Tuesday, March 31, 2020

A Viral Market Meltdown V: Back to Basics!

My first post on this blog was on September 17, 2008, a week into the 2008 crisis, and I honestly did not expect to be posting for long, anticipating that after a few posts, that crisis would be behind us, and that we could go back to our lives. That of course turned out not to be the case, as the crisis not only extended for months, but left its imprint on almost everything market or economy related for the next decade. Almost twelve years later, and six weeks into another market crisis, I have a sense of deja vu, as the days of volatility stretch into weeks, and each week brings new surprises. Unlike my four previous updates, this one will describe a week of market recovery, at least in sum, but like the previous weeks, the increase in market values came with wide swings, and continued uncertainty and volatility. It was also a week that saw governments around the world rush to pass rescue packages designed to get both individuals and businesses through a period where the global economic machine has been shut down. These bailouts, in addition to being many times larger than prior bailouts, have also reignited debates about what governments should be demanding in return. In the United States, a central issue that is being argued is how much stock buybacks done by companies in the last decade are contributing to the pain that companies are facing, and whether there need to be restrictions on them. While I will consider this issue in depth in a post later this week, I will look at the interaction between dividends, buybacks and market damage in this post.

A Macro Review
As in prior weeks, I will start this week's post by updating how the different asset classes performed last week, partly to put the six-week period (from February 14, 2020 - March 27, 2020) in perspective and partly to get a sense of where we are going next. The place to start is with equities, and in the table below, I look at the changes in equity indices across the world, both in the last week (March 20 -  March 27) and the last month.
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Markets around the world had a good week, with the US and Japan delivering the most positive returns. Even those solid weekly returns were insufficient to make up for an otherwise painful month, where most indices lost 20% or more of their value. Moving on to US treasuries, in a week where the Fed continued to aggressively support the market, rates dropped across maturity classes, with treasury bill rates again hovering around zero. The ten-year rate ended the week at 0.72% and the 30-year rate at 1.29%
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As in the previous week, stocks and bonds moved together, albeit with positive, not negative, returns. The  positive mood in the equity and treasury markets spilled over into the corporate bond markets, where default spreads that had spiked in the previous week dropped during the week, as default risk fears subsided strongly for the higher ratings and mildly for the lowest ratings.
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Moving on to oil and copper, the two commodities that I reported on last week, it was a week of divergence, with copper having a flat week but oil continued its fall, as Russia and Saudi Arabia tried, but failed to reach a detente.
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Finally, I look at gold and Bitcoin, my stand-ins for crisis assets and both gained for the week, though Bitcoin had a much larger deficit to make up, from its drop in prior weeks.
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All in all, it is telling that last week, with all its volatility, felt calmer than prior weeks, perhaps because more of it was on the upside and it is all relative. That said, we are still on a roller coaster and there are more thrills to come in the coming weeks.

Equity Market Breakdown
In keeping with my practice in prior weeks, I will break down the equity movement last week by region and sector first, looking to see if there are divergences. I begin by breaking down the change in market value, in both dollar and percentage terms, by region during the 3/20-3/27 week:

In the aggregate, Japanese stocks had the strongest returns this week (3/20-3/27), followed by US and UK stocks. In fact, last week was the strongest week for US equities since the 1930s, with stocks up more than 10% for the week. Globally, stocks added $5.7 trillion in market cap, but remain down $21 trillion since February 14, 2020, even with that revival. Moving on to sectors, and looking at the same metrics, I get the following:

The results here are consistent with the earlier findings that corporate bond default spreads declined last week, after the surge in the prior one, and the most highly levered sectors (real estate and utilities) benefited. Updating the list of the ten industries that have been hurt the most and least during this crisis (dating back to February 14, 2020, I get this list:
Download full list of industries
Some of the worst performing industries over the six-week period had the best weekly performance last week, but remain deeply damaged.

In previous weeks, I have looked at classes of stocks, focusing on a different dimension each week. in the first two weeks, I looked at stocks classified based upon growth/value (with PE standing in as proxy) and momentum (based upon the stock performance in the year leading into February 14, 2020) and found little differentiation in market damage across the classes. Put simply, there is very little evidence, at least during these six weeks, that the market is punishing high growth stocks or high momentum stocks more or less than other stocks. In last week's update, I noted that companies with high financial leverage were more exposed to damage at least during the week than less levered companies. In this week's update, I focus on another variable that people have pointed to, often with nothing more than anecdotal evidence, as a potential culprit  in the crisis, and that is stock buybacks. Their argument is that companies that have bought back stock, often with borrowed money, are the ones that have led us to the precipice, and that the viral shock to the economy is just a tipping point for these companies. To test this hypothesis, I classified global companies into those that bought back stock last year and those that did not, and looked at the market damage across the two classes:

It is true that companies that bought back stock last year were slightly more exposed to market damage than companies that did not, but the differences are small. Globally, buyback-companies have lost about 25% of their market capitalization between February 14, 2020 and March 27, 2020, whereas non-buyback companies have lost 21% of their market capitalization; for US companies, the analogous numbers were 26% for buyback-companies and 23% for non-buyback firms. To see if it was buybacks that were the drivers of this difference, I also classified firms into those that paid dividends in 2019 and those that did not, and got results very similar to the ones with the buyback categorization.
Companies that paid dividends suffered more market damage of almost the same magnitude as the the buyback companies did, suggesting that the old value investing adage of buying companies with big dividends is providing little solace in this crisis. 

Finally, I returned to buybacks and focused just on US companies, where the buyback phenomenon has been most pronounced, but looked at the cross effect of leverage and buybacks, to test the proposition that it is not buybacks per se that are the problem, but buybacks by companies that either already carry high debt loads or borrow money to fund the buybacks:

There are two groups, where buybacks make a discernible difference on returns. The first are companies with negative EBITDA that bought back stock (which strikes me as foolhardy), with market values dropping about 31% from 2/14/20 to 3/20/20, relative to negative EBITDA companies that did not buy stock, where market values dropped only 24%. The second is in the companies with the least debt, where market values for buyback companies declined  26%, as opposed to 16% for non-buyback companies. All in all, while it is true that some of the companies that are the recipients of government bailouts have bought back stock in past years, there is little evidence for the proposition that without the buybacks, they would not need the bailouts. I know that I am giving short shrift to buyback arguments, for and against, but I will return to this question, with a more in-depth breakdown in a post later this week.

Back to Basics
As with all of my viral update posts, I will end with a focus on the future and a return to fundamentals, by looking at how to value companies in the midst of a market and economic crisis unlike any in history. While many investors have put their valuation tools away, using the argument that there is too much uncertainty now to even try, I will argue that this is exactly the time to go back to basics and try valuing companies, uncertainty notwithstanding.

The Dark Side beckons..
If your concept of valuation is downloading last year's financials for a company into a spread sheet and then using historical growth rates, with some mean reversion thrown in, to forecast future numbers, you are probably feeling lost right now, and with good reason. Specifically, the last six weeks have upended almost all of the assumptions, explicit and implicit, that justified this practice.
  1. Historical data may be recent, but it is already dated: For most companies globally, the most recent financial statements are for 2019, and in calendar time, these financials are only a few weeks old. As the global economy shuts down, though, the one thing we know with certainty is that the revenues and earnings numbers reported in those recent financial statements are almost useless, a reflection of a different economic setting. The same can be said about equity risk premiums and default spreads, as I am painfully aware, since the numbers that I updated on January 1, 2020, are so completely out of sync with where the market is today that I plan to do a full update at the end of today. (March 31, 2020).
  2. This year will deliver bad news: There is almost no doubt that 2020 will be a bad year for all companies, with the key questions being how much of a drop in revenues companies will see this year, and how this will translate into earnings shocks. It is true that there are a handful of companies, like Zoom, Slack and Instacart, to name just three, that may actually benefit from the global quarantine, but they are the exceptions. 
  3. Survival has become a central question: The magnitude of the shock to corporate bottom lines and the speed with which it has happened has put companies at risk, leaving debt-burdened and young companies exposed to default and distress. While some of the largest may get help from governments to make it through this crisis, their smaller and lower-profile peers may have to shut down or let themselves be acquired.
  4. The post-virus economy will be different from the pre-crisis version:  Every major crisis creates changes in business environment, regulations and business models that reshapes the economy and resets competitive games, setting the stage for new winners and losers. Thus, for some companies, the bad news on revenues and earnings this year may be a precursor to superior operating performance in the post-virus economy, as their competition fades 
Put simply, this is not the time for purely mechanical number crunching and a blind trust in mean reversion, since the landscape has changed. It is also not a time to wring our hands, complain that there is too much uncertainty and argue that the fundamentals don't matter. If you do so, you will be drawn to the dark side of investing, where fundamentals don't matter (paradigm shifts, anyone?), new pricing metrics get invented and you are at the mercy of mood and momentum. Ironically, it is precisely at times like these that you need to go back to basics.

A Jedi Guide to Valuation
With these lessons in mind, I decided to revisit my basic valuation model, which has always been built around fundamentals:

While the fundamentals remain the same, I considered how best to incorporate the effects of this crisis into the model and arrived at the following:

Note that this post-Corona valuation model stays true to the fundamentals but introduces three crisis-specific inputs into the valuation:
  1. Revenue Change & Operating Margin in 2020: These are the inputs that will reflect the effects of the global economic shut down on your company's revenues and operating margin in the next 12 months. For companies close to the center of the viral storm (travel-related companies, people-intensive businesses and producers of discretionary products), the revenue decline this year will be large and they will almost certainly lose money. (See my third viral market update for a way of visualizing this damage)
  2. Expected Revenue Growth in 2021-2025 and Target Operating Margin: If you feel drained from having to estimate the 2020 number, I don't blame you, but the more forward-looking part of this valuation is estimating how your company will fare in the post-virus economy (assuming it does not fail). For some companies, like cruise liners, the answers will be depressing, because the sights of large cruise ships stranded on the high seas, and acting as Petri dishes for spreading diseases will linger, but other companies will find themselves in a  stronger position in  the post-viral economy, partly because of their product offerings but also because of their financial strengths. In the tales told about Amazon, people often forget how much its current stature and success is due to the dot com bust (not the boom) of 2001, which wiped out their online competitors and handicapped their brick-and-mortar competitors.
  3. Failure probability and consequences: In good times and when valuing mature companies, we become lazy and forget that conventional valuation approaches, where you project cash flows as far as the eye can see and beyond, and discount them back at a risk adjusted discount rate, are designed for going concerns. These are not good times, and even mature companies are facing threats to survival. It is almost impossible to adjust for this concern in discount rates and it is therefore imperative that you make judgments about the likelihood that your company will not make it, and this probability will be higher for smaller companies, young companies and more indebted companies. Even with large companies that may be recipients of bail outs, because they are too big to fail, your equity may go to zero, if that is one of the conditions of the bailout (as was the case in the 2009 GM bailout).
I have updated the equity risk premiums (not only for the US but the rest of the world) to reflect the market convulsions over the last few weeks, as well as default spreads for debt, and suffice to say that there has been a surge in the price of risk.  I know that that you are trying to make a judgment call in a period of incredible volatility, where no one (managers, analysts, governments) know what is coming,  but your reasoned guess is as good as anyone's estimate. So, be bold, make your best estimate and move on! If you get a chance, you may also want to watch this video guide I put together last Friday for using my spreadsheet:
I value Boeing in the webcast but rather than focus on my story and valuation of the company, please focus on the process, so that you make it your own. There is nothing magical in the spreadsheet, and I am sure that there are flaws in it and that you can make it better. Use it as a starting point, adapt it and make it better.  Carpe diem! 

YouTube Video

Data Links

  1. Macro Market data (stocks, bonds, commodities, gold) on March 27, 2020
  2. Industry Breakdown on March 27, 2020

  1. A Post-Corona Valuation spreadsheet (with a video guide on how to use it)


Mark said...

Hi Prof,

I'll like to ask how do we value companies engaged in M&A during this crisis? I have invested in a company that is about to be acquired in May 2020. The offer is part cash and part equity, so given the current crisis how would i determine if the offer is still competitive? Thanks!

Anonymous said...

Great work and I look forward to your next update!

FEA said...

This post mentions an update to country risk premiums by March 31, but it does not seem to have been posted yet (or was it posted on a different page in the portal?). Please let us know if you still plan to post an update / where to access it. Thank you.

FEA said...

This post mentions an update to country risk premiums by March 31, but it does not seem to have been posted yet (or was it posted on a different page in the portal?). Please let us know if you still plan to post an update / where to access it. Thank you.

Andrew Jr. said...

Hey Professor,

Thanks for all your work. Been following you for some time. Given what is happening in the markets do you have any thoughts around how an investor should be thinking about the Large US banks at this time. On the surface valuations seem relatively attractive. However, are these companies with too much uncertainty going forward?

Best regards