“Crisis does not create character; it reveals it.” – Jim Stovall, Wisdom for Winners
In just a few short months, our world has changed.
Even the word “pandemic” is scary. Health officials have labeled the coronavirus as “novel,” because the human species has never been exposed to it. We seemingly have no natural antibodies. As the news of the virus has unfolded, and nations and communities accepted that our first (and possibly only) line of defense was the concept of “social distancing,” I gained a newfound respect for survivors of previous pandemics. The Bubonic Plague. The Spanish Flu. Or even 1612 when Native Americans welcomed the Pilgrim settlers traveling from Europe bringing with them smiles, smallpox, and leptospirosis[2].
What we are experiencing is unprecedented. We know that the disease spreads more easily (exponentially) than the flu and is 10x as lethal. What we don’t know is the true mortality rate, when it will peak, whether people can be re-infected creating a second and third wave, and, due to lack of testing, what proportion of the population is asymptomatic.
As I consider our current situation and its impact on the economy, I realize that in some regards we are experiencing the opposite of what we have in the most recent past. Past financial crises were largely the result of supply side failures. During the periods of the Crash of 1929, Black Monday, 9/11, and the 2008 Financial Crisis, the financial system which supplies money, loans, and facilitates financial transactions locked up due to external shocks. Parts of our financial system were closed for business. What we are seeing now is a demand side failure. To slow the spread and mitigate the impact of the virus, the consumer world has essentially closed for business.
The immediate stop in demand for tourism and hospitality rapidly spread into manufacturing, education, healthcare, legal, technology and most service-related industries. While the epicenter of the 2008 Financial Crisis was the financial sector, the coronavirus touches all parts of the economy making it harder to remedy. Governments can’t just bailout banks, they have to consider travel sectors, manufacturing, energy, consumers….
The Federal Reserve has learned from history, and their top priority is to keep the financial system open, keep credit available and financial transactions flowing, and avoid consumer panic. If consumers worry that banks will fail, they run to pull out their money and we jump from crisis to economic system failure. This was the aftermath of the 1929 Crash. We are currently nowhere near that type of outcome.
The Fed has indicated they are willing to do whatever it takes to keep the economy afloat. The Congress and Senate passed the CARES (Coronavirus Aid, Relief, and Economic Security) Act to inject $2 trillion into the economy and support those hit hardest. We are using important tools that we did not have in the past. Given the complete loss of output from many sectors of the economy, there is no avoiding a recession at this point. The world will not end, but the longer we stay quarantined, the greater the impact on the global economy.
When will it end?
We will begin to recover the day after things stop getting worse! A few signs that we have reached a bottom:
- New infections slow – The number of new infections is no longer growing exponentially.
- Hospitals are no longer in crisis – They have adequate supplies, and systems in place to manage and support the caseloads. And even better, when we have more patients that are being released from the hospital than are entering.
- Cultural change – United behaviors to support virus limitation efforts, and a reduction in those wanting to prove they know more than health experts or questioning whether large-scale quarantining is legal. If anything, at the end of this crisis, if we find ourselves wondering if the shelter at home actions were too extreme, it means that our health experts did their jobs and protected us from the worst possible outcomes.
- An aspirational target – A cure, or rapid-test that can have results within minutes allowing people to return to work after being tested before entering the building.
We have not yet reached the bottom. Which means that we are closer to the beginning than the end of the crisis. But when we do reach the end, what will have changed? No disease in the modern era has caused countries worldwide to quarantine vast populations or triggered a collapse in supply chains, trade, business, and social activity. With an order from the Mayor, we can shut down events larger than 10 people. But what happens when we turn the lights back on? Not every small business will reopen. And what about the end consumer? When banks offer remedies to homeowners in the form of a three-month mortgage deferment, what happens when rent is due in July? Does the consumer owe the usual $2,500 mortgage payment or $7,500? These are questions that the Federal Housing Finance Agency will have to resolve. What about everyday activities? How appealing does a live sporting event feel at this point? How long will it take for us to feel comfortable gathering in large crowds?
The reversion to “normal” will take quarters if not years.
This lack of clarity has brought uncertainty to equity markets, and the selloff has been largely indiscriminate. It is my view that the magnitude of the falling prices has not been in line with the value of the lost profits. This typically happens in recessions, and so there are bargains available.
But the opportunities are non-obvious:
I have observed the spike in the stock of Zoom Video (ZM). The movement is understandable given the increase in usage. I have used their services to share video calls with friends and family, and many businesses have signed up for service to support staff working from home. Zoom offers the perfect product for this crisis. But I don’t believe the surge to be sustainable. Zoom’s products are currently among the best available and purpose-built for corporate use. But there are likely many other companies ramping up competitive offerings and, in the end, customers will buy the cheapest product with the best quality. The business really has no moat. There is nothing to lock customers in. And the privacy/security conversation and backlash have only just gotten started.
Multiple sectors have benefitted from the current environment including consumer staples (Clorox, Proctor and Gamble, Colgate-Palmolive) and the grocery stores (Kroger, Target, Dollar Tree, Dollar General) that deliver these much-demanded goods. However, as the logistics systems have become much more expensive to operate in this environment, margins will be impacted. And as the situation moderates, we will find that the surge in grocery buying was really customers pre-purchasing items for the remainder of the year. Many consumers will find they don’t need to refill toilet paper and cleaners for quite some time. Others will return to the convenience of dining out.
There will be opportunities in the rebound. Specifically, companies that will see an immediate surge in demand when the lights come back on. After spending months in home confinement, the world will be eager to dine-out, socialize, and engage in “retail therapy.” We are researching companies who can facilitate and benefit from this rebound by acting as the “picks and shovels” in consumer spending. Ideally, scalable companies who can reduce expenses as quickly as revenues decline.
We do not know when things will abate. But we are active buyers of companies who can withstand the drought and rebound quickly when things turn.
For the first quarter of 2020, the RCG Alpha Long Short Fund gained 18% while the Alpha Strategy declined (21%). This compares to the Equity Long Short Index and the Russell 3000 which declined (8%) and (21%) respectively. I was reasonably pleased with our results during the quarter. Our long-only strategy performed in line with the broader market, but we hold positions which I expect to outperform during the rebound. Our hedge fund shielded clients from negative downside as it was designed to do. The strategy benefitted from our ability to hedge and short. We shorted companies that would be disproportionately negatively impacted by the economic shutdown. But we were laser focused in our approach in that we targeted companies that were weakest in our target sectors due to challenged balance sheets and/or business models. The majority of our short positions are in companies we expected to underperform even in bull markets. We view shorting as an extremely valuable tool in the toolkit. We tend not to discuss our specific short positions as we do not want to appear to be profiting from pain. Instead, we view business markets as a natural evolutionary ecosystem. As new technologies and business trends emerge, others decline and fade away. We believe that we have a skill in identifying these trends and creating value for our clients.
We are buyers through the crisis.
The virus, and its residual impact, will be here with us for some time. But I see reasons for hope.
There were 19 cruise ships that were quarantined due to coronavirus. A cruise ship is the perfect environment to incubate and spread the bug[3]. Small living spaces. Shared air systems. Asymptomatic carriers. I would expect a high (75%+) infection rate. But what they found was that 20% of passengers got the full virus while ~50% of passengers had underlying exposure and minor pneumonia symptoms, but never contracted the virus. Despite its anecdotal nature, perhaps it is a positive sign that we have some natural defenses. The last three airborne outbreaks SARS (2003), Avian flu (2005), and MERS (2015) subsided after three months and then air traffic recovered over the next 6 to 8 months. Air travel declined 40% after 9/11 and gradually recovered.
We will get through this. Whether the economic recovery is U, V, or W shaped, we will recover. Many small businesses will fail. But these small businesses were launched by entrepreneurs with a fighting spirit. They will find a way to fight on with their existing business or the next.
The wonderful thing about crises is that they always end. Our world has truly changed, but change is not always bad. Progress can’t come without change. We progress when we learn lessons that leave us better prepared for the future.
I pray that all who are reading are safe and are taking every effort to protect loved ones and the fellow man whom you have never met. I hope that this crisis brings out the humanity in us all and that we are exceptionally generous to those who are impacted most significantly and saw their incomes go from “barely making it” to non-existent. We can help one another.
[1] All portfolio and index returns mentioned are presented net of expenses and maximum management fees paid by any account within the composite. All performance is estimated pending year-end performance audit. Completed audit numbers available upon request.
[2] https://www.forbes.com/sites/ericmack/2018/11/21/at-the-first-thanksgiving-the-pilgrims-were-thankful-for-something-much-darker-than-the-feast/#400ab4cf28c7
[3] Which is why I don’t do many cruises…
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