Even After Covid-19 The Market Is Not Cheap

From January 31, 2020 through March 31, 2020 the market as measured by the S&P 500 fell approximately 20%. As a result, I published an article on March 26, 2020 titled “It’s A Buyers’ Market – Choose Quality If You’re Scared: 20 A-Rated, Low-Debt Blue Chips To Consider” where I implied that the market as measured by the S&P 500 had gone from being overvalued to undervalued.

Based on the facts available to me at that time, I feel that my assumptions were correct as stated. The following FAST Graph on the S&P 500 as of March 23, 2020 supported that view. Note that earnings were forecast to grow 7% in 2020 followed by an additional 12% by 2021.

However, as time has passed analysts have had the opportunity to assess the Covid-19 potential damage to the S&P 500’s earnings. Current estimates call for earnings to drop 19% for 2020, followed by a 27% increase for 2021, and finally an additional 13% increase for 2022. Although the forecast past 2020 suggests a strong recovery, earnings still do not get back to what the forecasts were prior to Covid–19. Consequently, because of this updated forecast, I no longer believe the S&P 500 is currently undervalued. Instead, I would argue that based on fundamental value, the market is fully valued to slightly overvalued today as evidenced by the following graphic.

I Reject the “New Normal” Theory Instead See the “New Temporary”

The mainstream media seems to love to scare us with provocative headlines and scary sounding buzzwords. As the economy begins to slowly open again, the media is bombarding us with opinions and scary buzzwords such as the so-called “new normal.” Just Google the term and you will see numerous articles with headlines predicting how our lives will be permanently changed because of this virus.

Personally, I reject that concept and instead prefer my own buzzword the “New Temporary.” To be clear, I do expect to see continuing long-term behavioral changes associated with the social distancing guidelines we have been faced with since the crisis emerged. Instead, I believe that for the most part, behavioral changes will be temporary.

Therefore, I do see a time when we return to eating in restaurants, shopping at our malls, attending sporting events – and simply getting back to living our lives.

Of course, there will be behavioral changes and adaptations that people will make. However, that is nothing new. Evolutionary human behavioral changes are in fact normal and not new.

I simply point to how my life was as a child compared to the lives of my children, and now my grandchildren currently are. I did not have cell phones, social media and all the other technological advances that kids today have. In other words, change is both inevitable, ongoing, and normal. Therefore, rather than fear change, I think it makes more sense to embrace it and expect it as our natural evolutionary due course.

Although I majored in economics, I also received a minor in psychology. To my way of thinking, economics and psychological behavior are joined at the hip so to speak. Economic activity is functionally related to people satisfying their basic desires and needs. The most famous description of those needs was taught in my psychology courses as Maslow’s hierarchy of needs.

Abraham Maslow was a psychologist who in 1943 created his now famous hierarchy of needs. In summary, mankind fulfilled their innate human needs in a priority which culminated in self-actualization. First came our most basic needs that Abraham Maslow described as physiological needs. These included food, clothing, and shelter. Once these needs are fulfilled, then humankind moves up the pyramid to psychological needs, and from there to self-fulfillment needs. These are summarized in his famous pyramid below:

Maslow’s Hierarchy Of Needs Pyramid

Maslow suggested that people’s primary motivation came from the desire for attempting to fulfill their 5 basic needs, which he described as physiological, safety, social, esteem and self-actualization. Maslow believed that these needs created desires and internal pressures that influence human behavior. Personally, I believe that people will inevitably move back into posturing to fulfill not only their needs, but also their desires. As Maslow pointed out, we are social animals and we need that socialization desperately to consider our lives fulfilled.

I would not be presumptuous enough to try to predict when this will happen, only that it inevitably will. Therefore, I see a day in the near future where people will once again be attending religious services, sporting events, concerts, going to the movies, dining in restaurants, going to the hair salon – and all the other myriad activities that people have traditionally engaged in. I believe we are social animals, and that our innate spirits are stronger than any virus. Moreover, I believe that the needs at the base of the hierarchy pyramid are always given the highest priority. However, once those basic needs are met, the social, esteem and self-actualization needs and desires are also powerful forces that motivate and influence our human behavior.

The Crisis Created A Different Kind Of Value

Despite the Covid-19 crisis, it is still a market of stocks and not a stock market. Although I believe this is always important to recognize, I believe it is especially important during this crisis. Although most every stock had its price affected by the crisis, not all stocks have become undervalued or even fairly valued as a result. In other words, there are still a lot of significantly overvalued stocks. Nevertheless, a lot of value was created due to the virus, however, as I will explain, it is a different kind of value.

The reason it is a different kind of value is because there were several sectors that greatly impacted many businesses, but at no fault of the companies or the management teams. In other words, their earnings, cash flows and revenues, etc. were literally shut down and off by governmental mandate. Therefore, the precipitous drop in stock price was accompanied by a mostly undeserved short to intermediate term collapsing of fundamentals.

With stock prices and earnings (fundamentals) and in certain cases dividends simultaneously falling in tandem, the present value of many stocks is currently justified. In other words, current value has not become undervalued because lower earnings (fundamentals) indicate a lower valuation. However, if you believe as I do, that since the current fundamental collapse has been artificially instigated and beyond the control of management, then it is also prudent and sensible to look past the near-term to intermediate-term and focus on the longer-term as businesses and the economy normalizes.

Therefore, this is the reason why I stated that we now have a different kind of value. As sensible and prudent investors, we must focus on future value and accept the reality that current value is artificially inflated due to lower earnings achievements that were beyond management’s control. Stated more directly, we must try to assess the true earnings power of the companies we are examining and look for those that we believe will return to their real normal innate earnings potential.

Additionally, recognizing that it is a market of stocks and not a stock market, we also want to look for companies that have continued to prosper despite Covid-19. And of course, there is everything in between. The economic crisis created by the virus has certainly devastated certain industries, but other industries have remained unaffected. In other words, not everything in the market has gone on sale.

Just a Few Real-Life Examples

What follows is just a small sampling of the few industries and a few stocks that have been hit especially hard because of the pandemic. I would produce hundreds of examples, but that would only be redundant.

Retail Has Been Especially Hard-Hit

As recently as February of this year, I produced a video on Carter’s Inc (CRI)., the retailer of children’s and baby clothing. A screenshot from the video on Carter’s Inc. looked quite promising at the time.

However, since that original video was produced, along came the virus and the forecast data changed dramatically – and in the blink of an eye. The real question is how temporary is temporary? Unfortunately, I believe it is premature to state with any confidence what that might be.

Restaurants Were Also Devastated

For example, Brinker international (EAT) (Chili’s restaurants) was forecast to grow between 8% and 11% prior to the breakout. The following custom forecast calculator shows what the consensus of leading analysts were predicting. Given the level of the company’s valuation, those numbers would have indicated a very attractive investment. As illustrated in the pop-up, if Brinker simply traded at a reasonable P/E ratio of 15, then investors would’ve stood to see their money triple by the end of their June fiscal year 2022.

However, because of the pandemic, Brinker’s consensus earnings estimates fell from $4.38 just 3 months ago to current consensus of only $1.14 for fiscal year 2020 ending in June. However, the company just reported third-quarter numbers with operating earnings for the 3rd quarter of $1.28, handily beating consensus by $0.76. Therefore, it is possible that consensus estimates for the full year might be adjusted upward once analysts have digested the results. Time will tell, and it will be interesting to see.

Regardless, here is what the long-term adjusted operating earnings and price correlated FAST Graph of Brinker’s looks like today. Note the strong expected recovery for 2021 and 2022. Perhaps the most critical question is whether (or not) and when the company might reinstate its suspended dividend.

Darden Restaurants, Inc.

Darden Restaurants (DRI) provides very similar results to what I showed with Brinker’s above. Once again, will people return to dining out, and if so – when? Will there be a new normal, or as I suspect a return to normal? This is uncharted waters and it will be very interesting and perhaps even enlightening to see how everything pans out.

The cruise industry: Carnival Cruise Lines

Even more dramatically than the restaurant industry, the cruise industry has been crushed. Carnival Cruise Lines (CCL) the largest based on passengers carried and total number of ships in their fleet is expected to lose $1 per share for fiscal year ending November 2020. However, the company has announced that they expect to begin offering cruises again in August. Therefore, like the restaurant industry, this is all about how they can recover going forward. This could be a great time to buy Carnival, but as previously stated, this is not traditional value investing. Instead it would be speculating on the turnaround.

To illustrate how devastating Covid-19 has been to Carnival Cruise Lines, the following is a screenshot from a video I produced on the company on July 23, 2019. As you can see, business was doing quite well, and expectations were very positive. Cruising had become the favorite vacation choice for people all over the world. Can they return to their pre-pandemic popularity?

Here is a screenshot of consensus earnings forecasts for Carnival on July 23, 2019. On the basis of those estimates, the stock looked extremely inexpensive.

This is what current estimates look like. Once again, it would take a lot of courage to invest in this company today. However, it can also be very profitable once everything settles down – maybe.

Medical Distributors: AmerisourceBergen

There are several industries that have held up extremely well throughout this crisis. The following screenshot on the leading medical distributor AmerisourceBergen (ABC) on January 29 of this year showed optimistic expectations going forward. Note the earnings-per-share estimates at the bottom of the graph.

Fast forward to today and expectations for AmerisourceBergen looks much the same as they did in January. However, a quick glance at the bottom of the graph shows that earnings expectations today for 2021 and 2022 are actually higher than they were in January. Interestingly, yesterday’s closing price was slightly lower. On the other hand, as of the time of this writing, the stock is once again trading at $89 per share, or approximately in line with what it was in January.

FAST Graphs Analyze Out Loud Video It’s A Market Of Stocks Even During This Pandemic

In the following FAST Graphs Analyze Out Loud Video I am going to provide additional detail and color on what I suggested in the written portion of this article. For brevity’s sake, I will be only be examining the companies in the video based on adjusted operating earnings (non GAAP). However, I think many will be surprised by what I have to show.

Summary and Conclusions

My primary purpose for writing this article was to encourage readers to not fall into what I call “general think” about the stock market or more precisely what is happening in the market today. If we are going to call this a recession, we must also acknowledge that it is like no other recession at least that I have ever experienced over my 5-decade career. This recession is not a result of economic weakness. Instead, it is a forced shut down by governments all over the world. If the virus and the associated so-called pandemic had not happened, the economy – especially here in United States – would look a lot different today than it does.

Moreover, because valuations were so extended on so many companies, even the severity of this correction did not bring them into prudent valuation levels. I do not think I have ever seen a recession where so many stocks remain as highly valued as they do today.

In closing, what we have today is clearly a market of stocks and not a stock market. Furthermore, it is also a stock picker’s market. There is a lot of value to be found, however, as previously stated, this is a different kind of value. The best kind of value is when fundamentals remain strong, and only price falls. In this case, perhaps the most opportunistic value will be found where both price and fundamentals have fallen in tandem. Consequently, most of today’s value represents turnaround situations. This is especially tricky considering that I never witnessed anything like it before. Live and learn. Caveat emptor.

— Chuck Carnevale

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Source: FAST Graphs