Value of annual data in a financial crisis

With the current COVID-19 crisis (and any other financial crisis) how far are we able to trust that the annual data - which has presumably changed for the vast majority of companies for the worse, in determining which stocks have value and which just appear cheap because most everything is cheaper now than at the start of the year?

Would it be advisable to only look at companies that have had their annual data reviewed since the virus started and the stock markets crashed?
Or would the companies that the screener recommends be worth investing in anyway since the data was mostly from before the virus hit and it should only (hopefully) be a temporary problem and that we and they will get through it?

"What we do know, however, is that occasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community. The timing of these epidemics will be unpredictable. And the market aberrations produced by them will be equally unpredictable, both as to duration and degree. Therefore, we never try to anticipate the arrival or departure of either disease. Our goal is more modest: we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful."
"Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful."

Dear Jeff,

Thank you for your forum post!

By a rather curious coincidence, Buffett too is referring to diseases in the first quote above; but obviously of a rather different kind. But as far as the markets are concerned, the effects should be about the same.

The central idea in Value Investing is to maintain a Margin of Safety in one's investments. One either invests in good companies at reasonable prices; or in average companies at great prices, but with more diversification.

In a situation such as the present one, there are likely to be a lot more companies with stellar track records available for purchase within reasonable quantitative valuations.

A company that has grown profits for the last five or ten years — as required by Graham's framework — is also less likely to collapse in a situation such as the current one, even if it does struggle for a quarter or two. Any temporary dip in profits are also likely to have been already overcompensated for by the markets, where overreactions are traditionally the norm.

Annual data is therefore not only more reliable, but when considered over a period of many years also appears to be a better indicator of which investments would make the most sense during such times.

Thank you for your reply.

I understand that both fear and greed have been rife throughout this pandemic. Warren Buffett has remained rather quiet (fearful) and has not bought much, whereas there has been an influx of new investors (presumed mostly day traders) attempting to take advantage of it (greedy) on super-cheap platforms such as Robinhood, which have had a vast increase in members because of the crash. This old adage appears to be the contemporary thinking for a lot of people.

It seems we need to be mindful when we are greedy, especially when we consider extra waves of the virus that might hit us, and not buy companies that have filed for bankruptcy and have become 'cheap', as has happened with the likes of Hertz and Wirecard.

My interpretation is that we should continue buying as normal; stocks we find have value, diversifying etc. We should not be emotionally swayed by the 'cheapness of everything' (especially since most of it seems buoyed my the massive amount of money with which the governments have stimulated the economy) and just buy what we were going to buy anyway. If they were good companies before, like you say, they aren't likely to collapse.

Perhaps I am misunderstanding the government stimulation package, as you say that companies' profits are "likely to have been already overcompensated for by the markets". I see the businesses and a lot of markets almost immediately back to how they were before the crash without the workforce behind it or the companies actually making as much money. Please could you give some insight on this as I am only a beginner and I am probably not seeing the whole picture.

Anyway, it will be interesting to see how at all the annual data will affect the stocks' performance on the screener when they have been updated.

Dear Jeff,

Thank you for your comment!

As far as the markets are concerned, it appears everyone is a neophyte. Buffett himself recently said something to the effect, that the markets continued to surprise him despite the length of time he had spent with them.

In fact, Graham even gave a possible explanation for this phenomenon; which is also addressed in more detail in Soros' Theory of Reflexivity.

"Any approach to moneymaking in the stock market which can be easily described and followed by a lot of people is by its terms too simple and too easy to last."
Benjamin Graham, Chapter 8: The Investor and Market Fluctuations, The Intelligent Investor

This explanation may apply to the above adage about greed and fear as well. The market does appear to change every time enough people understand one aspect of it. Index Funds were derided for years when Jack Bogle first introduced them. Now that they have finally gone mainstream, they may no longer give the returns they did in the past.

Perhaps, if it becomes popular enough, Graham's framework will stop working someday as well. Fortunately, that day does not appear to be any closer today than it was in 1984.

"Some of the more commercially minded among you may wonder why I am writing this article. Adding many converts to the value approach will perforce narrow the spreads between price and value. I can only tell you that the secret has been out for 50 years, ever since Ben Graham and Dave Dodd wrote Security Analysis, yet I have seen no trend toward value investing in the 35 years that I’ve practiced it. There seems to be some perverse human characteristic that likes to make easy things difficult."

The most sensible approach appears to be what you yourself have written above — to continue investing as one normally would, look for stocks that have genuine long-term value (and are not just temporarily cheap), apply the required rules for diversification across asset classes and stock grades, and so on.

Graham himself recommended that one always stay invested, even during times of war or periods of extreme uncertainty.

I agree with some of the considerations above. But what do you mean by index investing may not give the returns it used to give now that it is popular? By definition index investing is designed to give average returns. Because usually the index is the benchmark. So I don't see how even as it has become more popular it would give less returns. It will just give the returns that the market on average gives, depending on how the economy goes.

Also one potential issue with this pandemic and the screener is that certain companies that are now defensive or enterprising, may close the year at a net loss. Just take Societe BIC for example. Defensive stock. Due to schools being closed, H1 they closed with a net loss. Maybe they close with a profit in the end, but with extended lockdowns some companies in hospitality, retail, airlines and sectors badly affected may close with a loss. Let's say a vaccine comes and they restart the business, they perhaps keep operating it as good as they always did and make profits, but because they have one net loss, for another 10 years they will be ruled out from the screener.

Also if they do not close with a net loss, if their EPS drop dramatically, this will affect their 3 year average significantly, possibly making some of them drop out from the screener due to the earning growth requirement.

Now, that makes it tricky to reconcile what you guys just said above with the approach of using a screener. Because for some companies this year should be bit of a wire off because it is unprecedented to have in certain sectors extended months with lockdown forcing revenues to zero while keeping costs, and that one year performance is not very representative of neither what the company had been doing up until that point, nor what it can continue to do after in terms of the returns it can generate on its asset. Simply for a few months it could not put those assets to work because the law prohibited it in a lot of countries. Hence I see this as a potential problem moving forward, because the screener will rule out potentially good value companies.

You may argue that those who will have made the cut moving forward have shown some resiliency, but that's mostly due to which sectors they have been in, as some have been less affected than others due to the nature of the business.

Dear rc2752,

Thank you for your detailed comment!

Your points are addressed individually below.

Reflexivity

The main selling proposition of Index Funds has been that they give better returns than most actively managed funds, which has been historically true and also something that Graham himself first observed and based his framework on.

But as Graham and Soros (references above) also noted, the markets are reflexive in nature. So any working strategy that gets adopted by too many people eventually stops working, because the markets adapt accordingly.

One of the first requirements for any investment strategy to work is for the price of entry to be a good one. If enough people move to Index Funds, that in itself could push the price of entry beyond the point where they can continue to beat actively managed funds.

Of course, this conjecture in the discussion above was purely hypothetical in nature. Index Funds may yet be far from this point, especially due to their large diversification and other structural advantages.

Averages

"for another 10 years they will be ruled out from the screener."

That could happen if such companies show a net loss for the whole year; and they may yet qualify for NCAV investment within the space of a quarter, or for Enterprising investment in five years.

Graham's framework also uses 3-year averages, both in its Earning Growth and Intrinsic Value calculations precisely for the reasons you mention above. Graham specifically mentioned adjusting for inflated earnings, but a scenario such our current one with reduced earnings would be equally compensated for as well.

Resilience

"nor what it can continue to do after"

Both Graham and Buffett have commented on the unreliability of forecasts and projections in finance. Graham's framework thus only uses objective figures from the past.

"will rule out potentially good value companies"

The central principle of Value Investing, is to allocate capital to stocks that demonstrate a better Margin of Safety and less vulnerability, especially during such times.

"mostly due to which sectors they have been in"

The idea of Graham's framework is to not only be able to pick the best investments across Stocks and Bonds, but across Sectors and Industries as well. In general, Value Investing requires that one allocate capital to companies that prove to have the best Margin of Safety, regardless of which Sectors and Industries they belong to.

Dear Jeff,

Thank you for your comment earlier!

"Warren Buffett has remained rather quiet (fearful) and has not bought much"

Do note that Buffett's Berkshire Hathaway Inc (BRK.A) bought close to $2.1 Billion of Bank of America Corp (BAC) stock in the last three weeks.

Interestingly, Bank of America Corp appears to handsomely clear all the Graham criteria for financial stocks, apart from the Equity : Debt one. But Graham himself wrote that such minor deviations were acceptable, so long as the other factors sufficiently compensated for them.

Graham Resources