances help dictate the types of investments and overall risk that is appropriate. We continue to be the eyes and ears for our clients in the financial world, investing for the long term but knowing as well the short-term pitfalls and tensions we all confront in today's challenging world. Stay well!