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Vitaliy Katsenelson's Contrarian Edge: This veteran investment manager is bracing for a coronavirus-induced recession. Here’s his game plan

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The U.S. as of March 3 has 124 confirmed cases of coronavirus COVID-19, but because people can harbor the virus for weeks without displaying symptoms, and because U.S. testing has been inadequate, there is a substantial risk that the virus is already spreading widely across the country.

Yet the U.S. and the rest of the world are anything but underreacting to the virus. Governments are restricting travel from virus-impacted countries and quarantining people who may have been exposed. Companies are curtailing business travel. People are postponing vacations. I suspect we’ll start seeing cancellations of large public events. Unlike China, the U.S. has had a lead time to allow our government and healthcare system to prepare a response.

Clearly, coronavirus will make our lives anything but normal for a period of time, and the media will amplify this. This brings us to the not-so-normal economy.

Economic hit

Let’s start with China — the epicenter of the crisis. China’s impact will be twofold, as a consumer of American-made goods and as manufacturer to the world. Chinese consumption of foreign goods will definitely decline, impacting some companies more than others (for instance, car sales declined 92% in February). From a big-picture perspective, U.S. exports to China total about $100 billion — a pimple on the $21 trillion U.S. economy that may shave a few basis points off of U.S. GDP growth.

A greater impact will be felt from the interruption of Chinese manufacturing. Quarantined cities, shut-down factories, and travel restrictions have had an impact on Chinese production. China reported one of the worst manufacturing numbers for February in the history of this number being collected in China — even worse than in the depths of the Great Recession. The U.S. imports about $350 billion worth of goods from China, which on its own is not a crippling number. But much of this trade figure reflects components China produces for consumer products. If you are missing a $10 component that goes into a car, you cannot sell the $30,000 car.

The global supply chain has been optimized for just-in-time efficiency (i.e. cost), not resiliency (shocks). If the coronavirus crisis continues for a prolonged period of time, it will definitely hit the global economy in the medium-term and China over the long term. China’s government has to make a choice: maintain the lockdown and contain the virus but undermine its status of manufacturer to the world, risking a long-term exodus of manufacturing. Or lift travel restrictions and send people back to work, risking a further spread of the virus, leading to more sick people, more shutdowns, and more lives lost. For better or worse, the latter path seems to be the one the Chinese government is taking now — people are going back to work.

It is hard to know the impact of supply interruptions, but on their own they could further slow U.S. economic growth and maybe even send the country into a light recession. I’d be surprised if companies do not semipermanently increase inventory levels and diversify supply chains away from China. Increased inventories actually will, at least temporarily, boost U.S. GDP growth. Moreover, Chinese losses are an opportunity for other countries to provide needed supply-chain diversity: Vietnam; India, and also the U.S., for example.

Now that the coronavirus has made it to the rest of the world, governments and people are overreacting. That’s ok in response to a highly contagious virus that spreads by a geometric progression. You want people to overreact and overreact early — the cost of underreacting is simply too great. The less people interact with each other, the less the virus spreads. The first and most obvious casualty will be the travel industry — airlines, hotels, travel agencies — and then it will impact restaurants, concerts, and sporting events. People will telecommute more.

I don’t know how long this virus will persist, but they do naturally die out. But if the U.S. goes into a lockdown, it will just be a matter of time before we go into recession. In truth, the U.S. economy is overdue for recession; there hasn’t been one in 11 years. Recessions are not the end of the world; they are a natural process, just like a forest fire that cleans out dead wood. Recessions are good for the economy in the long run, though the short term is painful, not just for investors but for people who get laid off. But like the virus that caused it, recessions end and the world goes on.

How to invest

We don’t think the coronavirus will send us back to Stone Age. We do think the coronavirus is most likely a recession-inducing virus, with its own unique characteristics and extra-scary headlines. But despite all the uncertainty and human suffering, the financial consequences are likely to resemble those of a moderate recession (higher unemployment, lower earnings).

Read: Why the Fed cut: The coronavirus is taking aim at consumer spending, the heart of the American economy

Also read:  Consumer-facing companies will be the first hit if the coronavirus spreads across the U.S.

I don’t know what I’d be doing if I owned a bunch of stock index funds. The market is expensive and the road ahead for an average (overvalued) stock is anything but exciting. For our clients, we built an all-terrain portfolio of quality businesses with strong balance sheets, protective moats, top management, and recurring revenues. Many of our companies pay meaningful dividends, and most of them are noncyclical (they will not be impacted by recession). They’ll survive and strive no matter what the virus throws at them. We have a lot cash and have put hedges on portfolios where it’s feasible. 

In fact, this is a good time for you to revisit the “Six Commandments of Value Investing” — a chapter in the book I’d like to be working on but am not. It describes the principles of value investing and provides an overview of our investment process. You can read it here or you can listen to it here. Also, remember that the quoted prices you see for your stocks is not a final judgment of their value but a temporary opinion by Mr. Market.

Finally, I’ve been asked if my firm has done or will do anything different because of coronavirus. Here is the one thing we did: When it was evident that the virus would come to the U.S., we sold a few stocks (in some accounts) that were very close to their fair value. That was it. 

We don’t feel pressured to do anything further. The more rational we are, the better decisions we’ll make; thus we’ll continue to stick to our process. We’ll continue to dispassionately identify high-quality companies, value them, and figure out how much margin of safety (discount) we need. We may make small tactical tweaks to our buying process. We’ll be buying in smaller increments. Instead of building a position through one or two purchases, we’ll buy in smaller sizes, because uncertainty induced by the virus may result in greater volatility and thus better bargains.

During market meltups and meltdowns, emotions can start to impact your time horizon – that’s very human. During a market meltup, the time horizon extends from five years to 10 to forever, while during meltdowns it shrinks to months and then weeks. With every investment decision we make, we are looking five- to 10 years out. This time horizon is deeply embedded into our investment process, and we believe this is the only way to invest. When we look past the (possibly) ensuing recession, the view is incredibly liberating.

It is possible and even likely that the headlines will get worse before they get better, but any economic crisis in the U.S. probably isn’t going to look anything like it will in China, and this virus will eventually die out. That is what viruses do.

Our ultimate goal is to continue to keep our emotions (fear and greed) in check and to remain as rational as possible, even when the world around us is anything but. 

Breaking news:  Get the latest on coronavirus here.

So, how does one invest in this overvalued market? Our strategy is spelled out  in this fairly lengthy article.   

Vitaliy Katsenelson is chief investment officer at  Investment Management Associates  in Denver. He is the author of “The Little Book of Sideways Markets” (Wiley). 

Read: Here’s what history says about stock-market performance in past instances when the Fed delivers an emergency interest-rate cut

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