Valuation Does Matter . . . in the Long Run

Markets continue to be disrupted by the news flow surrounding the COVID-19 outbreak. As a result, stock prices in particular have fallen dramatically, now down more than 35% from their peak just a month or so ago. During this period, the value of a company becomes irrelevant. Price is set by the desire an investor has for liquidity. When they want to get liquid, they don’t care about price. However, value does matter.

A company’s ability to make it through this economic downturn and malaise is important as well. Many companies were reporting record cash levels and near record profit margins just a quarter ago. That suggests that these companies are well run and have the balance sheets to get through this downturn. Good companies remain good companies. They will see a reduction in revenue and earnings for sure. That doesn’t mean they won’t look to take advantage of this downturn by solidifying customer relationships and perhaps even buying capacity where it becomes available.

Microsoft is a good example. The price of MSFT has declined by 25%. Last year they generated $52 billion in free cash flow. They’ll generate less this year. Their cloud computing services will continue to grow as a result of more being done online. Their Xbox gaming system will rack up more revenue as a result of many people staying home for a prolonged period. They will earn less this year than they did last. That doesn’t mean they won’t continue to be a good company whose free cash flow generation will assist them in weathering this temporary downturn. I don’t want to sell it for what anyone is willing to pay me, I want to sell it for what it’s worth.

The news flow will likely remain negative and get worse as the number of cases in the U.S. climbs and the population takes perhaps longer than it should to grapple with staying home and practicing social distancing to reduce the infection rate.

As a result, investors will continue to indiscriminately sell their assets looking for cash as the only safe haven. There are many examples of this. In the last week, the municipal bond market has been challenged by indiscriminate selling, causing yields on individual investment-grade bonds to rise dramatically. Even yesterday, the Federal Reserve put a facility in place to help money market funds raise cash for investors.

Financial plans should have incorporated the need for liquidity before the outbreak. If they did, then the value of the portfolio today shouldn’t be used to raise more cash when we know the price of securities only reflects investors’ desire to sell at any price. That is, unless your need for liquidity has changed due to a decline in business or increase in expenses resulting from the crisis.

Rather, look at your allocation to equity overall and determine if it is still structured to achieve long-term goals. There is no better time to evaluate your risk tolerance than during a period of extreme risk. If you determine it isn't, then discussing a change with your advisor makes sense, and planning for how that change comes about is wise.

Be well, listen to those most informed about the virus and the outbreak, and talk to us. We are here to listen and help you plan through this time.

ABOUT THE AUTHOR

Brian Andrew

Chief Investment Officer | Johnson Financial Group

As Chief Investment Officer, Brian Andrew leads Johnson Financial Group's investment strategy to provide consistent, actionable investment solutions for our clients.