Asset Valuations Post Covid-19: Where Long-Term Investors Should Look For Opportunity
By Grant Schwartz
The US economy is in the midst of one of the most dynamic times in modern history. We have slowly begun to recover from one of the largest economic downturns since World War II with GDP declining 3.5 percent in 2020, administer millions of vaccinations, reopen businesses, and put $1.9 trillion of stimulus into the hands of millions of Americans. With all this change on the horizon, alternative asset managers and other long-term investors are faced with the question of where to allocate capital for outsized risk-adjusted returns.
While I agree with Warren Buffett that no one can predict the stock market — or any asset price — in the short term, for long term investors, taking advantage of permanent secular trends will prove to be critical in generating strong future returns. Covid-19 has dramatically changed how we engage and interact with the world around us, and those who can accurately predict where we are headed are poised to perform the best in the coming years. While it is important to note that a great investment relies on other factors such as attractive pricing, diligence, and assessment of management, identifying these secular trends is a necessary starting point.
When discussing where investors should be looking to allocate capital, it is necessary to understand the current macroeconomic conditions we are facing. Going forward, economists predict that U.S. GDP will bounce back considerably from Covid-19 in 2021. According to the Federal Open Market Committee, U.S. GDP is expected to increase by 6.5 percent in 2021, with personal savings still at incredibly high levels at 13.6 percent as of February 2020. This is likely due to a myriad of factors such as several incredibly accommodating stimulus packages and pent up demand for activities such as traveling, eating out at restaurants, and other types of leisure.
The 10-year treasury has also been a topic of discussion among many investors. As the economy has begun to open up, demand for the 10-year treasury — which is generally viewed as the risk-free rate since the debt is backed by the US government — has gone down, which leads to lower prices and a higher yields. This makes sense as investors are not flocking to safety anymore as Covid-19 slowly wanes into the backdrop of our lives. This means that as investors are more optimistic about a strong recovery, people choose to allocate capital to other assets over the 10-year treasury.
The other necessary component to understanding where capital should be allocated is a high-level understanding of how to value assets. According to conventional theory in corporate finance, the value of a company is simply the present value of future cash flows discounted back to the present at the cost of capital. Therefore, when looking at valuations, there are two important things to consider: 1) the cash flows of companies and 2) the discount rate of those cash flows. For cashflows of companies going forward, there appears to be enormous growth on the horizon as the economy opens up: people are eager to consume and as a result, businesses in aggregate are expected to perform quite well. The second component of valuation refers to the discount rate or the cost of capital. Simply put, the cost of capital refers to a company’s cost of funding a project (both debt and equity) or the required rate of return demanded to conduct a project.
So far this year, the 10-year treasury has risen from less than 1 percent at the start of 2021 to its current rate of 1.62 percent. As the 10-year treasury begins to increase, the required rate of return demanded by investors increases as well since investors need to be compensated for any additional risk they take above the risk-free rate. While still low by historical standards, an increase in the risk-free rate does raise the cost of capital and thus, leads to lower asset valuations. While investors should for the most part expect strong cash flows to outpace the slight increase in the cost of capital, the main impact is on high-growth companies whereas the effect on slow-growth, value stocks will be minimal. This is due to the fact that higher interest rates cause the value of cash flows that are years or even decades away to be worth much less when they are discounted back to the present. For high growth companies that expect earnings to occur at a point in the distant future, a higher discount rate will result in a larger decrease in valuations compared to more value oriented businesses where cash flows are closer to the present.
Secular vs. Cyclical Trends
With the groundwork laid down, prudent investors can expect positive long-term results if they understand which sectors are likely to experience strong tailwinds. While the macroeconomic conditions are seemingly favorable, some sectors are better positioned to outperform than others. To identify what sectors are poised to do well, it is necessary to discern the difference between cyclical and secular. By cyclical, I mean sectors that have done well because of Covid-19 but are unlikely to have continued success as we emerge from the pandemic. An example of this might be home cooking versus eating out at restaurants. Over the past thirty years, restaurant sales volume has increased steadily before falling sharply during the pandemic. However, investors such as Jon Gray, The President and COO of The Blackstone Group, which is the world’s largest Alternative Asset Manager, believe that trends related to home cooking will be short lived as people begin to feel comfortable eating out at restaurants again. We have already seen this play out since according to the US Census Bureau, restaurant sales are up 13.4 percent on a seasonal adjusted basis rising from $54.8 billion in February to $62.2 billion in March. This is while the same data set from the US Census Bureau showed that U.S. Grocery store sales fell by 13.8 percent in March of 2021. Other sectors may also be prone to this one-off increase in sales due to Covid-19 but begin to slow as the economy opens up. Such sectors may include businesses that are benefitting from home improvement projects and even snacking, which has surged as the pandemic has increased peoples’ time at home and fears around food procurement. As an investor, identifying and avoiding these short term trends is critical as the future prospects of these sectors look far less promising than secular shifts in demand.
So what are these secular shifts? Covid-19 has accelerated a myriad of trends particularly in the technology space as more companies adopt enterprise software technologies and consumers become increasingly more reliant on e-commerce. According to a McKinsey Insights report in October of 2020, the share of digital or digitally enabled products has accelerated by a shocking seven years—meaning that after looking at past survey results for the average degree of digital adoption per year, the 2020 results greatly exceed the trendline for the predicted average rate of digital adoption for 2020 to what would be expected in seven years. Respondents also expect most of these changes to be long lasting and that businesses are already making the kinds of investments that ensure they will stick. Other trends include streaming, where platforms like Disney+ added millions of new subscribers, and a study from Full Search Research Co. reported that 70 percent of consumers would now rather watch a movie at home even if movie theaters were completely open. With increased technology adoption, data like these show sectors where shifts are permanent and present opportunities for investors.
Besides technology, there are many other secular shifts. While travel for work may take some time to recover as companies learn how much travel is necessary and how much can be done through platforms like Zoom, there is a lot of pent up demand for destination travel. According to a survey from The TravelPulse, a leading publication for travel news, 65 percent of respondents said that they plan on traveling more than they did pre-Covid-19, 33 percent are willing to spend more on travel than they traditionally would, and 54 percent said they are more likely to take their bucket-list trip this year than ever before. While demand for travel may not be this high forever, travel was the second fastest growing sector prior to Covid-19 and will likely continue where it left off in the coming years.
While there are undoubtedly other sectors that may experience outsized growth in the coming months, investors should use these examples of secular trends to look for growth. While identifying these trends is not exhaustive when making a good investment, it is a necessary starting point in an investor’s search for opportunities.