During a stock market crisis, it can be easy to view the stock market as irrational because prices are changing so rapidly in response to both new information and shifts in investors’ tolerance for risk. In the interest of reminding ourselves why we stay invested in stocks and specifically within value stocks during this financial crisis, we want to depart from our usual market-level commentary and dig into a specific example of one stock held by the funds in your portfolio.
While we do not recommend investing in this stock individually, we recommend being diversified in hundreds of these opportunities. We have chosen it purely as an example of the hundreds of value stocks in your portfolio. The return of picking a random single stock has historically delivered 30% lower returns compared to investing in the stock market as a whole.
For our example, we selected one value stock that everyone knows: Citigroup. In January, the high for Citigroup was $81.37. As of the end of the day on March 16, it had dropped to $41.49/share, a drop of 49%. The current market capitalization (the value of the equity ownership in the company) is about $87 billion.
The return to a stock owner is the underlying profits (the earnings) of that company. When we loan someone else money, we earn interest. When we buy real estate, our earnings are mostly from the rent less expenses. When we own a part of a company (which is what stocks are), the company profits are our earnings. The company can then decide whether to pay them out in dividends, stock buybacks or reinvest those earnings back into the company.
When we look at Citigroup, we see that in 2019, they earned $19.5 billion in profits and $18.4 billion the year before that. Based on historic earnings, an investor who buys Citigroup today could get an earnings yield of 22.5%, basically earning over five years more than 100% and still owning the same number of shares of Citigroup stock at the end of those five years. Even if Citigroup’s earnings were cut by 50%, the earnings yield is still compelling compared with the 1% yield on 10-year Treasuries. What the market is telling you is that there is a potential for very high returns to be earned in exchange for bearing the risk of holding this stock through the upcoming global events and company specific risks.
There are clearly some good explanations for current prices based on future earnings being reduced due to higher loan default rates and lower interest rates (banks make money on the spread between interest rates and what they pay depositors). Many companies are bearing similar risks right now. In the long run, investor returns are compensation for taking these kinds of market risk.
Clearly, we are not financial soothsayers, and we are not saying that Citigroup specifically is a good purchase. Public companies go bankrupt every year, but diversified asset classes with hundreds and thousands of companies never do. This is just one example of the hundreds of value stocks within financials, materials and the energy sectors that appear to have higher-than-average risk premiums and therefore high long-term expected returns right now. One way of looking at this is that stocks may be on sale right now and that is why rebalancing is so important.
We know we do not have (and we do not believe anyone has) a crystal ball to tell us which value securities will end up delivering on those high potential returns. But right now appears to be a fantastic time to be a patient, long-term, well-diversified investor.
We recognize it takes courage and trust in your financial advisor to weather these volatile times. To help, we would like to show you how markets have recovered in past downturns, such as the selloffs we experienced in these past three weeks. The below exhibit displays U.S. stock returns over one-year, three-year and five-year periods following market declines.
This is a reminder that being diversified and disciplined to your financial plan will help put your portfolio in a position to capitalize on market recoveries.
If you have any questions about your financial goals or your current risk tolerance, you can reach out to your advisor to re-evaluate and discuss.
All information is believed to be from reliable sources, however, its accuracy and completeness and the opinions based thereon by the author are not guaranteed and no responsibility is assumed for errors and omissions. Any economic and performance data published herein is historical and not indicative of future results.
Periods in which cumulative return from peak is –10%, –15%, or –20% or lower and a recovery of 10%, 15%, or 20%, respectively, from trough has not yet occurred are considered downturns. Returns are calculated for the 1-, 3-, and 5-year look ahead periods beginning the day after each downturn. Whether a period is considered a downturn is analyzed on a daily basis, and therefore the 1-, 3-, and 5-year look ahead periods are overlapping. The bar chart shows the average returns for the 1-, 3-, and 5-year periods following 10%, 15% and 20% downturns. For the 10% threshold, there are 3,442 observations for 1-year look ahead, 3,396 observations for 3-year look ahead, and 3,345 observations for 5-year look ahead. For the 15% threshold, there are 3,175 observations for 1-year look ahead, 3,167 observations for 3-year look ahead, and 3,166 observations for 5-year look ahead. For the 20% threshold, there are 2,561 observations for 1-year look ahead, 2,560 observations for 3-year look ahead, and 2,560 observations for 5-year look ahead. Peaks and troughs are patterns that are developed by the price action experienced by all securities. Peak is the highest point prior to a drawdown, and trough is the lowest point after the peak. Data provided by Fama/French available at http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html.