• Capital Access

Now What? Part 1

A key question on many investors’ minds at this time is likely to be: when do I buy? Second, probably, will be “what do I buy?” but I can’t help you much there – beyond asking you to consider our excellent array of client companies*, of course!

I joke, but this is far from a trivial question. We’re coming from a period of 10 years during which we’ve been rewarded for blindly “buying the dip” and embarrassed for missing that opportunity. This conditioning is now strong and shouldn’t be underestimated: there have been 14 V-shaped dips and recoveries during this 10-year cycle:

2010 Flash Crash

2011 European Debt Crisis

2012 London Whale

2013 Taper Tantrum

2014 Ebola Scare

2015 overnight fix in the Chinese Yuan

2016 Oil Crash

2016 Brexit vote and Trump’s election volatility

2017 the start of the Trade War

2018 Jerome Powell’s comment – “we have a long way to go”

2020 The assassination of Iran’s head of terror

It’s not hard to see how markets have learned to behave in a certain way: until February this year the answer to “when do I buy?” during a market downturn has always and unequivocally been ‘NOW’. To do otherwise has caused at best embarrassment and at worst reputational damage and risk of outflows.

One of my favourite charts comes from a US wealth manager called Ritholtz Wealth Management, and it takes a long term look at the S&P500. They call it the “Reasons to Sell” chart and it looks like this:

Source: Ritholtz Wealth Management LLC

The point clearly being that there is always something to worry about, and focusing too much on the negatives, especially when everyone else is, can be seriously damaging to performance.

Of course one could argue that this market behaviour is merely the result of huge government stimulus (in 2008 the UK spent £25bn on various programmes, the EU €200bn, the US$152bn, and China nearly $600bn) but that’s beside the point. The point is that governments did do this and markets did eventually rally and for a decade since have bounced back rapidly every time they’ve faced adversity. And markets did this with an unusually high degree of correlation – offering an explanation, in my view, for a large part of the success of passive strategies over the decade. Why pay fees if everything moves up in lockstep?

In response to the current crisis the world has pledged more than 10x what it did for the Great Recession: the UK is creating £350bn and the US a staggering $2tn for stimulus/crisis response packages.

I can’t tell you whether this time will be the same (to nail my colours to the mast I think it is unlikely given that it’s unprecedented for the world to have to recover from widespread economy-wide shutdowns) but it’s always worth remembering that at the time, each of these crises seemed all-encompassing and severe. Newspapers, colleagues, and clients focused on nothing but the crisis at hand. They took up a large part of our consciousness, and as such we deemed them important. And then, in some cases mere days later, the market forgot about them and rallied.

So what use am I then? Well, what I can do is discuss factors that may make a difference to one’s decision to invest now, and where. There are two key factors here: finding the right investment and timing it as well as possible.

For the former, we’ll take a look at the ideal investment for surviving an economic shutdown of indeterminate length. For the latter, we’ll look at indicators of investor sentiment to ascertain whether we could now be near a market bottom. Cash levels, attitudes, prior market behaviours (and investor expectations anchored to them) will all contribute to forming this view.

So, of paramount importance is understanding whether what is occurring now will result in a permanent impairment to profitability and cashflow, or whether it will result in a ‘blip’.

One of our wealth managers who wished to remain anonymous (a value investor by style) believes that well researched, well thought through investment theses can make a lot of money in environments like this precisely because of this point: “a key distinction is delayed vs. cancelled spending. Spending on phones, houses, etc. will be delayed but not cancelled provided the lockdown doesn’t last too much longer. Experiences, restaurant food, cinemas, etc. will suffer from cancelled spending. Equally panic buying may have stimulated massive demand in some areas – clearly empty shelves mean food shops are selling more…and much food expires so this may prove to be additional demand rather than just demand brought forward.”

Because of this, I don’t believe investing here will be best served by taking a macro view – buying an index tracker likely won’t provide investors with a sensible return because some industries will experience catastrophic decline and others will pull through or even make long term gains. Even within industries I expect a significant performance disparity depending on leverage, banking relationships, labour relations, etc.

Ultimately even something as disastrous as a year without revenue is only a year without revenue: if you’re a robust business and can count on government support this needn’t imply permanent damage. However, the permanence of damage will vary from industry to industry and will also depend on the ultimate terms of government aid, of course.

What would the dream coronavirus investment look like?

  • I’d start with a company with, in the best case, no debt (deliberately distinct from net cash, because covenants could still be breached), and a decent cash pile. Failing that, a constructive relationship with its bank (covenant light lending, history of co-operation) can be extremely helpful in times like these. Defensive cashflows are also a good defence here: now, and against whatever recession follows the coronavirus period.

  • It would either have long term take or pay contracts that can be fulfilled with only a skeleton staff, or stock that either doesn’t expire (like bricks) or that expires with no variable cost (such as an hotel). It would help if its revenue drop were the result of delayed, rather than cancelled spending.

  • Its contracts will be inflation-proof. I believe that if the whole government rescue package is required then inflation is likely to return. This appears to be a large-scale money creation exercise on top of another one a decade ago that still hasn’t fully unwound. A significant portion of the investing population has never experienced a high-inflation era so this could be jarring for many investors and consumers. Other sources of inflation could be wage pressure from reduced migration, or cost of goods sold inflation due to increased on-shoring.

  • It would have significant management ownership so you’re fully aligned – ideally management would cut salaries and suspend bonuses for the duration.

  • It would have employees it could furlough without the risk of losing them or of them losing skills.

  • Its supply chain will be robust, and already largely either onshore or easy to bring onshore. There may be significant working capital requirements if the era of Just in Time supply chains is replaced by the era of Robust Supply. WIP may actually come down in the long term (if domestic supply chain participants can scale up quickly), but it would surely rise significantly in the short term. Stock levels would have to go up to add resilience.

  • Its share price will have been hit hard by the current downtrend, so it represents good value on long term profit and cash projections – T12M and FY+1 forecasts won’t make any sense, of course!

  • Its valuation stacks up without dividends, and there are few income investors on the shareholder register. In order to pay for working capital increases, repaying government aid, and building up buffers (which may even become regulatory requirement) cash will need to be conserved for some time.

  • Finally, its competitors would have to be undergoing the same stress, and ideally would have less resilience in the above categories.

Effectively, for the best investment in the worst case you’re looking for something that’s cheap vs. its long term potential, that could be mothballed for a long stretch of time before picking up where it left off, that will thrive in a world that has changed shape significantly – and is resistant to inflationary pressures coming from several sources. Simple!

Obviously not, as no such ideal business exists. The skill will come in deciding which of these characteristics is most important and which is being misunderstood by the current market. This brings me neatly to my next point: passive strategies won’t cut it in this market. I believe that we’ll see a resurgence in active management as the difference between a good and bad investment opportunity is now higher than it has been since the last major dislocation in 2008. We all know a tracker can’t do this, so I believe stock picking skill should return to the forefront of investors’ minds.

I hope so far I’ve laid out plenty of food for thought in one place in an interesting way – and I’ve done so without claiming to suddenly have become an expert in exotic diseases. I haven’t seen this done elsewhere yet.

Later this week I will release part II of this blog, which will look at timing and provide more thoughts on what to do next. By bringing together a wide array of views on investor sentiment I will explore whether are we likely to have hit the bottom of this cycle, or whether this is a bull trap in the making.

* You can let us know which of our clients you’d like to (virtually, at the moment) meet on the second page of our 3 question survey here.


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