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CIO update: Avoid overpaying for growth

One month ago, I outlined several possible stock market recovery paths following the coronavirus crisis. Such scenario analyses are widely used as a strategic tool to guide tactical responses. These "what-if" analyses can be useful to determine what actions to take if a certain set of assumptions are fulfilled. We think through alternative actions and prepare ourselves in order to act quickly as the situation evolves. Being prepared eliminates the dependence on luck – although being lucky is always an advantage.

Scenarios for a sustainable recovery

In mid-April, we outlined the following potential scenarios for a sustainable recovery:

  1. The virus will be under control by summer and we will see a gradual return to normality. The stock market should continue to rise from here and the recovery will be V-shaped.
  2. The virus will be under control by summer, but a second wave will come in the autumn. The stock market will correct downwards again, and the recovery may then be W-shaped.
  3. We will not see a sustained recovery until a proven vaccine is developed, possibly in the first half of 2021. We will see a prolonged downturn and serious recession with the recovery looking more U-shaped.

A strong recovery since the beginning of April suggested, at the time, that we were in scenario 1. However, recent comments from both the Federal Reserve and International Monetary Fund (IMF) concerning the worsening development of the global economy have increased the likelihood that what we have been through was nothing more than a bear market rally. They also indicate that the increasing disparity between "Main Street" and "Wall Street" will most probably lead to a more muted "Wall Street" than a more vibrant "Main Street" in the near future.

A market rife with opportunities

If, then, scenario 2 appears more likely, this is an opportune moment to remind ourselves of what it means to be an active value manager.

The majority of academic research defines value according to quantitative metrics. Value stocks are then classified as those companies with the lowest ranking on metrics such as price/book (P/B) or price/earnings (P/E). A basket of value stocks thus defined can easily and cheaply be accessed through an ETF.

The major flaw with this approach is a tendency to distinguish growth and quality from value. For an active investor like SKAGEN, value investing entails considering quality, growth and value in our overall assessment of intrinsic value. SKAGEN will not invest in a stock that is optically cheap if the managers believe the quality of the company presents disproportionate downside risk relative to the current market price. Likewise, SKAGEN's managers may assign a higher value to a company with a more predictable earnings profile, or potential for structural (not speculative) growth.

The point is not to avoid growth, but rather to avoid overpaying for growth. Lately we have seen that markets are being held up by a small number of very large growth stocks. This is especially the case within the technology sector, exemplified by the tech heavy NASDAQ index which has largely remained unscathed by the movements in other global markets indices.

By taking a prudent and pragmatic approach to value, we see that today's volatile markets are rife with opportunities.

Looking beyond the pandemic

Returning to the scenarios, if we are indeed heading into scenario 2, a recession is likely throughout 2020. Our focus then is to manage our portfolios according to the above-mentioned scenario while increasingly starting to look beyond the pandemic to seek out the increasing number of opportunities in a world that will look profoundly different than before.

In searching for opportunities, there are some changed circumstances that we will need to reflect on and be prepared for:

Private sector

We will be more mindful of going to big events. We will be eating more at home and our eating habits may change – in Norway we have already seen an increase in milk consumption for the first time in years. We will be spending more time with family, watching Netflix, playing digital games as well as board games, ordering online, and working from home, which may reverse the flow of people from cities to the countryside. We will be much more focused on hygiene, and have new habits of hand washing, coughing and greeting.

Business

Operators of hotels, conferencing facilities and airlines face huge challenges due to fewer customers and the need to adjust to more social distancing, and as a result, their prices will need to go up. Sports, leisure and concert operators face challenges with customers moving online and becoming fewer. More mindful of hygiene and social distancing, there will be more people working from home.

Governments

There will be more government involvement, higher taxes, less privacy, battles with income inequality, the use of artificial intelligence, especially within healthcare, and mental health issues may need to be addressed. There will be a focus on climate change and a "Green Deal" to help overcome the crisis. Within education, governments will have to look into how to arrange for exams and degrees.

Global issues

Income inequality, more nationalism and protectionism and international cooperation.

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Historical returns are no guarantee for future returns. Future returns will depend, inter alia, on market developments, the fund manager's skill, the fund's risk profile and management fees. The return may become negative as a result of negative price developments.