Coronavirus fears have swept through markets recently, as concerns about its potential global impact have rapidly accelerated from “This will be bad for China for a while” to “How many weeks of food should our family have on hand?” In the face of this anxiety, we want to explain how we’re factoring in the possible significance of this virus on the value of your investments.
At Harris Associates, we buy stocks at substantial discounts to our estimates of their intrinsic value, taking the perspective of being the sole owner of a private business. We estimate these intrinsic values by forecasting future cash flows and discounting them to today. The S&P 500 trades at a 2020 GAAP P/E ratio of around 23-24x today, which, converting earnings to cash flow, means the typical company will generate 4%-5% of its current market cap in 2020 cash. Mathematically, most of the total value of a growing company comes from the aggregate cash it will generate in the years 2023-2050 and beyond.
If 2020 cash flows for the entire market dropped all the way to zero, the aggregate value of the market should only fall by 4%-5%. Therefore, we believe the proper question to ask when analyzing the coronavirus (or any emerging macro risk) is “How much will this affect the long-term cash flows of businesses?” I doubt very much that the owner of a thriving family business would accept a dramatically reduced offer for her entire company today versus two months ago simply because of virus fears.
While we can’t answer that long-term cash flow question with certainty, we can look back at prior “epidemic” fears to see the impact they had over time. SARS, bird flu, Ebola, and the West Nile virus are all examples of exogenous medical emergencies that the market faced the past two decades. In all cases, world economies adjusted to the threats without seeing significant impacts to long-term cash flows. In all four of those cases, the S&P 500 index exceeded its pre-outbreak high within two months of the initial concerns.
But it’s not just epidemics…it’s always something. In Bill Nygren’s third-quarter market commentary of 2016, when he discussed the Oakmark Fund’s 25th anniversary, he cited a litany of frightening events that occurred over that preceding quarter century (including the aforementioned epidemics, Desert Storm, 9/11, the global financial crisis, Brexit, etc.). Despite all of these risks, the S&P 500 increased nine-fold over that time frame.
As with those other nerve-wracking crises (each uniquely different from each other), no one knows how this particular issue will develop. There isn’t enough data today to reach specific conclusions. But you should know that at Harris Associates, our framework for dealing with exogenous risks like this is to attempt to determine the impact on business value rather than extrapolate near-term costs in perpetuity.
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The S&P 500 Total Return Index is a float-adjusted, capitalization-weighted index of 500 U.S. large-capitalization stocks representing all major industries. It is a widely recognized index of broad, U.S. equity market performance. Returns reflect the reinvestment of dividends. This index is unmanaged and investors cannot invest directly in this index.
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