As the coronavirus crisis now threatens to transform from a health crisis into an economic one as the shutdown across various industries carries on, it’s important to focus on businesses that have a level of durability and strength and which don’t need to depend on the flexibility of financiers, the generosity of stakeholders or the goodwill of governments (and ultimately taxpayers) for their survival.
While there no doubt will be bargains amongst particularly damaged sectors of the market such as the food service sector, retail stores (Macy’s (NYSE:M) was down as much as 75% during the worst of the declines) airlines, hotels and mall REITs, it’s fair to say that the level of uncertainty as to the duration of impact across these businesses is such that only the most resilient will likely endure. Trying to pick winners in some of these really damaged spaces will be certainly lucrative for some, but will also just as likely see substantial loss is in others. Unless one has a core competency or ability to navigate through the wreckage, it’s almost best to stay away and just focus on other opportunities.
I have put together a framework which I am looking at in my own evaluation of both existing holdings as well as potential new opportunities that may be able to stand the test of time. Ultimately, the greatest long-term returns occur from cheaply buying strong businesses that have the ability to earn strong returns on capital over a very long period of time which exceed their cost of capital. As such, while cheap ‘cigar butts’ may abound, investors should consider positioning themselves in high quality businesses that can survive the near term, and ultimately thrive in the longer term.
Strong cash reserves
Balance sheet strength and strong cash reserves at this point in time are pretty important. The ability to manage through a depressed demand environment means that businesses need ability to either access cash reserves on-demand through access to lines of credit, or better yet have sufficient existing cash on the balance sheet to be able to manage through an extended period of ongoing demand disruption. Investors should plan for capital raisings to occur across a significant portion of listed holdings. These are likely to become fairly prevalent over the next few months and not having to tap the market at all, or only minimally will avoid significant dilution at a time when it’s arguably most expensive.
Not surprisingly, the large technology businesses do particularly well in this regard. Google (NASDAQ:GOOG) (NASDAQ:GOOGL), for instance, has $115B in net cash, while Facebook (NASDAQ:FB) has almost $55B in net cash, providing them the luxury of not only being able to chart an independent future but also not have to dilute shareholders in the worst of circumstances.
Low debt levels
What will also likely become a fairly common phenomenon as the crisis progresses is heavily indebted businesses who all of a sudden have a collapse in demand may need to renegotiate debt servicing, or in the worst case, seek insolvency protection as they’re unable to meet interest covenants or repayment of debt obligations. Reductions in ability to service debt may become triggers to accelerate debt repayment and forced insolvency. This will certainly be something to watch out for and assess when looking at new positions.
Also, if businesses don’t tap additional equity, because their share prices have been particularly strongly impacted, then they may need to raise debt. If they already have significant debt on their books, it will be hard for them to raise additional debt without excessively raising leverage ratios or potentially breaching covenants.
There is a wide disparity here across the market in terms of the indebtedness of various businesses. More capital-intensive businesses such as the airlines are very debt laden. United Airlines (NASDAQ:UAL), for instance, has a debt/equity ratio of 1.77. That’s almost 2x the debt for every dollar of equity. You can compare that with something like Alibaba (NYSE:BABA) which a much more comfortable debt to equity ratio of just 0.16. It’s apparent that any type of demand destruction for the airlines consequently creates fairly drastic operational consequences such as cutting routes and laying off personnel, unless they can get a government handout (which was successfully secured).
Good cash flow generation
High margin, cash flow rich businesses that can generate good operating cash flows are very important. Businesses that are very capital-intensive like miners and industrial producers may struggle during this period as they need to crank cash flow just to manage and maintain the factories and machinery that’s necessary to keep the lights on. That’s where businesses of the likes of Visa (NYSE:V) or Mastercard (NYSE:MA) have a significant advantage. Operating margins are so strong, and cash flow generation so good that even significant demand declines won’t leave these businesses wondering how they will survive.
For every $1 of revenue for Visa, for instance, almost $0.6 is converted to operating cash flow and free cash flow. Compare this to businesses such as United that only converts $0.15 of every dollar to operating cash flow, and due to a heavy investment program, just $0.05 cents to free cash flow. You can quickly see that even in good times, that doesn’t leave much margin for error. In the bad times, that’s a potential recipe for tragedy. These businesses need cash flow coming in the door just to deal with maintenance and leasing or purchase obligations on expensive fleet just to run their business.
An absence of secular headwinds
Ideally, one has businesses that leverages secular tailwinds, which will help drive demand as a result of broader underlying trends. This is something that high quality businesses are fortunate to benefit from and is particularly preferred in the current environment. The likes of Alibaba and Amazon (NASDAQ:AMZN) will clean up in this environment. The result of enforced lockdowns throughout much of regional China may have actually had the perverse effect of accelerating the growth and adoption of e-commerce throughout the country, not only in the urban areas of China but more significantly in rural and regional centers. Provided the experience was a satisfactory one, there’s every reason to think that structural tailwinds will further accelerate, while those facing structural headwinds will see increased resistance even after the coronavirus pandemic resolves itself.
The same is true for Amazon. I’ve noticed the Amazon trucks piling up outside my neighbors’ doors while brick & mortar remain firmly shuttered. However, even if a position that you are evaluating doesn’t have secular tailwinds, it’s really not helpful to be adding that those that have very heavy secular headwinds in this environment of decreased economic activity and decreasing demand. I’d put brick and mortar retail at the top of that list. While there may be potentially eye watering bargains that may artificially be attractive such as clothing and discretionary retailers, many of these may be permanent casualties of current declines, with a prolonged economic downturn finishing off what shifting customer preferences have already started.
Transparent and easily understood businesses
While this is something that I have a strong personal preference for at even the best of times, I believe it’s particular important to have a clear sense and ability to understand what you’re invested in, especially during depressed conditions. It’s important to see and understand where businesses make their money and what the levers are that will influence these. The sources of revenue for businesses such as Alibaba or Amazon are easily understandable. And it’s not just these high growth businesses that have this trait. Companies such as Coca-Cola (NYSE:KO) and McDonalds (NYSE:MCD) similarly benefit from very transparent business models. You can see that selling more cans or Coca Cola, or fries and hamburgers will generate more revenue for these businesses.
Complicated financing structures or difficult to understand business models without clear underlying drivers become particularly challenging during these times.
Trusts with interlocking management agreements with management companies and REITs financed with a cocktail of unsecured debt, preferred debt, senior and subordinated debt tend to obscure to varying degrees how business cash flow ultimately rolls up to equity holders. If it’s not clear to you how returns will be derived, then it’s probably best to avoid these businesses.
Equity returns are a combination of returns on the underlying assets themselves, net of financing structures used to support the business. Hence, if either one or both of these things isn’t clear, that’s likely to be more an exercise in speculation and gambling rather than investment.
The same comment applies in the chase for yield. While there will be diamonds in the rough and no doubt some fortunes will be made on picking the few real diamonds that do exist, businesses that are priced to yield dividends of 20%+ (such as Tanger (NYSE:SKT) or Macerich (NYSE:MAC) show 20-30% yields), are likely being priced that way for a reason, their dividends are not sustainable and will likely be cut.
Concluding Thoughts
Investing is done best when the process is simple. Businesses with good cash generation that have clear and easy to understand business models and strong drivers that underpin demand, and manageable debt can control their destiny. These principles bode well during the best of times. They particularly apply during the worst of times. As the tide comes in, we will soon discover who has been swimming naked.
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Disclosure: I am/we are long GOOG, FB, MA, V, AMZN, BABA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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