Active investment management is grounded in the belief that markets are not always efficient. Generally the key culprits responsible for this inefficiency are investors’ emotions – and particularly greed and fear.
Few things cause more anxiety than a virus outbreak, and lately the Zika virus has commanded a great deal of attention globally. In late January, even Donald Trump could not match the virus in terms of online search interest.
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Some 40% of people aware of the virus would be less likely to travel to the Caribbean because of it, according to a Reuters/Ipsos poll conducted in February. Speculators reacted by selling off shares of cruise operators Carnival, Norwegian and Royal Caribbean by more than 20% in the first five weeks of 2016.
Understanding past pandemics
The market’s initial negative reaction to the Zika virus seems plausible on first glance: travellers are scared about contracting a virus that is most prevalent in an area popular for cruises. But, as active investors, our focus is on companies’ long-term fundamentals, and in that regard, we can look at past pandemics for clues about Zika’s likely impact.
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The 2009 H1N1 pandemic was grave. Spread easily through contact and sneezing, the virus infected tens of millions of people. The U.S. Center for Disease Control even went as far as to advise against travel to places like Mexico, a popular cruise destination.
H1N1 attracted acute public interest, and investors punished shares of Carnival and Royal Caribbean as coverage of the virus peaked. Yet the effect on these companies’ long-term fundamentals was limited, and their shares recovered quickly after the peak of public interest.
The 2014 Ebola epidemic was also tragic. While the disease did not spread as easily as H1N1, it was much more deadly, and received as much public attention. Within a month of the first case being discovered on U.S. soil, a poll by the Harvard School of Public Health/SSRS reported that 40% of Americans worried that they or someone they knew would catch the disease.
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Matters were not helped when a lab worker involved in that first case ended up on a Carnival cruise shortly afterwards. That person didn’t have the disease, but still, it’s not surprising that investors became fearful, and cruise shares sold off by more than 10%. But the epidemic had little fundamental impact on the businesses, and as fears receded, their shares recovered in a few months.
Focusing on the fundamentals
So what impact is Zika likely to have on cruise ship shares over the long-term? First, the facts. For most people who catch it, Zika causes only mild symptoms that generally disappear in a week. The fears are chiefly for pregnant women, as the virus can cause birth defects. On first glance, this seems a plausible threat to the companies’ fundamentals but with one caveat – few pregnant women cruise.
Even if they did, operators generally don’t let women cruise in their last trimester. Hypothetically, even if all other pregnant woman wanted to board a ship, this would represent less than 2% of potential cruisers.
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As the H1N1 pandemic showed, even when a virus impacts companies’ short-term fundamentals, it doesn’t necessarily impair their long-term intrinsic value. In this context, Carnival operates more than 100 ships, with the infrastructure to keep 200,000 guests cruising at any time.
The value of those assets is unlikely to permanently decline by 20% due to a virus in one year, yet at the height of Zika fears the stock’s valuation fell to 11 times our estimate of 2016 earnings – a modest multiple to pay for a company that we believed could grow earnings by 20% per year. Following the initial selloff, the market has subsequently come around to this view, and cruise ship shares have already recovered much of their losses.
By retaining one’s common sense when others temporarily lose theirs, fundamental contrarian investors may be able to uncover attractive opportunities by capitalizing on others’ mistakes.
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Craig Bodenstab is an investment counsellor at Orbis Investments. c.bodenstab@orbis.com