“Our knowledge of the way things work, in society or in nature, comes trailing clouds of vagueness. Vast ills have followed a belief in certainty.”
Economist Kenneth Arrow, quoted in Against the Gods by Peter Bernstein.
One of a portfolio manager’s main tasks is to make decisions amid “clouds of vagueness.” And while these times of social, economic and market upheaval have produced some particularly heavy clouds, they have also created opportunities. But our methods of assessing them must adapt to the current situation in order to avoid value traps: we need to be certain what we know and what we don’t.
We do know that, for the past few years, the market has rewarded industry winners and punished also-rans. As an example, we could look at the relative performance of Amazon versus eBay. The market has also transferred value from old business models to new ones. This pattern has remained in place, and even strengthened, amid the volatility arising from the Covid-19 outbreak because the business models that have increasingly worked for the past five years, have also worked better for the past few weeks.
This market dynamic has produced a valuation gap between US companies trading at high and low multiples that has only been so wide at three other points in history: in 1932, in 1975 and in 2009, according to data from Empirical Research.
The companies trading in a high range are well above the historical average of the high end. Those trading at the low end - the ‘cheapest’ part of the market - are trading at a much lower point than historical averages.
This dispersion is understandable given the structural changes in the world but opens up some big opportunities for stock pickers, and some individual companies are starting to get to attractive levels at which investors are being compensated for the higher associated risks.
To assess these opportunities, we have two buckets. One big bucket of opportunities is filled with perfectly fine companies, with no business or balance sheet problems, that we can now buy more cheaply. This is most of what we already own, and we keep finding new ideas and adding to existing holdings.
Another one, smaller in size, consists of companies in difficulties. In normal times, our analysis focuses on a company’s competitive position in an industry, its financial performance and its ability to deploy capital in order to create value over time.
Adapting our analysis
But in a world of shutdowns, our analysis must adapt. For some sectors, the question of whether a company will be more or less profitable in the future has been replaced by more existential concerns: whether the company will survive the crisis and what government intervention may mean for private capital owners.
Looking at a company’s debt profile gives us clues about its survival prospects, and we are privileged to be able to work closely with colleagues in fixed income to help unknot this part of the balance sheet. A company that owes money this year or next will behave differently to one whose bills fall due in 10 years’ time. We also look at the rights granted to creditors under the various covenants. Balance sheet strength is reflected in equity performance now more than ever.
Airlines are a good example of an industry priced for collapse. An airline can be reduced to two components: the planes and the operations. These are financed by equity and debt. With concerns over what a travel shutdown will do to leveraged balance sheets and business models, share prices have fallen sharply. At current valuations, for some names, an equity investor buys the planes and gets the business for free.
We do know that people will fly again, and the planes will be valuable after this episode has passed. But there’s no such thing as free money. The extra variable to contend with for this sector is government support. There is a risk to equity holders that any state involvement may dilute their stakes and water down any gains to be had from survival, and so this must be factored in to any investment decision.
Determining survival is complex
In summary, we are mainly buying good companies at lower prices, but also looking at a broader range of stocks if they can survive the economic shutdown. But determining the likelihood of survival is complex. Some stocks may drop substantially from here.
Others may increase several-fold from today’s low prices over the coming years. To battle through the “clouds of vagueness” produced by these volatile markets, we are adapting our valuation methods, focusing on what we do know to try and ensure that the companies we select will survive and prosper in the post-pandemic environment.
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