Suppose you invested in a stock with a forward P/E of 18x and whose EBITDA (cash flow) is expected to grow consistently at 4 per cent annually. Suddenly, a global pandemic emergency is declared, having a severe impact on your company’s business, not just for months, but for two years. Cash flow in 2020 is projected to contract by 66 per cent and by 33 per cent in 2021 before regaining its original footing in 2022. How much of a haircut would you expect your share price to take? Twenty per cent? Perhaps thirty per cent? Using a traditional discounted cash flow analysis, the answer is, remarkably, only 4 per cent. That’s because the composition of today’s equity prices is the present value of all future discounted cash flows – which spans years, not months or quarters. Without minimizing the human toll, both in lives and livelihoods, that the coronavirus clampdown has inflicted on the world, the current COVID-19 challenge is in effect just a speed bump along the arc of long-term equity investing. Why, then, are the equity markets off as much as they are?
Two critical assumptions are imbedded into this simple earnings model. First, company growth eventually is restored to pre-COVID levels and growth rates. Second, and most important, the company survives the pandemic shutdown. It’s the chance of extinction that’s prompting equity investors to behave like bond investors. Owning a bond presents binary risk: either the issuer pays its regularly scheduled interest payments and redeems the bond at maturity, or, thanks to default, it doesn’t. Nowadays, equity investors face a similar dilemma: will the companies in their portfolio survive COVID-19, or not? In today’s market, the answer lies in the distinction between liquidity risk and solvency risk.
In a liquidity crisis, an otherwise healthy company collapses if they lose access credit due to market-wide risk aversion and a general unwillingness to lend. A solvency crisis envelops companies that simply do not have enough revenue or cash flow to meet their current or future debt obligations, no matter how much credit they can access. The Federal Reserve has gone a long way to obviate a liquidity crisis by facilitating widespread access to credit. To date, the Fed has pledged about $2 trillion toward corporate and municipal liquidity, even though it hasn’t bought a single corporate or municipal bond. Chairman Powell’s actions have prevented illiquid companies and municipalities from plunging unnecessarily into bankruptcy due to a coronavirus-induced rush for cash. Drawing a line in the sand, Powell made a distinction between illiquidity and insolvency when he recently asserted, “We can’t lend to insolvent companies. We can’t make grants.”
Years of uninterrupted quantitative easing and low interest rates promulgated a massive debt buildup. Non-financial corporate debt rose by 13 percentage points relative to GDP over the last decade and now totals more than 30 per cent of GDP. Government debt rose by 30 percentage points in the interim.
The liquidity largesse of the last expansion gave birth to a population of “zombie” companies who, without the help of ever-decreasing financing rates, would have been forced out of business years ago. More than two dozen companies on US exchanges currently sport a CCC, “teetering on default”-level, credit rating, according to Investor’s Business Daily. These names include JC Penny, Revlon, Ascena Retail Group (operator of Dress Barn and Lane Bryant specialty stores) and energy firm California Resources. Default risks grow exponentially with every subsequent rating notch lower. Triple-C companies are eight times more likely to default on their debt than ordinary “junk-rated” companies. The Cresset Investment Team calculates the “breakeven” default rate for high-yield bonds is currently 11 per cent. That is consistent with Standard & Poor’s 2020 projection but well below the 14+ per cent default rate reached in 2009.
As of April, there were 22 debt defaults in the US, including companies like Steak & Shake, Pier 1 Imports, VIP Cinemas and Frontier Communications. The retail and consumer products sectors were among those hit the hardest, according to the rating agency.
Investors today are less worried about a company’s future profit potential than they are about its survival. The pandemic shutdown has forced investors to clamor for large and profitable growth companies while they shun highly leveraged value-oriented stocks. Year to date, growth companies have outpaced value companies by nearly 9 percentage points.
As regards solvency, companies rated below investment grade will likely have the hardest time battling a prolonged business stoppage. Larger companies tend to be higher quality. In fact, more than one-third of the capitalization-weighted S&P 500 are companies rated AA or better, with 6.5 per cent of the blue-chip index – Microsoft and Johnson & Johnson – perched at AAA. Owing to survivability, the factors influencing relative market performance this year relate to growth, profitability and size as positive attributes, and to value and leverage as the biggest detractors.
Investors have gravitated to large-cap stocks for their stability and growth potential. A small fraction of companies rated below investment grade are mingled into the S&P 100 (the largest 100 US stocks by capitalization). Only about 5 per cent of the S&P 500 is considered “junk”-rated, which includes BB-rated Netflix, whose business model is, in effect, built for a nationwide lockdown. Companies rated below investment grade populate a greater share of smaller capitalization indices, comprising 32.9 per cent of the S&P 400 midcaps and 26 per cent of Russell 2000 small caps.
The Bottom Line
Good companies have been dragged down with bad companies as panicky investors rushed for the exits in March. Security selection can separate risks from opportunities. This means, at least in the near term, investors should avoid passive, index funds in favor of actively managed mandates, particularly in markets with a greater share of constituents with weaker credit quality. Investors also need to recognize the world will be clouded by uncertainty for the next quarter or more, so short-term valuation measures like forward P/E are meaningless. In our earlier example, the forward P/E of our hypothetical stock spiked from 18 to 50 as this year’s earnings prospects collapsed – even though its “fair” value slipped by only 4 per cent. Instead, investors should focus on the other side of the COVID-19 closure gulch: which companies can make it across? That means investors must pay more attention to balance sheets, as too much debt could drag a company down under a tidal wave of debt service obligations that will forever dwarf incoming cash flows.
As regards investment style, “growth” companies are better positioned than “value” companies from a discounted cash flow perspective because nearer-term cash flows, like those in 2020 and 2021, represent a bigger share of the total present value for slower-growing companies. A stock whose cash flow is growing at only 1 per cent would suffer a 10 per cent price hit given an identical cash flow decline of 66 per cent in 2020 and 33 per cent in 2021. This could explain why the S&P 500 utilities sector is off nearly 12 per cent this year while technology is virtually unchanged.
We believe the heightened uncertainty and lack of information about the short-term situation is a good reminder to stay focused on the long-term earnings potential of the companies and markets in which you invest. Take the 100,000-foot view. Is the business model sustainable? Will there be a future for cruise ships? What will the future demand for office space look like? Will social distancing create more demand for automobiles and less demand for airline seats? Cresset views investing as a long-term endeavor, and the probability of investment success increases in tandem with your holding period. If you hold stocks for a day, history suggests your probability of success is a coinflip; hold them for 10 years, however, and your likelihood of winning rises to 90 per cent.