Unprecedented market events have precedence

– David Wanis, March 2020

The majority of historic market events are unprecedented. Markets don’t fall 30-40% due to events that have been observed many times before, and COVID-19 is clearly unprecedented for investors. Rather than speculate on what may change, we can instead look at the precedence of the unprecedented, invert the problem and identify clues to what likely won’t change and how we can capture the current market opportunity.

What doesn’t change?

  • Human nature: An emotional reaction to uncertainty seems to be consistent in almost every crisis. “Unprecedented” events tend to trigger overwhelming behavioural bias. This is a bit like using history to estimate a worst-case scenario. By definition, the previous worst case when it occurred was unprecedented and absent from all prior scenarios up to that point. Everyone seems to keep their emotions in check and their investment processes intact until it is needed most – in the face of unprecedented events.
  • The future: Always uncertain, despite how investors want to believe it isn’t. A pandemic is a reminder that we never know, and how we recover from a pandemic is almost as unforecastable as the pandemic itself. The range of possibilities is now wider than the market had previously considered, but the ability to pick the path that reality takes is no easier today than it was two months ago. Doubling down on forecasting the future is unlikely to be fruitful.
  • The capital structure of a business: Laws enshrine rights to different stakeholders (creditors, employees, lenders and equity holders) in a company. In response to COVID-19, the government has sought to hibernate businesses through the pandemic by temporarily altering or time-shifting arrangements (indirectly and by suggestion if not by law). However, capitalism is built on these foundations and it is unlikely they are torn down in this crisis.
  • The nature of assets (mostly): When expectations are tempered, most assets tend to behave broadly in line with these expectations. Equities are risky assets that are most reactive to uncertainty. Bonds and cash preserve near-term wealth. Private assets remain illiquid and may or may not be worth their marks. Gold acts as a safe haven, but with only 5,000 years of history further out-of- sample observation may be needed. Most of the portfolio heavy-lifting in crisis markets is done by asset allocation, not stock selection.
  • Long-term performance: Equity investors own perpetuity cash flows, which create long-duration exposures and should be aligned with holding periods of five years or more. Buying low is easy to say, but hard to do (see ‘Human nature’) and the past six weeks serve as a reminder of this reality. For true long-term investors buying at today’s prices represents an opportunity rather than a risk.

By considering what doesn’t change we can start to build a map for the unknown. Without specifically forecasting the future, we can estimate how human behaviour, the nature of assets and the capital structure of a business may react to shock, stress and uncertainty. Our experience investing through the GFC has provided one roadmap for the current environment.

Dusting off the GFC roadmap

The phases we saw in the GFC were;

  • “Unprecedented” shock causes all stocks to fall
  • First-order earnings downgrades: market focuses on companies with greater estimated direct shock exposures
  • Credit breaks: US high yield (HY) spread widening to >650 bps
  • Balance sheet focus: downgraded earnings and a breakdown in credit sees the market shift focus to financially weaker companies
  • Second-order exposures: second-order impacts and liquidity constraints (forced sellers) emerge, market focuses on companies with earnings risk not initially considered, corporate debt becomes a greater focus and government policy responses emerge.
  • Recapitalise or fail: companies with weak balance sheets face a stark choice – recapitalise with fresh equity (or government support) or fail. Small companies face a far greater risk of failure in the absence of recapitalization and the fragility of small and micro caps comes into focus.
  • Recovery in markets: assuming the economy has stabilised

Given the sheer magnitude and uncertainty of COVID-19, what took months to progress through the GFC is happening in days or weeks. Using the GFC roadmap, Stages 1 and 2 occurred in late February, Stages 3, 4 and 5 were passed in March and now in early April, Stage 6 is well underway. During the GFC, it took ten to twelve months to get to where we are today. If the 20th of February is the starting point for this crisis, the COVID-19 journey has taken six to seven weeks.

The path to recovery remains a big unknown. Additional capital for weakened companies should cover some but not all potential future scenarios.

We have so far participated in three recapitalisation events (IDP Education, WebJet and Kathmandu) as they are all businesses we like and owned and were done on very attractive terms relative to alternative opportunities. We believe they raised enough equity to survive all but the most pessimistic scenarios – but we cannot rule those out. There were numerous raisings we did not participate in, either for reasons of business quality, weak balance sheet strength (some companies only raised what they could rather than what they needed) or valuation. Many businesses look underpriced in this market, so recapitalisation proposals need to be weighed up against other available opportunities.

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