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A clear over-reaction

February was a turbulent month, fuelled by fears of a coronavirus pandemic. Carnegie Global fell 7.5 percent.

By the weekend of February 22-23, it was clear the coronavirus had gained a foothold outside China. The week after, the stock market began to price in a global spread and the MSCI World equity index fell 12 percent in the last five days of the month. Is it reasonable for global stocks to lose around USD 4 trillion due to the coronavirus? Let us see.

A company is worth all its future cash flows discounted back to today. We often talk about P/E and similar valuation metrics, but these are really just simplifications of a cash flow analysis. A cash flow analysis quickly makes it clear that a company’s value hinges largely on what happens in ten years and further ahead. This means that factors with only a short-term impact have just a small effect on a company’s value.

I believe the economic worst case from the virus is that companies’ growth completely disappears in 2020. The IMF estimates a reduction in global growth from 3.3 percent to 3.2 percent, so my scenario is like Armageddon compared to the IMF analysis. In a cash flow analysis that initially assumes 1) 3 percent annual growth in dividends in perpetuity, and 2) a 10 percent discount interest rate, the value of a company would decrease by 2.9 percent.

This is worth repeating: if companies do not grow at all this year, their value falls by only 2.9 percent. Short-term impacts are not as important as one might imagine when it comes to the value of a company. The 12 percent fall at the end of February means that the market expects company profits to not grow by a single krona in five (!) years. Not even if all listed companies in the world fail to make a single krona in 2020 is a 12 percent fall justified.

It seems clear to me that the market has over-reacted to the coronavirus, and I believe this is a good time for us long-term investors to buy fine companies at better valuations than those on offer just a month ago.

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