Holding our nerve is perhaps the most important element of investing at the moment. It doesn’t mean we don’t recognise new risks and incorporate them into our decisions; rather, it’s about being aware of the emotions running through us and the distortions this causes both in our perception and our judgement. In the ground rules set out in the 2018 Annual Letter, I highlighted the need to hold our nerve:

Investing in stocks will almost certainly be an emotional rollercoaster. Many people lose their nerve when prices fall, leading them to sell out just at the wrong time. If you feel you aren’t able to stay the course, then it might be better to part ways now.

As I’ll explain below, the risk of a recession has increased substantially. If this comes to pass, there is a high chance of significant share price declines. The last two downturns saw the S&P 500 halve, with many stocks falling even more. In such times it is very important to stay grounded, always anchoring ourselves in our expected future cashflows of the businesses we have invested in, and not reacting to share price volatility.

Before exploring the implications of COVID-19 any further, let us take a moment to consider those who have lost their lives, the impact this has had on their loved ones and those who have bravely risked their own lives helping others.

Where We Are Today

Developments of the spread of COVID-19 and the economic implications are moving quickly. I’m focused on gathering and analysing the data, reviewing the research, staying in tune with consumer and business sentiment through the news, continuously recalibrating my view accordingly. Here is a window to what I’m seeing at the moment.

It seems that a large gap has appeared between the risk of dying from the virus and our collective fear of it. In fact, it is very likely that our fear will cause more harm to society than the virus itself. Closure of this gap is not so easy, as:

• governments are focused on containment, so their actions continuously signal there is something to be afraid of, even though they may have concluded the overall health risk is not catastrophic.

• social media algorithms serve us what we are most interested in consuming. Due to evolutionary reasons we are more attentive to potential threats than the news that things are not so bad, so our perception is being shaped by fear-fueling content.

• fiscal and monetary policy stimulus do not directly address the fundamental source of our collective anxiety, the virus.

In the end, the gap between our fear and the actual risk will close – the key question is how long this will take and what economic damage will result.

The Economic Impact

The immediate economic impact is the disruption in activity caused by:

• containment measures set up by the government, such as travel restrictions.

• consumer confidence sharply declining, leading to a contraction of discretionary purchases and perceived high-risk activities where human contact is essential.

• business activity falling due to the above two factors, with second order effects such as supply chain disruption.

• financial conditions tightening, which increases the chance of company failures.

These effects are temporary in nature, and will subside when the virus is contained or has run through the entire society. During this process there will be significant pressure on many sections of the economy, resulting in many failures.

Following on from this scenario, there is a risk our fear of the virus shifts to (or is accentuated by) that of an economic downturn. We are particularly sensitive to the risk of losing our jobs. Our behavioural shift can then feed into softening business activity and financial conditions tightening. The longer this goes on, the greater the chance of a recession.

Should a recession come to pass, we should remember the economy will eventually recover, as it always has, perhaps with a new strain of seasonal flu and its associated deaths, which we’ll have to accept.

Risks

It’s important to remember that we are looking to achieve our returns from the operating activities of the businesses we invest in, not changes in their share prices. From this perspective, there are two risks we need to consider: balance sheet pressures due to market disruption and/or a recessed environment; lower business value due to a permanently lower cash flow profile.

Looking through each of our businesses, we have little exposure to balance sheet pressures. For some time now, we have been mitigating the risk of a US recession when making investment decisions by avoiding such businesses. The company with the greatest balance sheet risk in the portfolio is Tesla. It is cyclical (sells new cars), has both operating and financial leverage, and is susceptible to supply chain disruption. In early March, I reduced our allocation to Tesla and spread the proceeds across a number of our other holdings.

As you would appreciate, the vast majority of the value of our businesses are in the cash they produce beyond the next two years (the typical duration of a recession). In fact, this is typically well over ninety percent of the value of each business we own. So, near term disruption to the cashflows through a recession will have a minimal impact on our investment return – even though share price movements may temporarily indicate otherwise. The risk here is that when the economy recovers, the company sales won’t revert to the pre-recession levels. Looking at the implied assumptions of each of our businesses, I don’t expect this to be the case.

A point worth mentioning is that the market risk-free rate has taken another leg down, with the Australian 10 year bond rate currently trading around 0.7%. If sustained, this may outweigh the negative valuation impact of a recession for the companies we own.

Opportunities

Recessions are typically preceded by large market corrections. When this happens, the cash flows implied in share prices can become extraordinarily conservative. If we are fully invested, we might not be able to take advantage of such opportunities, since we would need to sell existing holdings (also at depressed prices) to fund in new ones. This is the primary reason for allocating a quarter of the portfolio to cash.

While COVID-19 has increased the risk of a recession, this is by no means a certainty. We could have a reasonably quick resolution if we find a vaccine, or a test that detects the virus early that’s easy to administer, or consumers and business confidence returns following the initial panic, or for other reasons. And so, at this time, my judgement is ~25% is an appropriate level of cash to hold to take advantage of a possible downturn.

Conclusion

A recession and the accompanying share market correction is likely to create fear within most investors, including ourselves. It is important during this time to ground ourselves in the cash flows our businesses are expected to produce through the cycle. A correction provides us an opportunity to purchase businesses at exceptionally attractive prices. Knowing this, we can navigate financial market turbulence with confidence.

Before finishing this note, I’d like to thank those investment partners who have been helping with this research. I do hope we are able to find a quick resolution. In the meantime, please take a moment to keep those suffering in this difficult time in mind.