COVID-19 is Attacking Your Stocks. Here’s How to Fight Back. ~ Worth

Originally published by Worth
Authored by Garvin Jabusch

An epidemiological and health crisis can quickly become a financial crisis, even where there was not an existing financial crisis before.

Scary times, right? The SARS-CoV-2 virus and the disease it causes, COVID-19, are affecting hundreds of thousands, soon to be millions, and may have a mortality rate as high as 2 percent or more. The fear this has caused has resulted in quarantines, factory closures, cancelled travel, declining production, reduced hours and other precautions that slow economic growth.

All these efforts to impede the spread of COVID-19, combined with consumer uncertainty about the eventual outcome, will slow global growth for Q1 2020, and maybe quite a bit longer. Although the actual scale of the disease and its impacts cannot yet be known, “it’s likely that at some point, widespread transmission of COVID-19 in the United States will occur,” in the words of the CDC. Markets, understandably, are repricing stocks to the downside to reflect the uncertainty, as well as the already observable slowdown. But what are the likely scenarios from here?

COVID-19, while quite dangerous to the elderly and immune-compromised, shows little likelihood of becoming a global pandemic of devastating proportions like the 1918 flu. A recent report from the Brookings Institution lays out seven possible scenarios, numbered 1 through 7, for the disease’s progression and its effect on global GDP. Under the middle scenario, Scenario 4, the authors write, “estimated deaths from COVID-19 can be compared to a regular influenza season in the United States, where around 55,000 people die each year,” although uncertainty remains front and center as they go on to caution that  “in the case where COVID-19 develops into a global pandemic, our results suggest that the cost can escalate quickly.” According to reporting in The Atlantic, “The emerging consensus among epidemiologists is that the most likely outcome of this outbreak is a new seasonal disease—a fifth ‘endemic’ coronavirus.” In a likely scenario, then, COVID-19 ultimately becomes another of the many endemic (always around) flus that afflict the world year in and year out, and as such it will fade into the general picture of global health, and business will resume. Moderately reassuring, but between today’s state of high concern and COVID-19 being another seasonal flu, there will be some consequences.

Meaning, the epidemiological and health crisis can quickly become a financial crisis, even where there was not an existing financial crisis before. In response to the anticipated slowing of growth, we’ve seen central banks use a meaningful portion of their dry powder to stimulate growth, which might work or might not (I’ve been asked lately if fighting a public health crisis with monetary policy is even a thing). Cutting rates probably won’t do much to help the supply shock component, but it may mitigate the demand shock side by way of reassuring consumers. In any event, the Fed’s 0.5 percent surprise interest rate cut means the federal funds rate is now 1.0 percent to 1.25 percent, which is now what they have to work with, stimulus-wise, going forward. This itself presents risk.

Already, we’re starting to see downgraded expectations on specific companies and industries, starting with airlines and hotels, and spreading to manufacturing and probably ultimately across all sectors, with the possible exception of some aspects of healthcare. These reduced expectations and real results manifest in capital effects like reduced revenues and cash flow, and so, in downgraded credit ratings. If you are one of these downgraded companies, your cost of capital just went up. This is a second-order drag effect from COVID-19, but one that not all companies share. Companies that during the recent bull rally spent a lot of their free cash flow in less-productive ways, such as share buybacks, will find themselves with a suboptimal capital mix (less cash and/or more debt) during the bear’s run. The rainy day is here, and this reduced access to capital will slow growth (and the pace of buybacks) for these companies, and maybe overall. (As I’ve written here before, but now more than then, companies mostly need to hit pause on buybacks.)

What does all this mean for investors? We’ll continue to see volatility, in both directions but mostly to the downside, for a while. Calling the date of a bottom is next to impossible, but it will come, and growth will resume. In the recovery, we will see the mindset of fundamental value finally returning to analysts and investors as companies that were able to weather the storm because of smart use of capital demonstrate better revenue and earnings results as global growth resumes. These companies will grow faster by gaining market share from their competitors who are now faced with reduced and/or more costly access to capital.

Of course, fundamentals always matter. In good times, smart allocators of capital are improving their businesses’ competitive advantages with things like R&D and hiring top talent, and therefore having better chances of innovating and gaining market share, even while less savvy allocators of capital are also doing reasonably well. But in tough times, the companies that were flippant about capital allocation or didn’t have their priorities right when times were good will have weaker balance sheets and lack the solid standing to battle through a tough slowdown. You can get away with poor corporate capital allocation for a while during growth cycles, but when growth slows, the vulnerabilities and weaknesses of that approach become clear. It is much better to be hit by an economic shock from a place of strength.

A downturn is when we see leaders emerge, which is why fundamentals are about to matter again. The COVID-19 correction provides an opportunity for investors to identify companies working from that place of strength, and get their shares for better prices than we have seen in a while.  If we put a little thought into it, and take some care not to indiscriminately invest in companies solely because they are in an index, we can find and profit from the smart stewards of capital and the best downturn survivors. Across industries, sectors and geographies, economic leaders and smart capital allocators will emerge. When you can get them cheap, you should.


Important Disclosures