Investing Lessons Learned from COVID - Part 1
Updated: Jun 9, 2020
From investing gurus to the teenager that recently bought their first stock, the COVID-19 pandemic has taught everyone new lessons when it comes to financial markets.
For beginner investors new to the game, we've compiled the few most significant lessons to be learned from the coronavirus below:
1. Quality Stocks are Key
Mohamed El-Erian – Chief Economic Advisor at Allianz – articulated the importance of quality investments for those who do not want to stay out of the markets in such volatile periods. This refers to businesses with a sustained level of profitability, cash flow and asset holdings: i.e. those who will likely survive despite the economic impacts of COVID-19.
The move to quality is critical for those who are holding high-risk positions (oil, companies with low cash flow, major debt levels), as such businesses are most susceptible to bankruptcy amid an economic standstill. Here, investors can re-allocate their focus to more reliable, "quality" stocks, all of whom will generally boast the following characteristics:
In the Income Statement: At the most basic level, Net Profit consistently above 10% indicates reliability and sophistication with managing capital. This figure may alter by industry, but positive profitability over time generally implies long-term fundamental strength, which is what investors should be looking for. Consider Disney's exemplary performance below:
Figure 1: Disney's constant stream of profitability (green line)
Source: (Simply Wall Street, 2020)
In the Cash Flow Statement: Focus on Free Cash Flow – this needs to be positive in order to ensure that the business has cash left over to protect themselves after paying off debt and other expenses. Some notable examples include General Electric, Apple, and others shown below:
Figure 2: Top 5 Companies in terms of Free Cash Flow
Source: (Seeking Alpha, 2020)
In the Balance Sheet: Assets. Assets. Assets. Does the business have enough assets to cover their liabilities or are we looking at a company that may face a liquidity crisis later on?
Generally, blue-chip stocks such as Microsoft, JPMorgan, Disney, GE etc. will meet the aforementioned criteria and therefore limit the risk assumed by investors.
Key Point: Whilst investing in such blue-chip business may lower one’s risk, it does not guarantee that the stocks won’t fall further: i.e. we can still expect a drop in stock prices if the market conditions worsen. However, the merit here is that blue-chip stocks will drop far less than others and rise far quicker afterwards, and that is why they are considered quality investments in such times of uncertainty.
2. Fundamentals Out, Technicals In.
With the unprecedented levels of volatility in the Feb-March period, fundamental analysis proves to be almost futile. This is because such analysis is mostly based on economic circumstances – both micro and macro – but panic-selling across markets (as we are experiencing now) will rarely allow for such fundamentals to make sense.
An example to consider is Microsoft Inc. - how would the effects of COVID-19 affect Microsoft? Aside from employees not being able to meet in person as well as some minor supply chain issues, it's unlikely that this business will be drastically affected. Despite boasting unquestionable fundamentals, MFST’s stock price still suffered a drop of over 30% last month.
This emphasizes the fact that frenetic selling in the market (as a result of panic/low investor confidence) will not allow fundamentals to come through in the short-term…and here is where technicals come in.
Essentially, this means that investors who a) are unfamiliar with technical indicators or b) prefer not to use them, should stay out of the market and remain in cash – unless the focus is on buying "quality" stocks as mentioned before.
3. Power of Momentum
Given how quickly the market has recently swung, understanding the direction of momentum in the market is substantial for both short and long-term investors.
In the short-term particularly, momentum of the market needs to be taken into account when making decisions as conventional thinking may not always work.
This is why the March 24th-26th period was especially discomforting for the investing community worldwide. The 24th posted an unusually large gain of 9.4% in the US market, which – given the poor economic sentiment – would've prompted investors to believe that the next day would be negative.
Figure 3: Market performance during March 24th - April 7th
Source: (CNBC, 2020)
While most investors followed this course of thinking, a minority understood that after such a large one-day rise, the short-term momentum of the market is more upwards than downwards. This is why the next 2 days of the week were followed by further gains, and why those who began to sell - assuming that the market would drop after one day of rising - would've been perniciously affected.
Momentum in either direction can occur for a variety of reasons - government action, market fundamentals, algorithmic trading - but understanding that it can repeatedly contrast conventional thinking is precisely how investors will be able to make more holistic decisions during future periods of volatility.
So, given these lessons…What should beginner investors do now?
Depending upon your investing preferences, there are 2 particular routes that beginner investors can take:
a) Buying “Up-in-Quality”: This means that investors will mostly keep cash aside, apart from somewhat “nibbling” at very high-quality stocks (as described in Point 1).
b) Staying out of the markets for now: This would be suitable for the more risk averse individuals, as current volatility does carry some sense of uncertainty for the near future of financial markets. These investors could wait until the long-term momentum of the market turns upwards: i.e. once world leaders confirm medical progressions or evidence of the infection curve flattening comes to light.
A consequence of waiting could be missing the first 3-5% gain in the market (as investors won’t be able to immediately realize the turn upwards), but this is generally welcomed by those who are willing to prioritize the value of minimizing risk over maximizing reward.