Monday, March 23, 2020

A Viral Market Meltdown IV: Investing for a post-virus Economy

At the end of each of the weeks leading into the last one, I have done a market update, reflecting the changes that occurred in the week, not just to market values, but also to investor psyches, and each week, I have hoped that it would be the last one needed for this crisis. That hope was dashed last week, as markets continued on their downward spiral, and here I am again, writing another viral market update. In this week's update, I will begin by again first chronicling the market damage, across asset classes, and within equities, across sectors, industries and company types, but I will follow up by looking at four different investment strategies for those who have the capacity and the willingness to look past the near term, recognizing that many of you might not have that luxury.

Surveying the Market
In what has now become a common component of each of these weekly updates, I will start with a survey of overall market performance in different asset classes, and  and then break down the damage in equity markets across the globe.

The Macro Picture
As was the case in 2008, it was difficult, perhaps impossible, to find a safe place to hold your money last week and no market was spared during the week. It was a week when equities lost trillions in value, across the world, but it was also a week when treasuries that had appreciated in prior weeks due to a flight to quality also saw no gain, oil continued its falls to multi-decade lows, and gold did not play its historic role as a crisis asset. Let's start with equities. The week started badly and did not get much better, as fear ruled across markets:
Download spreadsheet
The European equity markets, at least collectively, did better than the American and Australian markets between March 6 and March 13, with the Asian and African markets falling in the middle. When equities are in free fall, US treasuries are usually the beneficiary, but last week proved to be an exception, as treasury rates at the long end stabilized, perhaps spooked by the prospect of inflation from the trillions of dollars in rescue packages being proposed:
Download spreadsheet
The fears that this crisis will create an extended and deep recession, which, in turn, will cause corporate defaults to rise, especially in natural resource and travel-related companies, caused corporate bonds to have their worst week of this five-week crisis period:
Download spreadsheet
The damage in the corporate bond market, not surprisingly, was worse for lower-rating bonds, but the even highest rated bonds were not spared. Speaking of natural resource companies, oil continued on its downward trend, falling well below what many analysts had pronounced as its floor:
Download spreadsheet
The fact that copper, another commodity sensitive to global growth, has not dropped as much shows how much of an effect the Russia-Saudi tussle is having on oil prices.  Closing off, gold had a better week than stocks, but it too was down, but bitcoin ended the week on a little bit of an upswing.
Download spreadsheet
All in all, no asset class was safe and creative asset allocation would have best reduced the pain, not eliminated it.

The Breakdown
As in the weeks before, I will take apart the drop in equities around the world and look at the differences meted out, both in the last week and cumulatively over the five weeks since February 14.

Sector and Industry
I start by looking at the loss in value, broken down by sector, with the percentage changes in value computed over a week and over five weeks:
Energy remains the most damaged sector, with financial services and real estate close behind., and  consumer staples and health care have held up the best. Breaking the sectors down to industries, and looking at the ten best and worst performers last week:
Download spreadsheet
The industries that were worst hit were infrastructure companies (with the exception of healthcare support services and automotive retail) that tend to have debt. Read in conjunction with the earlier table on the widening of default spreads for corporate bonds, last week's market collapse seems to have been driven more by default risk concerns than the prior weeks. The least affected businesses tend to be those that cater to non-discretionary demand.

Earlier in this post, I looked at market indices around the world to conclude that stocks listed on the American and Australian continents were more affected than European stocks. Expanding on that proposition, I look at the market value lost, both in dollar and percentage terms, across regions:
Globally, companies have lost $26.1 trillion in market capitalization over the last five weeks, and US stocks alone have lost $11.8 trillion in market cap. Canadian, Australian and Latin American stocks have been worst hit, in percentage terms, and China and the Middle East have taken the smallest hits, in percentage terms.

Net Debt and Profitability
It looks like debt concerns rose to the top of the worry heap last week, and to see how this shows up at the company level, I broke companies down into five quintiles, in terms of net debt ratios, and five quintiles in terms of operating profit margins. Specifically, I want to see how much having a profit buffer and low debt has protected companies during this meltdown. 

I apologize if this table is a little overwhelming, but the way to read it to look at the combinations of net debt and profitability. For instance, companies with the least debt are in the bottom quintile of the net debt column and companies with the highest profitability are the top quintile of the profitability column. I don't want to read too much into this table, but if you look at last week's action, stocks with lower net debt ratios (in the bottom two quintiles) did much better than stocks in the top debt quintile.  At least for the moment, the profitability effect is being drowned out by the debt effect, since there is little discernible relationship between operating profit margins and market markdown. If you squint hard enough, you may be able to find something, especially in the middle quintile, but I will leave that up to you.

Looking Past the Crisis
In one on my first posts on this viral market crisis, I mentioned that the first casualty in a crisis is perspective. As you get deeper and deeper into the specifics of the crisis, you will find yourself not only getting bogged down in numbers, and in despair. I have had moments in the last few weeks, when I have had to force myself to step back from the abyss, think about a post-virus world and to reclaim the initiative as an investor. If you are a pessimist, you may view this as being in denial about what you see as an economic catastrophe that is about to unfold, but I am a natural optimist, and I believe that this too shall pass!

The Economy
There is no disagreement that the virus will cause the economy to go into a deep recession, since commerce is effectively shut down for at least a few weeks. During that period, economic indicators such as unemployment claims and measures of economic activity will hit levels not seen before, bur that should come as no surprise, given how large and broadly based the shock thas been. There are two questions, though, where there can be disagreement.
  • How quickly will the global economy come back from the shut down, and when it does how completely will it recover?
  • How much permanent change will be created by this crisis in terms of both consumer (and investor) behavior and economic structure?
There are some who are more optimistic than others, arguing that once the viral fears disappear, there will be a return to business as usual for most parts of the global economy, stretched out over months rather than years, and that the changes to consumer behavior and economic structure will be small. At the other end, there are many more who feel that economies take time, measured in many years,to recover from shocks of this magnitude and also that there will be significant changes in consumer behavior and economic structure in the making.

Investment Strategies
Your views on the economy, both in terms of how quickly it will come back from this shock and how much change you see in economic structure, will determine your next steps in investing. If you believe that recovery will be quicker and with less structural change, there are two strategies you can adopt. 
  • Bargain Basement: In this strategy, you focus on stocks that have been pounded in the last few weeks, losing 50% or more of market value, but which have the ingredients that you believe will allow them to survive, perhaps stronger, in the post-virus economy. Key among these ingredients will be low net debt ratios (Net Debt to EBITDA less than one) and pre-virus  operating margins that were solid enough to take the hit from the crisis. To the extent that survival until the turnaround occurs is key, you may also keep your search restricted to larger market cap companies.
  • Distressed Equity: There is a more risky strategy you can adopt, where you also look for stocks that have seen a significant loss in value over the last five weeks, but focus on the most endangered of these, with high net debt and fixed costs. You are effectively buying options, with some already out-of-the-money, and as with any strategy built around doing that, you will see a significant number of your investments go to zero. The payoff from this strategy comes the companies that make it back to life, with equity values increasing by enough to cover your losses. At first sight, the airlines and Boeing meet these criteria, but there is a catch, insofar as they are large enough to be targeted for government bailouts, which are a mixed blessing, since they allow companies to survive, while wiping out or severely constraining equity claims. Thus, smaller companies that have to make it through on their own may be better candidates  for this strategy than companies that are too big to fail, that attract large bailouts. 
If you are more pessimistic about economic recovery, both in terms of its length and strength, and believe that the recovery will restructure the economy and how companies operate in many businesses, there are two strategies that you may find work for you:
  • Safety at a Reasonable Price (SARP): Here, you focus on companies that are best positioned to not just survive a long downturn, but have the ammunition to make it work to their advantage. Large market cap firms with low debt ratios and high cash balances, that had high growth and profit margins in the pre-virus economy, would be good candidates. Facebook, Alphabet, Apple and Microsoft, for instance, clearly fit these criteria, but  since these companies are already sought after in a market where safety is rare and highly valued, you should add pricing screens that allow you to get them at reasonable prices. 
  • Change Agents: This is as much a bet on changes in consumer behavior and economic structure as it is on individual companies. Thus, if you believe that this crisis will make people more comfortable with delivery services for a wider range of goods and online interaction (in business and education), you could seek out companies that are innovators in these spaces. Again, the highest profile players, like Zoom, may be priced out of your reach, but there are others like Chegg that may meet your criteria.
The picture below summarizes the four strategies:

My views on the economy are mixed. I do think that the global economy will come back, but it will take more than a few months, and there will be structural changes in some sectors. I ran screens for all of the strategies, other than the Change Agents strategy (which is less about screening, and more about detecting macro trends), across all publicly traded stocks (about 40,000+) on March 20, 2020. As I look at the companies that go through the screens, I realize that there is more work to be done and better screens that can be devised, but think of it as work in progress, and if you have access to a large database, try your own.

YouTube Video

  1. Market Changes by Asset Class, through March 20, 2020
  2. Market Changes by Industry, through March 20, 2020
Screened Stocks
  1. Bargain Basement, as of March 20, 2020
  2. Distressed Equity (Options), as of March 20, 2020
  3. Safety at a Reasonable Price (SARP), as of March 20, 2020 (Add your pricing screen)


Anonymous said...

Good evening Professor,

When you build spreadsheets incorporating data from "all publicly-traded stocks," do you have a specific data source that works well for you? Any recommendations for vendors/resources to be able to pull in basic market/fundamental metrics across the entire stock market (rather than for single companies)?

Thanks in advance for any guidance!

Eyal Goren said...

Thanks. Great read.

If you look at investing as identifying market opportunities - than panic can be a lead driver for an opportunity.

In that regard - what about a strategy that aims for companies that were impacted by panic the most, such as airliners and cruise companies (but not only)? Seems similar to what you described as Distressed Equity, but not quite, since the trigger is different. You need a distressed equity AND panic for the actual product.

Panic makes sense in the short term. Everything looks terrible. Looks like we have to run. Than we run. Who would go on these ships while there's no vaccine? probably no one, and indeed they are temporarily shutting down. On the flip side - panic never last, since panic is not just a run, it's actually a sprint. So I wouldn't mind going on a cruise in 2021, knowing that all of the passengers were vaccinated, with the extra benefit of a probable cost reduction + all the safety measures management can come up with.

To move forward with such an investment you need to assume:
1. That there will be a CV vaccine available during 2021
2. Lenders will be willing to provide enough funds to sustain the invested company during these rough times

The main risks you're taking:
1. The company may die in the meantime due to high debt to EBITDA ratio
2. Valuation growth rate of these companies will be outpaced by other strategies

Anonymous said...

Are you suggesting using relative pricing as opposed to DCFs valuation?

Anonymous said...

Hi. You mentioned Zoom (ZM) in recent posts and instead, you should take a look at CSCO. Because Cisco’s Webex platform is much bigger than Zoom’s and I don’t think the market is on to the implications yet. Zoom is being priced (not valued :) at more than $40 billion. If Cisco spun off Webex, or even created a tracking stock, there is tremendous opportunity to unlock value for Cisco and its shareholders.

Anonymous said...

Nvda showed up in one of your screens. I know you previously stated you bought it at $145. Will you show how you valued it at that time? Thanks

Unknown said...

Hello Professor:

Very much enjoyed your presentation.

You set the long term perpetual growth rate using the 10YR treasury. Currently it is not only at historic lows but the TIPS Spread is negative. This implies to me that these assets are mispriced. Using a mispriced security in such a key valuation position seems risky businesses. I want you to be right as it undervalues the S&P. Can you please comment?

Ian Quigley

Anonymous said...


Thank you for yet another informative blog post.

When it comes to investing for that profile of people who are not full-time investment professionals but are also not completely clueless - suppose they took finance/security classes in school or worked earlier in their careers in investment banking where they had to do valuations and fundamental analysis, what investing approach do you recommend in terms of choosing between ETFs vs individual stock selection? I'm one of those people. I track 13-Fs to see what classic value investors or successful hedge funds have bought and sold, subscribe and read a couple investment newsletters monthly that contain stock pitches, check sources like SumZero for stock ideas, etc, but I don't have the time to do deep dive analyses and valuations of a stock myself. I do enjoy buying shares in individual companies more than just a basket of ETFs.

Is it still recommended to just go with ETFs and a basic asset allocation, or could you get away with triangulating some good stock ideas from the various sources one reads/tracks?

Ash said...

Thanks Prof Damodaran. I have learnt a TON from your posts. Regarding this point on the Distressed Equity investment strategy:

"Large enough to be targeted for government bailouts, which are a mixed blessing, since they allow companies to survive, while wiping out or severely constraining equity claims."

Why would equity claims be wiped out if I am holding their stock? Is it because the government (& other debtholders) would need to be paid out first so dividends would be constrained? With this strategy, you could still benefit from capital appreciation though?