The Good, the Bad, and the Ugly

Haircut…
..is the first thing this author is going to get once allowed out of the house. Sadly, that is also the painful but essential course of action many firms will likely have to take on its cost structure as the world returns gingerly from the Covid-19 lockdown. Positives are noted but with companies picking up broken pieces in a cautious environment, economic assumptions have to be realistic, acknowledging that latent demand of rich Chinese buying Hermes bags, are not in fact commonplace. Profit warnings (and a lack of forward guidance) by stock market darlings Amazon and Apple, have started to impact the market, with the S&P giving up gains on Friday and with US futures staying firmly negative despite reports that remdesivir drugs could reach hospitals this week.

At this juncture, central banks that have been printing copious amounts of money will still have to contemplate a tentative demand outlook and that people going back to what they were doing pre Covid-19 in a V or U shape like fashion, is showing evidence of looking increasingly unlikely. As the consumer segment is one of the key areas of focus for Karrin, we are looking out diligently for changing consumer trends in determining new demand areas as well as any abolishment of the old order.  A trend we are also keeping an eye out for is the observed higher savings rate indicating lower propensity to spend, this likely due to lower job security and disposable income. We note that a liquidity crisis demands liquidity and a solvency crisis demands demand. We are sadly in the latter basket and despite the stark increase in M2, the problem is not yet solved. (Read more on a deflationary environment in Canary in a Coal Mine published 27th April 2020).

​What is equally exciting as it is daunting this week, is the return to business for many economies, a difficult decision to make, but in our view the right one. Naturally, any decision this drastic will attract criticisms, but it is important to recognise that the purpose of a lockdown is to contain and not to eradicate infections. We are cognisant of the heightened risks of a secondary wave of infections, that said, from a societal point of view, the economic ruins that befalls a continued lockdown is in our view equally if not more devastating. The focus should now be on the assiduous enforcement of testing, distancing, hygiene and hospital vacancies to avoid further lockdown despairs as have been seen in the case of Singapore. If experts are to be believed, we should be looking at second wave of reinfections this year, but this could potentially be less overwhelming than the first time, if governments have learnt from their lessons.

As the market moves past vaccine related merriments, the economic devastation along with further fiscal and monetary support needed to kick start the economy, will be in focus. Limiting this is the reduced traditional monetary policy levers available in the G7 markets, this revealed by incoming Bank of Canada governor Tiff Macklem’s signal of a floor to its overnight rates at 0.25% and the disruptive forces of negative rates. Under these circumstances, it is fair to expect fiscal injections to take centre stage despite the already wide fiscal imbalances. To exhibit just how alarming the situation is, a yearly survey conducted by personal finance portal, GoBankingRates with 2000 respondents across the US in December 2019 revealed 45% and 24% of respondents with savings of USD0 and <USD1000 respectively. The main reason given for this low savings rate is the fact that many were living paycheck to paycheck.

Applying the predicament above to the overwhelming job losses and destruction seen thus far, it is likely that further fiscal support above what is already provided, will be required. This worrying state coupled with realistically lower corporate tax collections will lead towards a higher debt load (and servicing) and in the longer run stricter tax enforcements and higher tax rates in plugging these deficits. This has not only severe crowding out effects, but also potentially restricts avenues for wide corporate tax cuts, which have conventionally helped markets out of recessions.

The key global risk to markets at this point remains the US-China relationship, which has far reaching consequences beyond politics. The pressure placed on China by the US to open up its lab in Wuhan for investigation into the origination of the virus, has a familiar resemblance to the invading of Iraq in search of weapons of mass destruction. While this author is not casting any allegation nor has any knowledge on whether or not the virus originated from a Chinese lab, President Trump seems to be convinced, leading us to believe that this pressure and animosity with China will only escalate. Central to our expectation of a poorer US-China relationship, is that the Chinese remains an easy target in deflecting President Trump’s colossal blunder in the handling of the virus. The recent depreciation of the Chinese Yuan from US tariff threats are reflective of this deteriorating situation and are a bad signal for risk assets and EM currencies. It will be interesting to see how this altercation evolves given President Trump’s zeal in painting China as a culprit and China’s judicious exercise of shrewd (or cunning) diplomacy in mending its ‘old China’ image.

Is this the opportunity we have waited years for?
The timing of Karrin Associates’ formation has been predicated on the margin of safety that the crisis affords, as if there is anything certain about a crisis, it is that markets have historically come back higher. Our strategy in navigating this crisis, which we are happy to share with our readers, is to be disciplined by adopting a staggered approach in deployment. Of course the broad ‘dollar cost averaging’ as a strategy seems rational and simple in theory but as volatility persists, the mix of being shell-shocked and the feeling of missing out have ever so often influenced decisions. Commonly, this involves the practice of looking at dollar prices pre-crisis, comparing it to the current prices and find solace in this perceived discount, a practice of which we avoid.

In appraising investments, we implement a fundamental investment framework, which involves the appraisal of economic cycles, country risks, industries, financials and operations (our Covid-19 operations framework was relayed in Canary in a Coal Mine on 27th April 2020). Looking closer into valuing financials of companies in this crisis, we adopt two methodologies, one is the net present value of the company through actual cash flow projections and two in figuring out the practical valuation multiples to cashflows/earnings, which are determined by economic phases/cycles. The few elements in determining the net present value of cashflows involve a two part evaluation, during the crisis and the other in a ‘steady state’ period. The key factors to observe are revenue generation, operating margins, capital expenditure, return on investments, capital structure and cost of capital, all this while taking into account risk probabilities which are impacted by the macro/industry. Some of these are captured graphically by valuation guru, Aswath Damodaran below.

Finding exact entry points into investments require that crystal ball, that we just have not gotten our hands on. In the unfortunately absence of alchemy, Damodaran’s work on market phases also provide some ideas of the various crisis phases and what good practices of multiples and earnings expectations to adopt when investing in these phases. Looking through the diagram, it is likely that we are only in Phase 1 of ‘Shock’, where stocks seem cheap on a trailing basis but given an absence of corporate guidance in determining future earnings, trailing numbers are likely unreliable. Phases 2 and 3 of ‘Adjustment’ and ‘Acceptance’ are where the hard work of determining the structural and cyclical changes that companies face in this crisis will start showing some fruition/clarity. Sadly for those in a hurry, these Phases 1-3 will probably take a good 12-18 months depending on the severity of the downturn.  Understanding these phases/timing and the multiples appended to cashflows/earnings have severe implications on investment returns.   ​

​We note that while some parts of this framework do fall back on a ‘ceteris paribus’ caveat and may not take into account idiosyncratic factors, that said, having this structures in place and understanding the reasons for departure away from this, are good guidelines to ensure the right discipline is implemented when deploying capital in a noisy market. Remember anyone can buy and hope to get lucky. But maximising the probability of profits and loss avoidance require discipline, knowhow, risk containment, and a lot of work!