Musings on Markets

Friday, April 24, 2020

A Viral Market Update VII: Mayhem with Multiples

I get a sense that I am approaching the end of this series of weekly posts, or perhaps I am just hoping that it is true, as the COVID crisis continued to play out in markets in the last two weeks, albeit on a more subdued scale and with a more positive twist. In this post, I will, as in the prior weeks, update the prior weeks’ market action (for two weeks, from April 4 to April 17) in different asset classes, and within equities, across regions, sectors and stock classifications. I will close this post by looking at how pricing tools, including a range of multiples (from PE ratios to price to book to EV to EBITDA multiples) will become shakier and less reliable in the aftermath of the crisis, and suggest ways in which we can compensate for the uncertainties.

Asset Classes

I started my crisis clock on February 14, reflecting the fact that I am US-based, and markets outside China did not wake up to the crisis until that week. In the weeks since, we have seen volatility rise and equity markets get whipsawed, with much of the pain being dispensed in February and the first three weeks in March. In the last month, equity indices around the world have seen positive returns, and in some cases, very good positive returns, as can be seen in the table below.

Download data

The week of April 10 to April 17 was a benign week, at least in sum, even though individual days still brought big movements, with most indices flat for the week. Moving on to the treasury market, we also saw steadiness, with both short and long term rates staying close to the lows that they hit just two weeks ago.

Download data

Looking at commodity prices, the divergence between oil and copper illustrated again the unique travails of oil, where a detente between Russia and China did little to stop oil prices from continuing to drop, while copper prices changed little.

Download data

In the two months since February 14, oil prices have dropped more than 65%, providing a contrast to copper, another commodity sensitive to the global economy, which has declined less than 10%. (To top of the craziness, the price of futures on Texas crude dropped below zero on April 20, but that is a story for another day/post.)

To complete the picture, I looked at gold and bitcoin, and while both have settled into holding patterns, the divergence since February 14 is stark.

Download data

In sum, gold has held its own, increasing 6.3% since February 14, though investors holding it were undoubtedly expecting a bigger pop, given the economic and market chaos, but bitcoin has disappointed those who believed it would play the role of a crisis asset, down 31% since the start of this crisis.

Risk Update

In my last post, I focused on how the price of risk has changed since February 14, 2020, starting with the corporate bond market, where default spreads have changed significantly over the last few weeks.

Download data

Note the surge in default spreads across bond ratings classes from February 14, 2020 to March 3, 2020, though there has been a drop off from highs in the last two weeks. The fear that has played out in the bond market has also affected the price of risk in equity markets. In the graph below, I updated the equity risk premiums, by day, that I computed in my post two weeks ago, through April 17.

Download spreadsheet

The implied equity risk premium which I computed to be 6.01% on April 1, 2020, has declined to 6.27% if I compute the risk premium using the (now stale) earnings and cash flows, and 5.60%, if I assume a 30% drop in S&P 500 earnings this year and a substantial drop in buybacks. I have a feeling that this roller coaster ride is not quite done and I will continue to estimate the numbers daily.

Equities Breakdown

In keeping with my practice in my prior posts, I looked at market capitalizations of all publicly traded companies (36,481 companies with market caps exceeding $5 million on February 14, 2020) and started by computing changes in market capitalization, by region:

Download data

Looking at the aggregated returns since February 14, 2020, the worst performing regions in the world are Africa and Latin America, and China remains the standout as the best performing market. Australian and Canadian stocks have been punished, largely because of their natural resource focus, and globally, stocks have lost $15.2 trillion in value, a huge amount but about half as large as the loss was four weeks ago. In the next table, I break market cap changes down by sector:

Download data

There are few surprises in this table, with healthcare and consumer staples being the best performers, and energy and financial services the worst. Breaking down the sectors into finer detail, I look at companies classified into 95 industries, and list the ten best and worst performers over the crisis period (2/14 - 4/17):

Download data

I know that it fashionable to talk about how inefficient and volatile markets are but this crisis, in many ways, has been surprisingly orderly and markets have dispensed punishment judiciously, for the most part.

I also looked at other classifications, from pricing levels (PE and PBV) to momentum to dividends/buybacks and found no significant differences across companies. In fact, the evidence seems to more strongly support the notion that the market is punishing low PE, high dividend yield stocks that had little momentum coming into this crisis more than high PE , non-dividend paying stocks. That is disappointing news for value purists who have been waiting a long time to say "I told you so" to momentum and growth investors. In fact, the only variable that seems to offer support for financial moralists is financial leverage, as can be seen in the table below, where I break down global stocks based upon how much debt they had at the start of the crisis:

Download data

The most highly levered companies, with leverage measured as debt scaled to EBITDA, have suffered more damage as this crisis has played out.

Pricing Update

In my earlier posts, I argued that just because uncertainty has increased, there is no excuse for abandoning valuation first principles or process; you can still value companies, albeit with a much wider range of outcomes. One common counter that I got to this argument was that valuation is pointless when the uncertainty is so great and while most of those marking this argument did not bother presenting alternatives, my guess is that many will fall back on pricing metrics to decide what to buy or sell. Put simply, they will use a PE ratio or an enterprise value multiple of EBITDA or sales to decide what stocks to buy or sell, acting under the delusion that this will allow them to escape having to make assumptions in the future. In this section, I will start by breaking down pricing multiples and then use simple valuation algebra to argue that there are assumptions about cash flows, growth and risk embedded in every pricing multiple. I will close by noting how multiples behave in a crisis, and report on pricing multiples, broken down by region, sector and industry, pre and post crisis.

Anatomy of a Multiple

I think of multiples as standardized prices, allowing investors to get past the challenge of comparing per share values, which are determined by share count. That said, it is easy to be overwhelmed by the number of multiples you see in practice, with some in wide use (PE, Price to Book, EV to EBITDA) and some obscure (EV per subscriber, EV to Invested capital). To put these in perspective, I will start by breaking down the choices that you have in constructing a multiple and using it to make a pricing judgment:

The numerator for any pricing multiple is a market value of equity, firm or operating assets, and the denominator is a scaling variable: revenues, earnings, cash flows or book value. There is no one "best" multiple or timing choice, since that will vary across time and across sectors, but here are two simple consistency rules to keep in mind, when constructing and using multiples:

Equity/Firm: If the numerator is an equity value, the denominator should be an equity value as well, while if the numerator is a firm or enterprise value, the denominator has to be an operating value. Thus, PE (market cap, an equity value, is divided by earnings per share, an equity value) and EV to EBITDA (EV is a market value of operating assets and EBITDA is a measure of operating cash flow) are consistent, but Price to EBITDA is an inconsistent abomination and Price to Sales is almost as badly constructed.
Timing: Multiples are constructed for comparisons across companies, not as stand alone measures. It follows therefore that you should be consistent in the timing you use for your scaling variable (revenues, book value, earnings) across companies. Thus, if you choose to use trailing earnings for your company to compute PE, you have to use trailing earnings for all your companies.

Put simply, in pricing, you estimate a value for a business or its equity, based upon how "similar" companies (equities) are being priced in the market place.

Determinants of Multiples

Many analysts who use multiples to find under and over priced stocks do so because they do not want to confront the uncertainty associated with forecasting future growth, margins and cash flows in intrinsic valuation. That is an illusion, since embedded in every multiple are assumptions about growth, risk and investment efficiency. When you pay a hundred times earnings for a stock or ten times book value, you are assuming high growth in earnings for the former and a monstrously high return on equity for the latter. In the picture below, I list out the fundamentals that are embedded in each multiple:

This cheat sheet, designed to find the variables that are embedded in a multiple, brings home a reality about pricing that should make anyone using it uncomfortable. The difference between intrinsic value, where you try (sometimes desperately) to forecast future growth and cash flows, and pricing, where you use a multiple, is that you are explicit about your assumptions in the future, making them both more transparent and easier to critique, and that you are implicit in your assumptions with the latter, making them easier to defend but also more dangerous.

Pricing and Crisis - A Time Line
In the aftermath of every crisis, investors abandon fealty to fundamentals, on the premise that they are in unique times and fall back on pricing. I am sure that will happen with this one as well, but if you decide to go this route, the nature of this crisis will make pricing much more difficult. To see why, take a look at how multiples will move as this crisis unfolds:

In phase one of this crisis, the market reacts to the crisis by marking down stock prices almost immediately, but the scaling variable (revenues, earnings, book value) does not, partly because it takes time for the crisis to show up in operating numbers and even longer for accountants to record that in the financial statements. Consequently, as the crisis first unfolds, stocks will look cheaper on a trailing basis, as the market price drops and earnings/revenues/cashflows stay stagnant, and analysts/companies are too uncertain to offer guidance about future operating results.
In phase two, analysts and companies start to provide forward guidance, and you can switch to forward values, if you trust them, but since the crisis can cause more companies to lose money, you will also see a greater dependence on revenue multiples in pricing.
In phase three, as operating results more completely reflect crisis effects, trailing multiples will reflect the updated operating results, but you should not be surprised to see companies trade at much higher multiples of trailing earnings (if earnings are still positive), or have earnings multiples that are not meaningful. Again, a naive comparison of the trailing PE to historic norms will lead you to conclude that everything is over priced, even when that is not the case.

No matter which phase you are in, you ultimately have to make judgments about whether the company will come out of the crisis, and if it does, what it will generate as earnings, to make sensible investment decisions. Just as there is no room for lazy and mechanistic valuation, in the midst of a crisis, there is no payoff to lazy and mechanistic pricing.

Pricing Effects
We are still in phase one of this crisis, though we are hopefully approaching its tail end. Not surprisingly, as market prices have dropped and trailing operating numbers reflect what companies did in 2019 (pre-crisis), there has been a drop in trailing pricing multiples across all regions of the world:

Download data

The same story unfolds across different sectors:

Download data

In some sectors, such as financial services, energy and airlines, where the punishment meted out by the market has been severe, you should not be surprised to see stocks trade at extraordinarily low multiples of trailing earnings. At the same time, companies have been reluctant to offer guidance for the coming year, making it difficult to shift to forward values. You could, of course, get ahead of the curve and try to forecast earnings in a post-virus world, say in 2022 or even 2025, and scale market capitalizations to those values.

As companies start to report their first quarter earnings, you are starting to get a glimpse of the damage created by the crisis and my guess is that you will start to see more analysts and companies start to forecast forward numbers. For those companies where forward earnings are positive, you can switch to forward PE ratios, but expect these numbers to be much, much higher than historical norms. For those companies that expect losses in the next year, you will see revenue multiples or creative variations on future earnings, from earnings before COVID to earnings in 2025 used as the scalar. Later this year, as companies report numbers for the second and third quarters of 2020, the trailing operating numbers will finally catch up with the crisis, but they will come with caveats. Put simply, if you are abandoning or refusing to do intrinsic valuation, because you feel uncomfortable with having to make assumptions, the same uncertainty is going to pervade your pricing as well.

YouTube

Data

Viral Market Update Posts

Wednesday, April 8, 2020

A Viral Market Meltdown VI: The Price of Risk

It is a sign of how volatile the last few weeks have been, that a week like the last one, where index levels move only 2-3% a day, high by historic standards, felt stable. As in prior weeks, I will start this one by looking at how the market action last week played out across asset classes, and within equity, across regions and industries first, but the bulk of this post will be an update on the price of risk, and how it has changed in both bond and stock markets over the last six weeks. In the process, I will compare this six-week periods to the 2008 crisis, which was also global, and shook the faith people had in markets, institutions and companies.

The Markets last week

The market action last week was more muted than it had been in prior weeks, but that is a relative statement, as we still saw big swings in almost every asset class. Using the same sequencing that I have used for the last few weeks, I will start with a review of equity indices globally:

Download raw data

It was a quiet week for most markets, with the Nikkei and the Sensex being the exceptions, dropping 8,09% and 7.46% respectively. Over the last month, every market has seen double digit negative returns, with Shanghai being the only exception. Moving on to US treasuries, we saw more calm than in prior weeks, with rates staying close to where they were in the previous week:

Download raw data

The (relative) calm in equity and treasury markets also played out in the corporate bond market, with spreads decreasing slightly for higher rated bonds and increasing marginally for lower rated bonds.

Download raw data

The commodity markets continued on their wild ride, with oil again diverging significantly from copper:

Download raw data

Oil prices surged dramatically towards the end of the week, mostly on rumors that Saudi Arabia and Russia would come to an agreement on oil production, but copper prices stayed stable. Completing the analysis, I looked at gold and bitcoin last week:

Both gold and bitcoin saw little price action during the week, not a bad development in a crisis market. In summary, looking at returns across asset classes last week, and comparing those returns to prior weeks, it is clear that last week saw a reduction in the volatility that has characterized previous weeks. It is unclear, though, whether the week is just the calm before another storm, or a true break in the crisis. The next few weeks will tell!

Breaking down the weekly movements

As in prior weeks, I start by looking at publicly traded companies around the world, and looking at how they did, in market capitalization terms, last week, and break down the information by region, sector/industry and classes (PE, momentum, debt etc.). I start with the regional breakdowns:

As with the market indices, it was a week of losses, albeit small ones, in much of the world, with the outliers being Eastern Europe & Russia, which saw a gain of 9.07%, and Japan, which lost 9.38% in market capitalization. Collectively, global stocks lost $1.6 trillion in the week of March 27-April 3, and have lost $22.7 trillion in market capitalization since February 14, 2020, a decline of 25.08%. Moving on to the sector breakdown:

The rise in oil prices pushed up the market capitalization of the energy sector by 6.31%, but most of the other sectors saw losses during the week of 3/27-4/3/20. Incorporating the last week into the data, financial service firms have now taken the dubious lead among sectors, of biggest percentage drop in market capitalization since February 14, 2020, and consumer staples and health care still lead the list of least damaged sectors. Honing down to the industry level and updating the list of ten most hurt and least hurt industries:

Data on all industries

The loser list has many of the same infrastructure industries that showed up in last week’s list, but the winner list has a healthy sprinkling of energy stocks, pushed up by the rise in oil prices during the week. I also did the breakdown, looking at companies in PE classes, momentum classes (based upon price change over the year leading into 2/14/20, net debt classes and dividend/buyback classes) and found that the only categorization where there is significant differentiation in market damage is net debt, where more highly levered companies continue to be punished more than less levered companies. You can find these categorizations and results by clicking on this link. I did extend the analysis to look at companies that have bond ratings, a subset of 2271 Firms out of the total sample of 36,789 firms, and the results reinforce the finding that leverage has the biggest explanatory power for damage from this crisis:

As bond ratings drop, the decline in market value is more precipitous, with the ratings below investment grade (below BBB, in red) being particularly hit.

The Price of Risk

In the last few weeks, as markets have tumbled, I have held back on reporting on a measure that I update every month, which is the equity risk premium. That said, the last six weeks reinforces a lesson that I learned the hard way in 2008, which is that dependence on a static, historical estimate makes no sense in a dynamic, shifting market. In this section, I want to focus on how the price of risk has changed over the last six weeks, and what lessons, if any, we can glean from those changes.

Determinants

In a post from earlier this year on the topic, I argued that every risky asset class market has a price of risk, though that price is more observable in some markets than others. The price of risk changes on a day-to-day basis, and is determined by a combination of variables that encompass almost everything going on in the world from uncertainty about future economic growth (more uncertainty -> higher price for risk) to political stability (more instability -> higher price for risk) to worries about catastrophes/disasters (more worries -> higher price for risk) to investor risk aversion (greater risk aversion -> higher price for risk) to information availability/reliability (less reliable and accessible information -> higher risk premiums). I know that I am giving short shrift to weighty topics, and if you are interested in a more in depth assessment of these variables, you can read my 2020 update on equity risk premiums here. (Be warned. It is long and boring, and may put you to sleep, but that may be a good thing..) The more general point though that emerges from identifying the determinants is that changes in these variables will change the prices for risk, and since investing and valuation has to be based upon updated prices for risk, you need measurement approaches that capture these changes.

Bond Market Price of Risk

In the bond market, the price of risk is observable, since as investors see more default risk in the future, and demand higher prices for risk, bond prices drop and interest rates on bonds increase. That is what I chronicled when I reported on the default spreads on bonds in different ratings classes in the last section, and looked at how these spreads changed over the last few weeks of this crisis. It is true that default spreads, for a given default risk class, don't change much in mature markets during periods of stability, and this can be seen in the graph below, where I look at the default spreads on Moody's Baa rated bonds (translating into an S&P BBB rating) since 1960:

Download raw data

Even during this period, there have been sub-periods of tumult, as evidenced by the change in default spreads in the 2008 crisis. Looking more closely at the the period between September 12, 2008 to December 31, 2008 at the spreads on bonds, here is what you saw:

In 2008, default spreads doubled between September 12, 2008 and December 31, 2008. In the last six weeks (February 14, 2020- April 3, 2020), the default spreads on bonds in every ratings class have widened, not surprising given both the economic damage done by the crisis and the higher likelihood of default and the fear factor:

It is interesting that the default spreads did not show much effect during the first two weeks of this crisis (February 14- February 28), but woke up to the crisis in the third week. Over the six weeks, spreads have almost doubled for the highest risk classes, and have increased significantly even for higher rated bonds.

Equity Market Price of Risk

Unlike the bond market, it is more difficult to measure a forward-looking and dynamic measure of equity risk, though there are short cuts that people have employed. For instance, there are some investors who use the earnings yield (the inverse of the PE ratio) as a rough proxy, arguing that it should be higher, when equity investors are demanding a higher price for risk. There are others who focus on the VIX, a traded measure of volatility that is observable and is a gauge of fear and worry, rising during crisis and market downturns. In the last six weeks, the VIX has gone on a wild ride, as can be seen in the graph below, peaking at 85.47 on March 18, 2020.

While the VIX is an instrument for measuring market fear, it is not a direct measure of the equity risk premium. My preference is an implied equity risk premium, computed by estimating the internal rate of return investors can expect to earn, given what they pay for stocks and expected cash flows in the future, and netting out the risk free rate:

As some of you who have visited my website know, I update this equity risk premium (ERP) at the start of every year, and the graph below summarizes the implied equity risk premiums on the S&P 500 at the start of every year from 1960 to 2020.

Download historical implied ERP

Note that the equity risk premium stood at 5.20% at the end of 2019, but is has been more volatile since the 2008 crisis, than prior to it. It was during that crisis that I developed the practice of computing the premium on a day-to-day basis to capture the battle between fear and greed that characterize every crisis. In the figure below,I graph the implied ERP from September 12, 2008 (the Friday before Lehman’s collapse) until December 31, 2008:

Note that on September 12, 2008, which was the triggering point for the 2008 crisis, the equity risk premium for the S&P 500 was 4.22% but during the next eight weeks, the ERP rose sharply to reach a high of 7.83% on November 20, 2008, before subsiding somewhat to end the year at 6.43%. One of the limitations that I faced during that period is that while I was able to update the index values and treasury bond rates every day, the earnings and cash flow numbers were being updated with a substantial lag, with the full changes not showing up until several months later.

I decided to do the same day-to-day calculation for the implied equity risk premium, with an augmentation. Rather than allow earnings and cash flows to remain stagnant, in the face of a crisis that will almost certaintly decimate both, I computed a COVID-adjusted ERP as well, with estimated drops in earnings and cash flows. In making these judgments, I did change my estimates across time, starting with a 15% drop in earning in the first two weeks of this crisis, and ending with a 30% drop in earnings for the S&P in the most recent two. Those changes may reflect my slow learning, as the gravity of the crisis magnified each week:

Download raw data

I understand that this crisis is by no means over, and I intend to keep computing the implied equity risk premium daily for as long as I think necessary, but if your estimates are close to mine, the equity risk premium for the S&P 500 was 6.01% (with the adjusted numbers) on April 1, 2020.

Country Risk Premiums

At the start of each year, I compute equity risk premiums, by country, with the intent of using these numbers when I value companies, and leave them unchanged for the first half of the year. This year, though, the crisis has caused the numbers to change, and in some cases, dramatically. First, the base premium that I use is the US implied equity risk premium which has jumped from 5.20% to 6.01% (see above). Second, the additional risk premiums for countries are based upon sovereign default spreads, which like corporate bond spreads, have widened significantly. My updated basis for computing the country equity risk premiums is below:

My global picture of equity risk premiums at the start of April 2020 is provided below:

Download spreadsheet

Just to illustrate how much of a difference a few weeks can make to your estimates, I have also included the ERP from January 1, 2020, for comparison. Note that the premiums have not only climbed in every country, but they have increased more in the riskiest countries.

Conclusion

One of the lessons that I learned from the 2008 crisis was to move away from static approaches for computing equity risk premiums, dependent on looking at long periods of history. What I learned during the last three months of 2008 made me switch to using implied equity risk premiums in my valuation and corporate financial analysis, and to compute them on a monthly basis. This crisis has reinforced that practice. I have always found it difficult to grasp how companies can use hurdle rates that are not only set in stone, but set in stone a decade or two ago, even as the market environment shifts and the price of risk changes. The median cost of capital for a global company, which was 7.6% at the start of 2020, is now closer to 8%, with the increase in risk premiums more than compensating for the decline in risk free rates in much of the world and the rise in cost of capital, in US dollar terms, steeper in emerging markets than developed markets.

YouTube Video

Paper on Equity Risk Premiums

Equity Risk Premiums: Determinants, Estimation and Implications- The 2020 Edition

Datasets

Spreadsheets

Equity Risk Premium Calculator, April 1, 2020

Viral Market Update Posts

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.

Download data

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%

Download data

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.

Download data

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.

Download data

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.

Download data

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.

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).
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.
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.
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:

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)
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.
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

Spreadsheets

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

Viral Market Update Posts