Time and time again, it’s proven that investors are best served ignoring media noise and remain focused upon their long term plans.
Sage advice indeed. It is also human nature to be inquisitive and understand what is going on around us.
In an effort to provide a fundamental understanding of what is occurring with the markets and a perspective of where things may lay in the near future, I’ve provided some personal insights for you that I hope you consider worthwhile reading.
The key point I would like to make is that the market is likely to get wild, most likely in both directions for the forthcoming weeks that lay ahead.
Industry Impacts of the Coronavirus
Last week I passed through Brisbane Airport where the airport staff outnumbered the volume of passengers quite considerably.
The Qantas plane was about 60% full, and the flight crew advised that the route is typically at capacity almost every day, however the coronavirus is deterring travel plans for many.
For airlines, hotels, cruise operators and many more associated industries, the impact of these falls in revenue will be significant.
Further muddying the waters for businesses, there is no immediate end in sight to curtail the virus.
What Does This Have To Do With Your Superannuation Investments?
The sharemarket simply is a pooling of buyers and sellers of shares.
These shares represent ownership of companies such as Qantas, etc.
When you buy a share of a business, you are purchasing a proportionate share of the companies earnings and profitability.
This fundamentally will drive the value of the business (and the increase in price of your shares) over the long term.
Short term, the price of those shares will rise and fall by a variety of factors.
Ultimately, the day-to-day price at any given time is reliant upon the appetite of buyers (demand) and sellers (supply).
The increase of demand may see prices rise.
In contrast, a higher volume of sellers may see prices fall.
Over the past week, we have seen significant price falls in the Australian and global markets followed by sharp spikes both up and down this week.
These moves highlight how ‘new information’ can influence the prediction of future earnings for businesses, and the company’s value therefore goes up and down.
Hypothetical Business Case Study
For many, the sharemarket seems a complex and suspicious structure.
To gain a better understanding, I’d like to provide a basic scenario to illustrate key points of what influences a business value, and what that means for investors.
Let’s say you’d like to buy a local hamburger fast food franchise in the local area.
This fictitious store may have gross revenue of say $2 million with expenses of $1.5 million.
That leaves a profit of $500,000.
There are many ways to value a business but for this example we will use a Price to Earnings (Profit) ratio. We will assume that the average sale of fast food restaurants is a P/E Ratio of 15.
In essence, this means that the valuation of these stores is equal to 15 years of future profit.
For our example, the Valuation of the franchise store is $7.5 million (ie. $500,000 X 15).
If you have 99 other friends and family equally investing in the store, then with 100 owners, you would all have 75,000 shares each valued at $1 (ie. $7.5 million divided by 100 owners).
2019 Value of Your Business
In 2019, the earnings (profit) of your business has been a little up and down which meant the potential value of each share (theoretically if you were to sell your shares) went up and down slightly on a daily basis as well.
The good news is that your profit has been on track as forecast and therefore value of each share remains around the $1 mark and the business valuation remains around that $7.5m purchase price.
The coronavirus results in the government announcing measures that mean less social interaction and consumers start to eat at home more, rather than dining out.
Your sales start to drop, along with your profits. The value of your business falls, as the earnings are now less.
You had assumed 8,333 customers each month spending $20 (equals $2m in sales) however this societal change has meant that for February and March there have only been 5,600 customers each month.
They still spend $20 each, however the sales now amount to $112,000 per month rather than the target $160,000 per month.
Your master franchisor updates the ‘market value’ of all the franchise stores every day via morning emails.
Unfortunately for you, it’s just like the sharemarket noise you watch on the morning news.
You are forced to see the value of your shares rise and fall incessantly.
Today though based upon:
(a) a fall in sales of 30% and
(b) forecast fall in net profit from $500,000 down to $350,000
(c) The value of your business drops from $7.5m down to $5.25m ($350k x 15 P/E)
What does that mean for your shares?
1 – You bought the shares for $1 (ie. $7.5m business value)
2 – They are now valued at 70 cents each (ie. $5.25m business value).
Good News – Lower Interest Rates
The past week we saw the Reserve Bank reduce interest rates.
This should mean your customers will have more money as their monthly home loan repayments went down (eg. car loans, credit card debts, etc).
The benefit is that your customers could potentially spend more than the average $20 spend in future weeks which may boost the profit of your business back up.
Just like we see in the sharemarket, investors may see the potential increase in profits for your business and the price of each share rises (even though it may not have occurred just yet).
Bad News – Product Supply Issues
The franchisor requires products to be purchased from particular manufacturers.
Those manufacturers provide attractive discounts due to the scale of the franchise, but they’re located in China.
Paper cups for drinks, packaging for hamburgers and other tableware are now behind in production in China due to the virus.
This means that your sales may be impacted as you cannot supply the products to your customers.
Investors would therefore analyse and forecast the potential drop in revenue and profitability of your business.
The balance of the good news from the interest rate potential to boost each sale, less the impact of lower product availability would be assessed.
Buyers and Sellers of shares in your business would then trade their shares on prices that are based upon their estimates of the future earnings of your business
This is just one business.
There are 2,185 companies listed on the Australian Stockmarket (ASX).
With so many enterprises across so many industries, it is easy to see why markets move up and down so much in one day as analysts forecast future earnings of these companies.
The coronavirus is therefore likely to have an ongoing impact upon valuations companies listed on the sharemarket for some time to come.
My expectation is that we will see markets rise and fall for some time to come as analysts and investors extrapolate what the potential impact the coronavirus will have upon businesses worldwide.
Biggest News Yet To Come
The USA has a population of more than 320 million people and is the world’s largest economy.
Yet, the country has very few recorded cases of coronavirus. Speaking with a number of Florida locals, they have held the view that the country is low risk and have nothing to fear.
The maths and logic just doesn’t add up given the diversity of the population and sheer size.
This week, we have seen via social media a number of stories arise whereby US Citizens have sought testing for the virus and been turned away.
Recently, the media reported that many of the first batch of test kits seemed to be faulty.
As a result, the number of US citizens that have been tested is incredibly low as shown in the table below:
Predicting the Short Term
The fact that the majority of the American population is yet to measured, it is unknown at what scale the virus is upon the country.
This is crucial information given the USA is the largest economy in the world and represents 43% of the global sharemarket.
In the past couple of days we have seen health experts advise that new test kits have been ordered. However this is likely to have a timeframe of weeks, if not months, before we have clarity as to the impact of the virus in the USA.
If the virus penetration into the country is low, then this will definitely provide positive market sentiment and we may see prices rise.
Conversely, if there is a high rate of virus detected with no vaccine available in the short term, business revenues will be expected to decline and sharemarket prices may fall.
Given the lack of information and delayed handling of the situation in the US, it is impossible to predict whether there will be good news or bad news in coming weeks.
Long Term View
If we go back to the local franchise hamburger store, you bought the business to build your wealth via capital appreciation of the business growth.
It will also provide an income stream via ongoing dividends.
With a marketing plan to boost customers visiting your store, ideas to offer additional products and continued growth of the local population means you are very confident that over the long term the business will do very well, and profits will increase.
This will result in a business value that will be much more than what you originally bought it for.
This form of reasoning applies just the same for your portfolio of money that is invested into the sharemarket.
Short term, these are unfortunate circumstances that are concerning to many.
For many companies their earnings are expected to fall due to the impact of the virus.
Future earnings are likely to be lower.
This means the value of the business (ie. the sharemarket price) will be lower.
Taking the positive perspective, should there be a breakthrough for the virus containment or eradication, then those factors will be removed, and we may see business valuations spike upwards very quickly.
Where do we go from here?
The below chart provides a variety of reasons over the past 10+ years where investors had a choice to sell out of their sharemarket investments:
There is one important perspective of this image.
Take a look at the ‘big picture’ first rather than reading the small text.
Over the 10+ years the sharemarket trends upwards at approximately 45 degrees.
Each high of the sharemarket is exceeded by the next one.
We don’t know when that next high will occur, but history tells us that it is common for external factors to impact the value of businesses and the sharemarket falls accordingly.
For investors that stay in their seat, they are rewarded by capturing attractive rates of returns on their invested money that the sharemarket provides over the long term.
As one of the world’s greatest investors of all time, Mr Warren Buffett remarks:
“We don’t have to be smarter than the rest.
We have to be more disciplined than the rest.”