How the sharemarket can rise when the economy is toast

"What's going on with the sharemarket? The economy is toast and we have a 7% rise?!" That WhatsApp message came through to me in late March from a friend who's no dummy. He's had a successful career in finance and now runs a small business. Or, at least, he did until it was recently closed, a victim of the COVID-19 recession.

I use the term "recession" with confidence, despite the economic measures that will make it official not being available yet. Two consecutive quarters of economic shrinkage (the technical definition) seem all but impossible for Australia to avoid in the March and June quarters.

The national economy has been cratered by governments around the country. The forced closure of many venues, sporting event cancellations and an effective halt to travel are unprecedented. You surely know people whose jobs have been impacted - either by being stood down, having to take pay cuts or, like my friend, having their small business all but destroyed. It's devastating.

No doubt you've also seen the falls in the sharemarket that began in February and picked up steam in March. The fact that we have short-term bad news is obvious. The economy is, as my friend said, "toast". For now.

But the second part of his message, about how the sharemarket could rise in such circumstances, is a more intriguing issue.

Discounting machine

Every serious investor I know agrees on what a company's value should be. It's the amount of cash it will deliver to its shareholders over its lifetime, adjusted back into today's dollars. The theoretical calculations involve projecting the cash that will be paid out by a company in the future (usually through dividends) and then figuring out what those are worth in today's dollars.

Interest rates are a key variable in this equation. If you're interested in the details, you can search online or find a basic finance textbook that explains "discounting cashflows". The upshot is that the lower interest rates go, the more future profits are worth in today's dollars and vice versa.

So the exact same company producing the exact same amount of cash can be worth substantially more or less depending on the interest (discount) rate applied to its projected future profits. And that's only the beginning.

Imagine a company that also has borrowings. In that case, lower rates will also mean a lower interest bill and therefore higher profits to shareholders (assuming it survives the current downturn and its operations aren't permanently damaged). So you could have higher profits that are in turn worth more to shareholders due to the lower discount rate. A positive double-whammy.

The whole situation quickly becomes complicated by introducing even this one extra variable, interest rates. And when you add in a larger variety of factors, such as broader economic and international issues, government actions, currency movements, competitor behaviour, new technology and consumer behaviour, the range of possible outcomes opens right up.

Sharemarket investors are constantly trying to get their minds around all these variables in estimating a company's future profits. Then they consider factors that impact the valuation of those future profits.

Bring it all together

All of this brings us back to the conundrum presented by my friend. Namely, how can the sharemarket rise when the economy is doing so poorly?

Short-term profits have been slashed across many industries, losses are likely to be widespread and many businesses will fail. There's no doubt that the current circumstances are putting downward pressure on the value of most businesses listed on the sharemarket. But there are offsetting factors.

The impact on company profits when we look out three to five years is less clear. And, in theory at least, the sharemarket should be looking even further into the future than that. This is a real wild card and perhaps the biggest element in changing short-term sentiment as investors try to look beyond today's situation and visualise what the economy might look like when we arrive at our "new normal".

The sharply lower Australian dollar is another factor. It has a positive effect on our exporters. Most commodities are priced in US dollars, so a lower Australian dollar means our mining companies receive more for their output at the same official price on world markets. And if they're paying the majority of their costs in Australian dollars, then their cost base may not change and their profits will be higher than they would if the currency were stronger.

Most of our iron ore, coal and gold miners are in this situation. If your costs are the same but your revenue is rising, times aren't too bad.

Central banks step in

Central banks around the world have acted quickly during this crisis. They have taken important steps to support the banking system and, more broadly, have forced long-term interest rates down. As discussed above, this makes future profits more valuable to today's investor, which puts upward pressure on share prices.

These are just some of the cross-currents that go into moving share prices around. As positives are perceived to outweigh negatives on some days, the sharemarket can rise sharply despite the current economic situation being bleak.

In answering my friend, I told him that the relationship between the sharemarket and the economy can be described using the same terms many millennials like to use when discussing their love lives: "it's complicated".

Long-term value

Opportunity can arise for sharemarket investors in times like these. Share prices can overreact as investors project current turmoil into the future, letting today's difficult circumstances overly impact a level-headed analysis of the future.

Magellan Financial Group (ASX: MFG) is a recent example, in my view. It's previously been featured in this column (August 2018) and I could make the case that Magellan is the finest funds management business in Australia.

The company's share price fell from a high of $75 in February to a low of $30 in March. In less than six weeks investors lopped an astonishing 60% from its valuation. Such a fall might be understandable for a business in travel or hospitality, but funds management?

Magellan had $87 billion of funds under management at June 30 last year. At March 31 this year, the figure was $94 billion. The business has proven remarkably resilient, has hundreds of millions in cash on its balance sheet and is run by a passionate founder.

I used the "March madness" as an opportunity to establish a long-term holding and see the stock as reasonable value below $50 a share. Markets could go lower and Magellan's share price could fall back, but I believe investors have overreacted. I hope it proves to be a prime example of the way level-headed investors can benefit in periods of turmoil.

Disclosure: Private portfolios managed by Greg Hoffman own shares in Magellan Financial Group.

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