31 March 2020

    Lessons from Covid‑19

    Kiwis are getting fitter during the crisis ‑ can companies do that too?

    Margin Call: Coronavirus has exposed the fragility of many businesses. We need to fix that.

    This article first was first published in the NBR

    I went for a run on Saturday afternoon. As I ran slowly past shuttered shop after shuttered shop, my mind wondered: What would the world look like after the coronavirus crisis?

    It almost feels too early to think like that. But this is exactly the time to think about the world we want when this is all over and to start driving change.

    The word that kept jumping into my head, borrowing from writer and thinker Nassim Nicholas Taleb, was “antifragile.”

    As Taleb noted: “This is the central illusion in life: that randomness is a risk, that it is a bad thing. Much of modern life is preventable chronic stress injury. The fragile wants tranquillity, the antifragile grows from disorder, and the robust doesn’t care too much.”

    The coronavirus crisis is not normal and was not the sort of shock Taleb was referring to – this is no societal “chronic stress fracture” – but it has exposed weaknesses. While we need to be careful drawing future guidance from an unexpected shock event, from – to quote Taleb again – a “black swan” event, there are still lessons we can take.

    We need a more robust world post-coronavirus. That means making trade-offs – being prepared to trade current consumption or returns for future strength. It’s like insurance. Paying the bill every year takes sacrifices but invariably there will come a time you need it.

    There has been a lack of ‘insurance’ in how some businesses are managed, in some of the choices we have made in society and it’s evident in the risk-seeking behaviour of some investors.

    The consequences are being keenly felt. This is a chance for a reset.

    Awash in a sea of debt

    Debt creates fragility. It can mean borrowers lose control of their destiny. It creates a timetable they don’t control – when is the next loan payment due; if profits fall, even temporarily, can they meet their objectives, and what happens when the debt falls due? Normally this is manageable. But not always.

    As we are seeing now, many businesses are facing an existential crisis because of the debt they are carrying.

    The dangers of too much debt is a lesson we should have learnt after the global financial crisis. We didn’t.

    Global debt has continued to build, now, according to the Institute of International Finance, topping $US250 trillion, or 322% of global GDP – a record level.

    Some debt is not a bad thing. Modest borrowing to fund productive assets that will generate high future returns on capital is one of the key ways we create economic growth.

    But two things have happened in the past 10 years that challenge this healthy arithmetic. More debt has been used to acquire expensive assets, rather than on developing productive capacity. And, with low interest rates, it has been possible to borrow more, leading to more debt and less equity being deployed to buy these assets. We have lived beyond our means.

    The composition of the global bond market paints a picture of this dynamic.

    Triple B-rated companies are the lowest rung on the investment-grade debt ladder. In 1999, BBBs made up a quarter of the global corporate bond market. The market was dominated by higherquality borrowers.

    By December 2007, BBBs had grown to about a third of the market. Fast forward to today and they comprise 50% of the investment-grade corporate bond market. Poorer-quality borrowers have been borrowing more and more.

    In the coming months there will be a rebalancing.

    That means debt defaults. And there will be forced equity recapitalisations of some businesses. This trend has already started, with capital raisings in Australia this week at Cochlear and Ooh Media. Expect to see more, including some New Zealand companies.

    Robustness or anti-fragility often involves trading off present returns for future strength. Companies with more equity and less debt might generate lower returns but they are stronger.

    We forgot this after the GFC. Maybe this time we won’t.

    Loss-makers aren’t great

    Like heavily indebted companies, firms that don’t generate profits are reliant on the kindness of strangers for survival. They need to routinely raise equity. That’s fine when investors are exuberant but it means business failures when investors are nervous.

    New and innovative companies are an important growth engine in an economy. And some of the investment in loss-making, innovative companies in recent years is entirely rational. It has led to some of the great companies of this century – just think Google and Amazon. Unfortunately, there is a flip side. Some of this investment looks more like pipe dreams and collective Kool-aid drinking.

    Like many trends that start well, this has gone too far. According to the Wall Street Journal, close to 30% of all listed companies in the US were lossmaking over the past 12 months. The Journal also highlights that, at its recent peak, more than 75% of new companies in the US coming to the market in initial public offerings were lossmakers.

    Too much capital chasing too few genuinely good ideas invariably means businesses that should never have got off the ground did. There will be failures. A slimmed-down and more capital-rationed venture capital industry, and listed market investors pickier about what they will fund, will result in fewer companies but better, innovation-funded and a more robust market.

    Social investing

    More than three million Americans lost their jobs last week. The US was not alone, with unemployment rising around the world. Many of the people losing their jobs are in the most vulnerable parts of our society, living a paycheck-to-paycheck existence.

    Similarly, healthcare systems in many parts of the world have been caught short by this crisis, with years of chronic under-investment dramatically limiting the ability to respond. Countries such as Singapore, which did invest heavily in pandemic response strategies post-SARS, have shown that being prepared saves lives.

    Fiscal authorities around the world are doing and will do more to respond to this crisis. In the short term this involves a vast array of programmes to support people, particularly the newly unemployed, and smaller businesses.

    Longer term, this should result in changes in how we think about our vulnerable communities, on how we use good times to prepare for the inevitable tough periods, on what we need to do to deliver more sustainable economic growth and, then, how we ensure the spoils of that growth are shared.

    Returns and reality

    In the depths of the crisis, it’s hard to be certain about future investment returns.

    There are, however, some things we already know.

    Share prices are lower, great insight there. Valuations have now fallen to average levels in the US and to generationally cheap levels in Europe.

    That means prospective returns from shares have improved although there is one caveat in my view.

    The post-coronavirus world will be different. It is likely companies will focus more on robustness, doing more to insure their business against the bad times, rather than just optimising for the good times.

    Doing this adds cost and means lower through-the-cycle earnings. This ultimately flows through to lower, albeit not massively, fair value for companies. But, by diversifying supply chains, funding through more equity and less debt and investing in more business continuity initiatives, companies will be more robust. That is a good thing. It might even lower their cost of capital.

    Prospective returns in fixed income are more troubling. While credit spreads for corporate debt have exploded and look appealing, yields on safe-haven government debt have collapsed.

    There is a lot of conjecture over where government bond yields head from current low levels. None of the scenarios look particularly appealing. Either yields remain anchored at low levels meaning returns are poor or, principally as a result of the outsized and justified, in my view, monetary and fiscal policy response to the coronavirus, we have let the inflation genie out of the bottle. That would be bad for fixed-interest returns.

    After the crisis, investors need to embrace the reality of lower returns, particularly for less-risky investments. Some of the excesses we are now seeing in debt markets, the leveraged loan market, hedge funds and in parts of private equity are a result of investors hunting for returns in what has been, post-GFC, a lower prospective returns environment.

    The common factor in these areas of excess is the use of debt to juice returns on low-return assets to make them look better than they are. This may look smart when things are going well but, eventually, the environment changes and companies get caught out.

    Embracing the reality of lower returns, unfortunately, is like eating Brussels sprouts but we all intuitively know the prescription – save more, take on thoughtful risk and be patient.

    Hopes for the future

    I am optimistic that we will learn as we battle through this crisis. I hope anti-fragility or robustness is an idea we talk about more as investors, as company executives or board members and as a society. It will make us stronger.

    And if we don’t learn those lessons, and history suggests we don’t always, at least with the number of people I saw out running on Saturday, we will emerge from this fitter. That’s one small step toward becoming more robust.