When markets fall, equity investors should become more constructive on the prospects for future returns. However, as prices fall, intrinsic value may be influenced. Discerning which factors drive this could help investors capitalise and avoid getting caught in value traps.
Read this article to understand:
- Why low share prices are not always a good indicator of future returns
- The types of companies most likely to be caught in negative – and positive – feedback loops
- What to look for to understand these mechanisms
Fundamental analysis is the discipline of determining the intrinsic value of a company. That, simply put, is the cashflows a company is expected to produce between now and doomsday, discounted back at an appropriate rate.
Value investing involves finding companies to buy at a discount to their intrinsic value. If prices tend to return towards their intrinsic value over the medium term, then, all else being equal, the greater the discount, the greater the potential reward.
Seasoned value investors also argue lower prices counterintuitively imply lower risk. At a large enough discount, the shares start to embed what US hedge fund billionaire Seth Klarman calls a “margin of safety”, when prices are sufficiently low to compensate for the risks.
In periods where equity indices fall significantly, the margin of safety applies to all styles of investing. But investors need to do their analysis as intrinsic value is not always reliable.
Exploring the concept of reflexivity
In The Alchemy of Finance, George Soros explained the concept of reflexivity, the idea some assets are negatively influenced by lower prices and vice versa, while others are positively influenced by higher prices. Finally, some assets are positively influenced by lower prices.1 In other words, share prices can create positive or negative feedback loops, depending on whether prices are higher or lower than their intrinsic value.
While much of modern portfolio theory and economics are premised on long-term equilibrium, Soros argued these feedback loops are what drives booms and busts, beyond what would be dictated by traditional economic theory.
Reflexivity leads to a very different view of financial markets
In a 2009 series of lectures published in the Financial Times, Soros explained that, humans all having a partial and distorted view of reality, “these distorted views can influence the situation to which they relate because false views lead to inappropriate actions”.
But our actions will in turn impact reality. This is reflexivity, which Soros said was in direct contradiction to the economic principle of equilibrium, as the latter implies perfect knowledge of markets and rational behaviour.2
Reflexivity therefore leads to a very different view of financial markets. Although it differs by investment style, sector and companies, the way it works overall is market sentiment as expressed by current share prices can have a real-world impact on companies’ intrinsic values.
Determining which assets are influenced in this way by negative feedback loops is paramount in understanding when low prices represent value and when they increase the likelihood of a permanent loss of capital. Simplistically, the idea can be illustrated as shown in Figure 1.
Figure 1: Theory of value investing versus reflexivity
Source: Aviva Investors, February 2023
What this means for investors
Thinking through the implications for companies reveals three areas investors need to focus on.
Capital intensity
Companies with capex-heavy business models, perpetually dependent on capital markets, are at risk when prices fall, as they often do not generate enough cashflows to maintain the competitive position of their assets.
Companies with capex-heavy business models often don't generate enough cashflows to maintain the competitive position of their assets
Over the past decade, low interest rates have been a panacea for such companies by ensuring a low cost of capital, but sectors like heavy industry and those involved in the built environment are at risk when the tide turns. In the latter, real estate investment trusts’ legal obligation to distribute all their earnings, required to maintain their tax-advantaged status, could exacerbate the problem.
Non-profitable information technology and biotechnology firms are also at risk as they need capital markets to continue building critical mass.
For some companies in these areas, low share prices are directly linked to a higher cost of capital, capital they need to survive.
Price takers
Lower prices can also impact the income statement of companies such as wealth and asset managers. As equity and bond prices fall, so too do the fees linked to assets under management. Bad news in share prices means bad news for those companies’ cashflows – and intrinsic value.
This might not necessarily mean a permanent loss of capital, as prices may rise in the future, but fundamental value investors must be conservative in extrapolating current cashflows to future cashflows. The path-dependency on market prices makes them difficult to predict.
Share-based compensation
Traditionally a welcomed item as it theoretically aligns the interests of companies’ senior executives and shareholders, share-based compensation is most often overlooked as it pertains to reflexivity, because it has no relation to the operational resilience of the company.
More shares dilute per-share cashflows, reducing the asset’s intrinsic value
However, it is highly dilutive and destructive. As share prices fall, management teams are forced to issue more shares or grant more options to deliver the same compensation in dollars as in previous years. More shares dilute per-share cashflows, reducing the asset’s intrinsic value even if operating fundamentals remain unchanged.
The way companies account for share-based compensation also muddies the water, as some choose to include it in their income statement and cashflows, while others exclude it based on its non-cash nature.
Counterparty risk
During times of crisis, investors look for information to assess the materiality of the risks as events unfold. When no new information is forthcoming, either from companies, industry bodies or regulators, investors will invariably turn to the share price as a gauge of whether conditions are improving or deteriorating. This applies not only to shareholders, but equally to customers, suppliers and even competitors.
Share prices impact depositor confidence and, in turn, behaviour, creating a cycle of reflexivity
Recent events in the US regional banking sector are a powerful example of this. Following the collapse of Silicon Valley Bank, share prices of its regional peers came under pressure. As a result, many depositors began to question whether their own deposits were secure.
With limited information on deposit flows, and arguably a limited understanding of capital adequacy ratios, lines of liquidity and funding provisions, many withdrew deposits as falling share prices drained confidence. While share prices have a limited impact on deposits, they do impact depositor confidence and, in turn, behaviour, creating a cycle of reflexivity.
Positive reflexivity
Fortunately, feedback loops are not all negative. For companies whose intrinsic value is relatively immune from the pitfalls of reflexivity, that intrinsic value may in fact be enhanced as other market participants suffer.
Figure 2: Positive reflexivity
Source: Aviva Investors, February 2023
Companies with capital-light business models, pricing power and lower use of share-based compensation are at a long-term advantage. Reflexivity also creates positive effects which, when combined with low prices, might result in what Warren Buffet coins a “fat pitch”: companies with a durable competitive advantage selling at a significant discount and margin of safety.3 To identify these, investors need to assess three areas.
Changing competitive landscape
When prices are low, market leaders and incumbents are often able to increase market share, as smaller peers are unable to access the capital they need to compete.
When prices are low, market leaders and incumbents are often able to increase market share
Biopharma is a good example, where venture capital funding is drying up, leading existing contract research outsourcing leaders like IQVIA and contract drug manufacturers like Lonza to take market share at a time when the overall pie might be shrinking.
Supply/ demand dynamics
In capital-intensive industries, a rising cost of capital also has the effect of reducing the new supply of goods to market.
Warehouse and logistics real estate is a good example. Long-term demand significantly outweighs supply, now exacerbated by fewer new construction projects and even tighter rental markets, leading to higher operating cashflows. The world’s leading warehouse and logistics company, Prologis, also boasts one of the strongest balance sheets (with a significant cost-of-capital advantage), putting it in a strong position for the long term despite changing market conditions.
Share buybacks
In direct contrast to share-based compensation, management teams with capital allocation prowess can enhance per-share cashflows by buying back shares when prices are depressed. This might be funded either from existing cashflows or by selling less-productive assets or divisions.
Management teams with capital allocation prowess can enhance per-share cashflows by buying back shares when prices are depressed
Either way, it means redeploying the cash at a higher rate of return as implied by current share prices. For example, if a company’s assets are producing a return of ten per cent and shares are trading at a discount to asset value of 50 per cent, then the shares imply a return of 20 per cent on these assets. Buying back shares will give the company a 20 per cent return instead of ten per cent if it invests in production capacity.
In addition, fewer shares in circulation means higher per-share cashflows. Thanks to positive reflexivity, the returns per share (and intrinsic value) of the business are improved even though the underlying assets are generating the same return.
Semiconductor bellwether Texas Instruments is possibly the best example of the long-term benefits of this approach. Since 2004, its disciplined capital allocation strategy has allowed it to increase growth in free cashflow from three to seven times on a per-share basis4.
At low share prices, it is worth thinking about the relationship between share prices and intrinsic value to understand when negative or positive reflexivity may apply, because both risks and potential rewards are high.
Potential rewards are high thanks to the greater margin of safety, but risks are high because of possible negative reflexivity. The best outcome is to look for companies where positive reflexivity applies, meaning lower share prices will lead to stronger, more resilient intrinsic value.
