Howard Marks, a very thoughtful investor (which have made him a couple of billion dollars) has recently commented on the crisis and recovery. I have collected what I believe to be the most salient points.
Will the market dip again? “Markets rarely rally in a straight line. Rather, their movements represent a continuous tug-of-war between the bulls and the bears, and the result rarely goes just in one direction. After the optimistic buyers of the initial dips have responded to the low prices and bought, the pessimists find the new, higher prices unsustainable and engage in another round of selling. And so it goes for a while…The bottom line for me is that I’m not at all troubled saying (a) markets may well be considerably lower sometime in the coming months and (b) we’re buying today when we find good value. I don’t find these statements inconsistent.” The future is unknowable, but is subject to informed extrapolation “I’ve defined investing as the act of positioning capital so as to profit from future developments. I’ve also mentioned the challenge presented by the fact that there’s no such thing as knowing what future developments will be. This is the paradox we must deal with.
Will there be a quick recovery? “One of the greatest uncertainties we face toda………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
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Howard Marks is a billionaire American investor with a reputation for insightful analysis of markets and economies. He is the co-founder and co-chairman of Oaktree Capital Management, the largest investor in distressed securities worldwide. He wrote the well-received investment book, The Most Important Thing, Uncommon Sense for the Thoughtful Investor. For this newsletter I have collected some of his recent writings.
Investors tend to the extremes “In the real world, things generally fluctuate between ‘pretty good’ and ‘not so hot.’ But in the world of investing, perception often swings from ‘flawless’ to ‘hopeless’. What I can say is that a month ago [February], most people thought the macro outlook was uniformly favourable, and they had trouble thinking of a possible negative catalyst with a serious likelihood of materializing. And now the unimaginable catalyst is here and terrifying. (There are a few important lessons here. First, the catalyst for a recession or correction isn’t always foreseeable. Second, it can seemingly appear out of thin air, as this virus seems to have done. And third, the negative effect of an unforeseeable catalyst is likely greater when it collides with a market that reflects so much optimism that it is 'priced for perfection'.)” Bad news does not move share prices unless the bad news changes psychology “Most investors seem to think in terms of a very simple relationship: bad news → price declines. And certainly we’ve seen some of that over the last week or so. But I’ve argued in the past that there’s more to the story. The real process is: bad news + decline in psychology → price declines.” Price and value “Intelligent investing has to be based – as always – on the relationship between price and value. In other words, not “will the collapse go further?” But rather ‘has the collapse to date caused securities to be priced right; or are they overpriced given the fundamentals; or have they become cheap?’ I have no doubt that assessing price relative to value remains the most reliable way to invest for the long term. I want to acknowledge up front that ascertaining intrinsic value is never a simple, cut-and-dried thing. Now – given the possibility that the virus will cause the world of the future to be very different from the world we knew – is value too unascertainable to be relied upon? In short, I don’t think so.” Policy makers are not all powerful “Market participants seem to think that (a) rate cuts and other stimulus are always a good thing and (b) they’ll work. Yet, given that the economic impact of the disease is unknowable, how ca………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 Capital Economics, a highly respected organisation supplying immediate and highly relevant economic analysis, has gathered some interesting data on the economic and the potential recession facing us. We investors need to make a judgement on likely future scenarios for various industrial sectors and so we must consider the macroeconomic environment impacting those sectors.
Whilst the Capital Economics team are very able, it must be noted that the level of unknowns on the persistence of the Covid-19 health crisis means we all have to accept a high level of uncertainty in any forward looking economic analysis. How long will severe lockdown last? When it is eased, will it only be by a small amount or will we go back to normal within days? Nobody can answer these questions with certitude. But we can make reasoned assumptions given what we know. Capital Economics has assumed that severe lockdown will be in place across most of the world for April and there will be a gradual lifting of restrictions in May. You and I might think that its optimistic to think that we can start to open-up society in May. Perhaps we won’t have the testing, taking and tracing regimes up to speed by then? Perhaps the government may want us to go back to normal, but families refuse to take the risk of going to work or the shops, airports and restaurants? My judgement, for what its worth, is that Capital Economics are erring on the more optimistic side – there is a distinct possibility that most of the restrictions will remain in place as we go into 2021 and therefore the economic impact will be worse than what it shown below. There is a list of Capital Economics publications from which I have taken these quotes at the end of the end of the Newsletter. Virus waves “Broadly speaking, there are two different ways in which viruses recur: through subsequent waves of a mutated virus or through multiple peaks of the same one. The 1918 flu is thought to have come in three waves with each more severe than the last, although reporting and recording was patchy. Flu pandemics in 1957 and 1968 had multiple waves. And more recently, the 2009 H1N1 “swine flu” started in April and was followed by a second wave in the autumn. Pressure to ease containment measures before the virus is fully under control, most notably in the US, might cause an unintentional resurgence. And we have already seen a renewed pick-up in infections in North China, Singapore and Japan, at least partly due to re-infection from elsewhere in the world. Hopefully, a vaccine will be found in time to prevent multiple peaks from occurring. But it is worth considering what the economic impact of any resurgence might be in the meantime. There are several reasons to think that the effects might not be as severe as the current wave. For a start, there should be increasing immunity in the population which could limit the need for containment measures.” “For some companies that are just about surviving now, a second wave might be the final straw that tips them into insolvency even if the related containment measures are less severe.” “The behavioural implications of a second, or indeed multiple, peaks could be very different to those of a one-off pandemic. If the virus seems set to recur regularly, it is much more likely that people will permanently change their behaviour to avoid crowds. This would increase the risk of sustained economic damage, with industries like leisure and tourism particularly exposed. The upshot is that there are reasons to think that any resurgence in cases in the months ahead will have less severe immediate economic effects than the first peak. Nonetheless, it would make any recovery much slower and increase the permanent loss of output likely to occur as a result of all this.” What about the global economy? Global GDP will fall at its steepest rate since WW2; a contraction of 5.5% this year. For comparison, in the 2008 financial crisis world GDP was down only 0.5%. Even though Capital Economics says “once the virus is under control output should rebound” they also note that it will take years to get back on the path we were on pre-Covid-19. “Policymakers’ bold action should prevent this recession from turning into a depression… And most countries’ banking sectors are healthy enough to stop this morphing into another financial crisis.” “Once the “shutdowns” are eased, the global economy’s capacity to produce goods and services should rebound strongly. Firms will re-open and people who were temporarily laid off will go back to work. That said, restrictions may be eased in a gradual and piecemeal manner. On this front, there is a risk that some of the rebound that we expect in Q3 ends up coming later than that.” “Moreover, we suspect that some demand weakness will linger. Consumer and business confidence might well remain subdued for some time, not least if fears of a second wave of the virus linger. In some countries, there might be the prospect of a new wave of austerity to repay the rise in public debt. “When world GDP contracted by 0.5% in 2009, pre-tax earnings of global non-financial corporations plummeted by 45%. We’re expecting a 4.5% decline in world GDP this year, so there’s a good chance that earnings will fare worse than they did in 2009. Even if they fall by the same 45%, the overall interest cover ratio (pre-tax earnings coverage of interest expenses) should fall to a historic low.” “Banks can hardly escape large loan losses in the worst global recession since WWII…Even where banks’ direct exposure to affected firms is small, they will face losses on loans to households that are struggling in a weak labour market”. Banks are also exposed to leveraged loans. Fund managers are also in trouble: “[There is a] risk tha………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 Smith News, freed from the shackle of Tuffnells, has a lot going for it. But there is a risk that it runs out of money before shareholders benefit from the simplified and focused company.
The Group has £175m committed bank facility available until 31 January 2021, of which £68m is current unused, implying that around £107m is being borrowed. The directors reckon they will still need to borrow £83m in the new year. They have already been in discussions with current bankers for a renewal of lending. “However, following preliminary negotiations the company has not been able to secure refinancing terms it considers commercially acceptable…and has decided to defer the refinancing process given the current uncertainty and tightening of the debt markets, including as a result of the onset of the COVID-19 pandemic. The Company expects to re-commence the refinancing process following Completion of the Proposed Transaction (which has been consented to by the requisite majority of the Company’s existing lenders) and when the debt markets and general market conditions each settle following their current period of heightened volatility.” In other words, Connect directors reckon they’ll get a much better deal from bankers once they have dumped Tuffnells and can point at the long history of profits and cash flow at Smiths News. They say, “Taking into account the underlying profitability and cash generative nature of…Smiths News, which generated adjusted EBITDA of £48.6m and free cash flow of £36.8m in the year ended 31 August 2019, the Board is confident that, following Completion of the Proposed Transaction, the Continuing Group will be in a stronger position from which to negotiate the Proposed Refinancing than would be the case either prior to the Proposed Transaction.” They are looking to conclude discussions on refinancing in the next nine months. But that is a tight timetable given the cliff edge of 31 January – if there is no new debt facility there might not be a business. The directors are confident: “Longer term, the Board believes that as and when restrictions ease, the operational and market resilience of Smiths News mean it will be well placed to swiftly return to previous levels of service and profitability.” And if they don’t get a good banking deal? Then they’ll go for a combination of measures:
Will shareholders save the day if bankers will not? In normal times Smiths News should be able to borrow the £83m it needs because it has a very stable, if declining, cash flow founded on five-year contracts with publishers most of which now stretch to 2024/5. But we are not in normal times and bankers may be in such cautious frames of mind that they will not advance the company £83m on good terms. Connect Group’s history of cash flow (including the deduction of Tuffnells losses in 2018 of £5m and in 2019 of £14m) £m Interest paid Free cash flow (after paying for capex, WC changes, finance lease payments, taxation – but not interest or dividends) Dividends 2019 5.1 13.4 0 2018 5.8 26.0 7.6 2017 4.4 33.1 24.0 2016 4.9 41.1 23.2 2015 7.3 45.6 21.4 2014 5.5 43.3 17.7 2013 6.5 39.1 16.0 2012 3.7 30.9 14.9An idea: If the bankers are still reluctant to supply the full £83m then Smiths News could perhaps borrow £60m. This would mean the ratio of company debt to cash flow will be in the region of one and a half - surely an acceptable level to the bankers? The other £23m could come from shareholders. For this to work out we need to understand the character of the main shareholders and whether they would blanch at putting money into a risky company. Aberforth Partners Aberforth holds 17.13% of the shares. They are committed value investors and therefore used to dealing with small companies going through a time of troubles. Their website states: “We are value investors who seek to purchase shares in companies that are selling below their intrinsic value. The chosen investment universe [small companies] yields a disproportionate numb………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 Last week Connect Group (LSE:CNCT) announced the sale of its Tuffnells division. At first, investors greeted the news with enthusiasm, pushing Connect’s shares up 50%. But the following day they were back down where they started because the details of the deal revealed that Connect wasn’t getting much out of it other than removing Tuffnells’ future losses from the Group’s P&L accounts.
The sale of Tuffnells has been long awaited. When it was bought in 2015 it made a decent amount of profit, but in the last two years it has it lost money month after month and the management team seem to be bereft of ideas and skill to sort it out. (Losses were over £1m per month in the year to August. Rumours are that this lose rate have doubled during the Covid-19 crisis). And it seems that Tuffnells’ managers can’t even stir themselves to take advantage of the current shortage of parcel delivery services in the country. A quick sale to a rival or private equity group would be a neat solution, even if the price achieved was zero, because this would take away the financial drag of Tuffnells, releasing Connect to concentrate on collecting the fairly predictable profits from it local monopoly newspaper and magazine distribution business, Smiths News. (Previous newsletters on Connect: 29th Sept – 4th October 2017, 24th -29th January 2018, 19th May 2018, 14th June 2018 14th – 27th June 2018, 11th – 15th Dec 2018, 5th Feb 2019, 13th – 18th November 2019, 3rd February 2020, 23rd – 27th March 2020) But the sale is far from neat The buyer is a special purpose vehicle set up by Broad Oak Support Services called Palm Bidco. It has agreed to buy Tuffnells for £15m. Well that sounds good, you might think. But the £15m will not arrive for quite some time - in three tranches: £6.5m in 18 months, £4.25m in 27 months and £4.25m in 36 months. And there are real risks that the new team will not be able to make a go of the standalone Tuffnells, and so the £15m might not arrive at all. Then there is the problem that Palm Bidco doesn’t have much cash. It is so badly off that Connect’s directors have agreed to lend £10.5m of Connect’s shareholders money to it. From the point of view of the shareholders of Palm Bidco the deal has tremendous upside: if they return Tuffnells to profits of £15m per year then their shareholding will be worth over £150m. If it goes wrong, then they receive large salaries until it goes under. They’ve ensured that the organisation that has committed the most to Palm Bidco is Connect. It faces the possibility of being in the unfortunate position of a creditor in a liquidation and then very unlikely to get back its £10.5m. There is another problem: Tuffnells rents most of its depots. Naturally, the landlords will not be happy if the only guarantor that the rents will be paid is this poorly-capitalised loss-making Palm Bidco. Thus, landlords will refuse to allow transfer of the leases from Connect and the deal will collapse. To get around this problem Connect agreed to guarantee that the rents will be paid, thereby putting itself on the hook for millions of pounds of rent each year should Palm Bidco falter. And another thing: the guy who has been paid a great deal of money by Connect since November to turn Tuffnells around, Michael Holt, has jumped from the Connect ship to the Palm Bidco ship. Michael Holt will receive 5% of the equity in the new company for managing it (other Tuffnells’ executives might obtain equity totalling 25%). He was ostensibly putting his heart and soul into getting Tuffnells on the right road for the benefit of Connect shareholders. As a future 5% shareholder in Palm Bidco would he be most interested in the special purpose vehicle paying a high or low price for Tuffnells? and therefore would he be most interested in getting Tuffnells numbers turning up or turning down? I make no accusation, merely raise the questions. One comfort might be that the other Connect directors excluded him from discussion regarding the sale. Another downside: Connect will settle Tuffnell’s £16.1m overdraft and pay about £2.6m in Palm Bidco’s transaction costs. Despite all these negatives I stil……………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 Professor Carmen Reinhart, Harvard, an expert on macroeconomics and international finance found popular fame with her book co-authored by Kenneth Rogoff, This Times It’s Different: Eight Centuries of Financial Folly, which examined the striking similarities of booms and busts through history. She helps us understand financial crisis, drawing on her studies of so many of them.
She wrote a piece for Project Syndicate three weeks ago entitled “This Time Truly is Different”. I summarise the main points below. “The vast uncertainty surrounding the possible spread of COVID-19 and the duration of the near-economic standstill required to combat it make forecasting little different from guessing.” One of the key features that makes this economic event truly different is the response of governments: complete lockdowns. But the scale and scope of the shock has been so great that it has led to simultaneous cratering of aggregate demand (people don’t want to spend) and supply (factories and restaurants are closed) leading to “the initial effects on the real economy likely to surpass those of the 2007-09 global financial crisis (GFC).” Reinhart notes that corporate balance sheet are far from healthy with too much debt and increased default risks. There are also negative effects from “the Saudi-Rus ………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 A negative bubble? Professor Robert Shiller’s take on likely human reactions to the crisis16/4/2020 Professor Robert Shiller, a renowned student of behavioural finance, was awarded a Nobel Prize in economics in 2013.
He recently wrote an interesting piece for the Project Syndicate group entitled “The Two Pandemics” He is most interested in the less obvious pandemic that is starting to sweep across nations - it is “a pandemic of anxiety about the economic consequences of the [COVID-19] pandemic”. His arguments draw on the ideas of imperfect rationality and heightened emotion, leading people down a path of feeding on each other’s fear, ending with panic. Understanding this phenomenon might help us gain some grasp of likely market trends. Shiller says that the source of our anxiety is that we are unsure what action to take. Furthermore, the two pandemics may feed on one another: “Business closures, soaring unemployment, and loss of income fuel financial anxiety, which may, in turn, deter people, desperate for work, from taking adequate precautions against the spread of the disease.” If these pandemics were confined to one country the demand drop there may be lessened due to the continuation of its exports. But now recession “threatens ………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 On Tuesday, the organisation charged with keeping an eye on UK government spending, and the economy more widely, published its ideas on where we might be headed. The economists at OBR assume a three-month lockdown due followed by another three-month period when restrictions are partially lifted (so that the economic impact is halved in Q3). Then in Q4 activity returns to pre-outbreak levels - thus there is no second wave of the virus. They also assume no lasting economic hit. The main conclusions are that real GDP falls 35% in Q2, but the economy bounces back quickly. Unemployment rises by more than 2m to 10% in Q2 (to 3.4m), but then declines more slowly than GDP reco ………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 On Tuesday the International Monetary Fund peered into the future, providing its informed guesses on what is going to happen to our economies (World Economic Outlook). It does not paint rosy pictures.
(BTW: I’ve gone even more into cash with the sale of my shares in the industrial and office property company J Smart) Far worse than 2008 IMF: “The output loss associated with this health emergency and related containment measures likely dwarfs the losses that triggered the global financial crisis. Second, like in a war or a political crisis, there is continued severe uncertainty about the duration and intensity of the shock. Third, under current circumstances there is a very different role for economic policy.” The worst economic conditions we have faced in a long time “It is very likely that this year the global economy will experience its worst recession since the Great Depression. The Great Lockdown, as one might call it, is projected to shrink global growth dramatically.” Baseline scenario There are various paths we might be forced down, but the main determinant on how bad the path we follow will be is the length of the lockdown. The IMF start by assuming a fairly short lockdown period of three months (Q2) and then “the pandemic fades in the second half of 2020 and containment efforts can be gradually unwound,” resulting in a total loss of 8% of working days this year for severe epidemic countries and 5% of days for other countries. Then “the global economy is projected to contract sharply by –3 percent in 2020, much worse than during the 2008–09 financial crisis”. This scenario assumes that global growth in 2021 will be positive 5.8% as economic activity normalises. The IMF acknowledge the “extreme uncertainty” around this forecast. “Many countries face a multi-layered crisis comprising a health shock, domestic economic disruptions, plummeting external demand, capital flow reversals, and a collapse in commodity prices. Risks of a worse outcome predominate.” In the baseline scenario the western world is hit far harder than the developing world where GDP for the latter is 1% down for 2020, pushed up by a China rebound this year. The West does not recover all lost ground by the end of 2021 – see table. IMF projections using its baseline 2019 growth 2020 GDP falls projection, % 2021 GDP rise projection, % World 2.9 -3.0 5.8 USA 2.3 -6.1 4.5 Euro area 1.2 -7.5 4.7 UK 1.4 -6.5 4.0 Emerging Market & Developing Countries 3.7 -1.0 6.6From the table I conclude that a three-month lockdown is likely to result in 2022 GDP only being about the same as it was late 2018 in the USA, the Euro area and the UK, after having put the population through the appalling experienced of a slump in supply and demand. The mechanism for falling output Initial shock “Curtail[ed] mobility, with particularly acute effects on sectors that rely on social interactions (such as travel, hospitality, entertainment, and tourism). Workplace closures disrupt supply chains and lower productivity. Layoffs, income declines, fear of contagion, and heightened uncertainty make people spend less, triggering further business closures and job losses. Domestic disruptions spill over to trading partners through trade and global value chain linkages, adding to the overall macroeconomic effects.” Amplification channels “Flight to safe assets and rush to liquidity put upward pressure on borrowing costs and credit has become more scarce, aggravating financial strains. Rising unemployment………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1 |
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