It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to Heaven, we were all going direct the other way, so wrote Charles Dickens in 1859 (A Tale of Two Cities) but these words ring true now more than ever. Day 83 of 366 in the leap year that is 2020, yet it already feels like we have lived through a decade in the past three weeks with enough statistics on volatility and capital lost to make the financial history record books overshadowed only by the human tragedy unfolding as Covid-19 speeds across the globe - 300,000 affected so far, over 10,000 mortalities and a near certainty of many more to come in the days ahead. With the real economy likely to come to a sudden stop to protect life over the next few days, record high levels of debt and near certainty of a recession, Q2 unemployment in the US expected by the Federal Reserve to soar to 30%, compounded by a global pandemic and an oil shock, is it any wonder that we have not had two consecutive days of stability in the markets1. There are just too many trade-offs and too many decision trees to compute between the bad and the less bad - the machines lack the data and the humans lack the compute power making for a powerful volatile cocktail. This overload led to quite a few market participants clamouring for market closure last week - a problem of too many questions and too few answers. Everyone has been seeking a parallel to this period. The Marriot International CEO Arne Sorenson (link to his heartfelt message to employees) sees a parallel to his business to a combination of the period post 9/11 and 2008 great financial crisis2. Some have looked at the pandemic as the Spanish flu epidemic of 1918, whilst others have compared this period to 1987 (Black Monday), LTCM (algorithms failing - read Ray Dalio’s Linked-in note Our Performance) or 1929 (onset of the great depression)3. As Howard Marks eloquently put it - Nobody Knows in his recent memo to clients, investing today is a bit like (to paraphrase the tag line from my favourite television series of all time - Star Trek) - going boldly, where no one has gone before! This is how investing through 1929 would have felt like where there were no parallels to go back to or what investing during the great wars must have felt like (incidentally in my view the great wars possibly offer the best parallel - more on this below). However, I believe that what we lack in compute power, we more than make up with the power that is imagination (machines don’t yet have that!). What do we know, what do we not know? Covid-19 Related
Interest rates, Government and Central bank response:
In the near to medium term it is important to remember that if you are getting unduly bearish, you are fighting the Fed and nearly every central bank and government in the world along with the single-minded dedication of various health care professional and scientists to find a cure/vaccine. Think hard and rationally about your odds! Country Selection & Politics & The Long Term - the 1945 Crossroad
The 1945 Crossroads & The Marshall Plan
The open questions for the path ahead:
From the macro to the micro - comments on equity valuations & things to focus on:
Forecast pre-Covid-19
This is the draconian forecast assuming that for about 3 months revenues are down to zero while costs stay constant (i.e. no job losses or production cuts and for simplicity sake no changes to any other assumptions like capex or working capital)
For a draconian 93% negative change in a year’s operating profitability, the change in the franchise value is $2 or less than 5%. This is because this is a business with pricing power where a disproportionate chunk of the value in the business lies over the long term. Business managers who are focussed on long term value creation will intuitively know this trade-off. However, recessions don’t treat all businesses equally. Here is the same exercise for a cyclical business which trades at much lower multiples with lower margins (hence high operational gearing) and more importantly is unfortunately highly levered going into this recession. Forecast pre-Covid-19
Forecast post Covid-19 (3 month hard stop with no cost support and 100% drop down on leverage- no other changes to assumptions)
As is apparent the combination of high financial and operating leverage is a toxic cocktail which together can destroy significant amount of capital in a downturn. In this example, three months loss of revenue and without any attendant management action would see the company’s equity becoming worthless (is it any wonder the high yield market is in such a stake of funk?) Having said that, this is not to suggest investing in one versus the other. On the contrary, this is where evaluating the difference between market price and your view of franchise value becomes so important. During dislocations, all businesses trade at significant discount or premium to market valuations and it should not surprise you if you have over 50-100% upside on your price targets. Further the correct investment strategy in the 2009 recovery was to sell everything that had been defensive in 2008 (good quality, low leverage & had protected capital) and buy everything cyclical that had survived (generally had great management teams who had navigated the cycle with often lower than peer group leverage). In fact, in 2009 the defensive high-quality businesses were not good areas for capital preservation, given the weight of capital which flowed in the other direction. As soon as governments announce the all-clear on the pandemic, or a cure is found, or restrictions go, expect 2009 like investment environment to repeat. So, the message is really to be flexible and continue to look through the wreckage in cyclical areas where the market has thrown out the baby with the bath water (for e.g. if 9/11 did not make us stop flying, it is doubtful that Covid-19 will). To repeat what could be described as one of the core tenets of Anthony Bolton’s investment philosophy ‘The most money in equity markets is made when things go from bad to less bad’.
Closing thoughts:
On a more personal note, everyone has a guiding philosophy - mine is ‘Whatever happens, happens for the best’ - it has kept me steady through both good times and bad and is one which I cling to as I grapple with both the uncertainty in economies and financial markets and the worry around the health of my loved ones especially my grandparents (one octogenarian and two nonagenarians). In that spirit, I wish you and yours the best of health.
You can find previous editions of Amit's 'From the desk of' on the Fidelity Global Equities Fund page
Footnotes & References: 1. Source: Bloomberg News Article Link, U.S. Jobless Rate May Soar to 30%, Fed’s Bullard Says, 23 March 2020. 2. Source: YouTube Video Link, COVID-19: A message to Marriott International associates from President and CEO Arne Sorenson, 20 March 2020. 3. Source: Linked-In, Article by Ray Dalio, Co-Chief Investment Officer & Co-Chairman of Bridgewater Associates, L.P. Article Link, March 2020. 4. Source: James Aitken - Systematic Risk in Crisis Podcast Link
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