Ice Age: the Post Covid-19 New World

Six months into the Covid-19 crisis, many of us feel like Manny, Diego and Sid: hurtling through a world on the edge of life-changing cataclysms, not sure what tomorrow will look like.

Nowhere has this angst been clearer than in the stock market.  Cruise lines have tanked, which is understandable given the industry very high fixed costs, high debt leverage and its inability to operate (in the US, as per the No Sail Order).  Airlines are likewise in an existential crisis for similar reasons.  At the other end of the spectrum, Zoom Video Communications (ZM) has experienced a massive rise in both customer usage and stock price.  Generally speaking, companies involved in physical activities have suffered while those that are associated with at-home or virtual activities have flourished.

But the stock market is supposed to look ahead, to discount future cashflows; monoclonal antibody treatments are proving useful, vaccines are expected to start being distributed by next spring, and the second wave of infection has so far been much less lethal than the first.  Trillions in savings remain on the sidelines which, at some point, will either be spent on Main Street or invested on Wall Street.

Why is it that the stock market seems to believe that we are and will remain mired in the Ice Age, confined at home, watching streaming videos and leaving home only for quick dashes to the supermarket?  Or are the fears of a change in the White House and the Senate so great as to stamp any feeling of hope and optimism?

Are we entering a new era where, among other changes:

·        No one flies for vacations or business reasons?

·        No one shops for clothes, be they fashion or sports oriented?

·        Alternative energy sources quickly take the place of oil and natural gas?

 

I don’t think so.  The question then is (a) which company to invest in and (b) when?

There is no magic recipe.  Logically, in times of stress and uncertainty about the future, it pays to be selective.  We will not give up flying, but we may fly less (at least for a while); in this case, only the strongest might survive; why invest in the #5 airline stock which could return 150% if investing in the #1 could return 50% over the same horizon but with a lot less risk?

In the fashion sector, uncertainly is the nature of the business.  I would ask myself: ”what is a reasonable value for this brand and does the enterprise value of the company (market value + debt - cash) reflect it?” There is no set formula but a commonsense approach (looking at comparable products and companies, historical data, likely future earnings, etc.) should yield a range of values to work with.

Energy, being the single most important factor for economic growth, has strategic, political and social dimensions in addition with concerns about global warming.  While it is reasonable to assume that oil and gas will fade as energy sources just like coal did, such transition will likely take 20 to 30 years:  the demand for energy keeps increasing, solar and wind power are both expensive and not easily scalable, nuclear fission is unpopular in the US and Western Europe and nuclear fusion is still at the experimental stage.  Fossil fuels are widely used because they have several big economic advantages (such as energy density, ease of transport and storage, scalability, cost) which solar and wind lack, and will continue to lack.

In all of these sectors, given their depressed valuations, investors willing to take the plunge should stick to the top companies: those that have enduring market positions, the riskier the sector the more reason to stick to the #1 firm.  Targeted companies should also enjoy very strong financials to carry them through extended periods of volatility or low growth, and high quality management; it is worth emphasizing that high quality management usually translates into a strong company culture which facilitates good execution and overcoming hard times.

The other question is when to get in.  Picking a good entry price is the most important decision in an investment cycle.  It is easier to determine if a good company is selling at an attractive price than to try and guess when market bottoms may be reached.  Finally, in times of stress and volatility, picking realistic goals is key: a stock which may rise by at least 30% over the next 3-4 years while paying a 2.5% dividend would return around 40% over that period while a US treasury would return 4% at best.  Why be greedy? 

The Madness of Crowds

 

In 1841, Charles McKay wrote his famous book “Extraordinary Delusions and the Madness of Crowds”.  Its first volume dealt with economic manias and bubbles, the most famous of which, to that date, had been the Dutch tulip mania.

Manias, being born from mass human behavior, have endured as exemplified by the Internet and “eyeballs” stock craze at the turn of last century.  Over the last decade, another one has flourished and while its cost has already been high, we likely haven’t paid the full bill yet.  I am talking about stock buybacks.

This mania is insidious and rarely makes headlines: after all, it is easier to laugh at hapless retail investors riding the latest wave of euphoria for Covid-19-proof stocks or for cloud-centric IPOs.  Large companies are managed by cooler heads, have carefully crafted operating procedures and vigilant boards of directors to rein in overly optimistic CEOs, or do they?

The truth is many companies have bought back their stock, and over the last 30 years, those that did have seen, in the aggregate, their share price perform better than those that didn’t.  In part, this is explained by the fact that the better companies generate more cashflows (with which to buyback shares) and their better share performance also reflects their better businesses.

The stock buyback movement has accelerated over the years.  While the ratio of buyback value to market (S&P500) hasn’t changed much since 2004 at around 3% p.a., the timing of these buybacks has been poor: companies backed the truck as market indices soared (see below) but stepped back when valuations were attractive. 

Furthermore, more and more buybacks are funded by debt as opposed to free cashflows (see below).

 

The table below maps the trends in shares outstanding (in millions)/long-term debt outstanding (in billions of US$)/net worth (in billions of US$) for a cross section of US blue-chips.

	2010	2012	2014	2016	2020 (e)
American Airlines			697/16.2/2	461/22.5/3.8	515/30/(4.5)
Boeing	735/11.5/2.8	756/9/5.9	707/8.1/8.7	617/9.6/0.8	566/60/(13)
Corning	1,561/2.3/19.4	1,470/3.4/21.5	1,271/3.2/21.6	926/3.6/17.9	761/7.5/13.3
Emerson Electric	753/2.5/9.8	724/3/10.3	697/2.4/10.1	643/1.9/7.6	595/1.2/8.5
McDonald	1,054/11.5/14.6	1,003/13.6/15.3	963/15/12.9	819/25.9/(2.2)	744/35/(10.5)
Microsoft	8,668/4.9/46.2	8,381/10.7/66.4	8,239/20.6/89.8	7,808/40.8/72	7,571/59.6/118.3
Regeneron	87/0/0.5	95/0.3/1.2	102/0.1/2.5	106/0.4/4.5	105/0.7/12

 

Source: Valueline.

 

The above table deserves a few comments.  First, shares outstanding reflect the issuance of new shares and corporate buybacks, so that annual buybacks are generally higher than the difference in year-end outstandings.  Second, the table shows long-term debt outstandings with no mention of cash holdings which reduce net debt levels.

As to the companies listed: American Airlines filed for Chapter XI in December of 2011 and emerged from bankruptcy in December of 2013.  Nevertheless, in 3 years (2014-2016) it repurchased at least 1/3 of its common shares outstanding and despite generating an aggregate of $13 billion in earnings and $17 billion in cashflows, it increased it long-term debt by 39% or $6.3 billion.

On the surface, although Boeing share count was reduced by 16% through 2016 and 41% through 2019, the company seemed to have acted reasonably since its long-term debt actually decreased over the 2010-2016.  Not so.  By the end of 2019, debt had risen by 73% from 2010 levels, and by the end of 2020 it is expected to rise another 200%!  Worse, to support its massive share buybacks and the payment of dividends, the company diverted funds which normally would go to investments in new products and manufacturing excellence.

This is apparent in the table below.  Over the 2016-18 period, Boeing used 88% of its cashflows to buyback stocks and pay dividends, leaving very little for productive investments.

 

Boeing	Cashflow from Operations	Dividends + Stock Buybacks	End of Year Cash	Cumulative use of cashflows for dividends and buybacks
2016	$10.5 bn	($9.4 bn)		($9.4 bn)
2017	$13.3 bn	($12.3 bn)		($21.7 bn)
2018	$15.3 bn	($12.8 bn)		($34.5 bn)
2019 Q1.[1]			$6.8 bn

McDonald pushed the envelope even further, spending 158% of its operating cashflows on dividends and buybacks over the 2016-2018 period.   From 2010 to 2020, its share count will have dropped by 29% and its long-term debt will have tripled!  It almost paid the price when Covid-19 wrecked financial markets this last March.  Had the Fed not injected trillions in liquidity, McDonald could have faced real difficulties.  Unlike Boeing though, its capital investment needs follow a shorter cycle and are more discretionary in nature.

 

McDonald	Cashflow from Operations	Dividends + Stock Buybacks	End of Year Cash	Cumulative use of cashflows for dividends and buybacks
2016	$6.3 bn	($14.2 bn)		($14.2 bn)
2017	$5.8 bn	($7.8 bn)		($22 bn)
2018	$7.2 bn	($8.5 bn)	$2.7 bn	($30.5 bn)

Microsoft on the other hand is one of the few companies which could afford large buybacks yet did them in a measured way (12% over the 2016-2020 period); its net worth more than doubled, unlike the others which shrank.  Finally, while its long-term debt grew exponentially to $60 billion, it held $134 billion in cash on 6/30/19.

 

Microsoft	Cashflow from Operations	Dividends + Stock Buybacks	End of Year Cash	Cumulative use of cashflows for dividends and buybacks
2017	$39.5 bn	($22.8 bn)		($22.8 bn)
2018	$43.8 bn	($22.4 bn)		($45.2 bn)
2019[2]	$52.2 bn	($32.2 bn)	$133.8 bn	($77.4 bn)

Last, but not least in the first table, is Regeneron, a biotech company which has famously focused on R&D and been dismissive of short-term move in its stock prices.  This strategy has probably impacted its market valuation, but rock-solid financials allowed Regeneron to sail through the recent crisis and to keep putting money where it has great expertise, i.e. the discovery of new drugs[3].

This buyback mania is dangerous in many ways.  First, it represents an apparently easy and safe way to boost financial results by reducing the number of shares outstanding and boosting earnings per share.  The problem is that this fix is difficult to abandon once used a few times.

It reinforces management’s focus on short term results, with the danger that a transparent result-booster like buybacks may incentivize management to look for other financial performance levers in accounting, purchasing, etc. which can become questionable.

Another problem with buybacks is that they tend to detract management from an essential responsibility, that of assessing the risk-reward of long-term investment decisions and making such decisions.  This was, I believe, an issue with Boeing and its 737 Max: massive stock buybacks funded by starving new product development provided immediate financial benefits while the development of a new airplane was fraught with risks (even if these risks were in a field where Boeing was an expert and world leader).

Besides diverting funds, excessive reliance on buybacks eventually affect a company culture: short-termism, avoidance of risks and eventually responsibilities.  Once this sets in, reforming a corporate culture can take very long and be quite disruptive: bringing in a new CEO from outside is easy, changing the rest of senior management takes time, can be operationally costly and doesn’t insure that lower rank employees will trust, accept or understand what is now expected from them.

Extremely low interest rates have been a huge factor in this buyback mania.  As they remain low, companies pile on debt which they can easily service.  But even if interest rates don’t rise any time soon, these last few months have shown that a sudden crisis can abruptly zap fixed-income investors’ appetite for anything but risk-free US treasurys.

The smartest financial minds can’t successfully time their buybacks.  Last year, Liberty Global tendered for $2.5 billion of its own shares, repurchasing them at around $27. The stock price never reached that level since and stands at $20.50 today.  During the first quarter of this year, Liberty bought back $500 million at around $16.50 per share.  $3 billion in buybacks which, so far, have been value destructive.

For the foreseeable future, the Fed seems able and willing to cast a wide safety net.  But the draw of near-zero interest rates is still alive, as is the desire to beat short-term earnings per share expectations.  Caveat emptor.

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[1] Last trimester before the massive raising of fresh funds due to the problems of the 737 Max.

[2] Fiscal year ends in June.

[3]  In the interest of disclosure, I own shares in Microsoft and Boeing.