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Markets around the world are down anywhere from 20% to 40% YTD causing massive losses for many investors. In past few days, many investors and friends have pinged me so I am writing my thoughts in this post.
I will breakdown post into two segments (1) What is happening and why? (2) Is it time to own something? If yes, what? If not, what framework I should use?
Part 1 – What is happening and why?
As of now, there are two shocks in the system
- Supply shock – two uncorrelated events caused supply shock at the same time. COVID-19 outbreak across the world and Russia / Saudis oil dispute.
- Demand shock – because of COVID-19 outbreak, countries and cities need to go in self lockdown / quarantine mode, people are staying at home, working from home and watching Netflix, Amazon prime, HBO etc. with family. No one is going out (at least, that’s the base assumption). No one is traveling, vacationing, cruising, eating out which means small businesses across the world are suffering resulting in a worsening demand shock.
Source – someone traveling from Seattle to DC 2 days ago
Lower oil price will cause high yield energy company bankruptcies resulting in job losses and destruction of wealth, health, and communities.
Now let’s bring risk parity strategies into the discussion (see reference material). In the simplest possible form, a risk parity strategy tries to allocate equal risk among different asset classes. Stocks with higher volatility get lower allocation while bonds with lower volatility get higher allocation to have similar risk across asset classes. These strategies tend to be highly levered to produce superior results over long horizon. After 2008 financial crisis, most financial institutions (aka banks) are well capitalized and not (or barely) involved in these trades but many “shadow” financial institutes (big hedge funds including some quant funds, asset managers etc.) are highly exposed to risk parity strategies. This was a great trade in last decade during low volatility regime. Since I am not an expert in this area, please check out reference material for more details.
Risk parity strategy also assumes lower correlation among asset classes. During times of stress, all these assumptions breakdown with higher volatility and higher correlations across asset classes resulting in deleverage and high mark-to-market losses.
Another popular trade over last decade was simple “basis” or “arbitrage” trade by exploiting price differences between cash treasuries and futures market to make 5-10 bps and then lever it 40-50 times through REPO market.
Source – RENMAC
Without going into technical details (see reference material), overnight financing for these strategies became a big issue after emergency rate cut (50 bps) by Fed as spreads widened. This resulted in massive mark-to-market losses – similar to LTCM (long term capital management) in 1998. Correlation among asset classes and within S&P 500 stocks started rising along with rising volatility – all this is resulting in across the board degrossing of portfolios and indiscriminate selling across stocks, bonds, gold, bitcoin and almost everything you can think of. This may bring down some “shadow institutes” – only time will tell which emperor has no clothes.
Due to these event, Fed is trying to avoid 3rd shock – financial system shock. Fed is pumping up liquidity into the system (including REPO market, see reference material) and for the first time since 2008, has opened up swap lines with central banks across the world to address USD liquidity issues (explains strength of $ against major currencies). Best thing among all this is a very healthy banking system across the world (“may be” except Deutsche bank – see reference).
Source – stock charts
How long this sell off will last and how deep it will be – I just don’t know. One thing I will say about stock market sell off (of this magnitude) is that whenever we have big swings, usually time and price action – both are needed to recoup such losses. This means I am not expecting any quick V shape recovery.
Part 2 – is it time to own something? If yes, what? If no, what framework should I use?
During my hedge fund career, I was very lucky to have great mentors. One of my mentor told me – stock market is a market of stocks and you can always find individual gems if you look hard enough. So without predicting how low S&P can go in near term and how long it can take to recoup losses, I am looking for companies with following characteristics
- Solid management with long term business focus
- Company growing faster than sector and sector growing faster than GDP
- Pricing power, monopoly / duopoly / oligopoly structure
- Fragmented customer base / fragmented supplier base
- Big addressable market
- Network effects
- Solid FCF profile, strong balance sheet
- High EBITDA to FCF conversion
- Solid unit economics and high incremental margins
It is difficult to find all these characteristics in one company. I usually look for companies which satisfy most of these, if not all. After identifying such stocks, I focus on valuation and chart. In simplest terms, any stock’s valuation can be described as
Stock’s price P = (P/E) * E
Here E represents earnings power (fundamental indicator) and P/E is a valuation multiple (sentiment indicator). I would like to own stocks with characteristics listed above with weak sentiment and high earnings power over long term.
Based on all these, I am working on following companies / stocks with a multi-year horizon – MasterCard, Visa, Google, Amazon, Apple, Microsoft, Salesforce, Adyen, Square, Shopify, Booking.com, Tencent, Alibaba, JD, Kakao, Trainline, Jack Henry, CoStar group, ADP, bill.com, Transunion, MSCI, Booz Allen Hamilton, Live nation, MercadoLibre, Meituan-Dianping to name a few. This is not a complete list and is NOT AN INVESTMENT ADVISE but should give you an idea so that you can do your own research to look for highly cash generative companies with solid balance sheet which can be valued on GAAP P/E and not “corona adjusted EBITDA”.
Please note that almost all of these companies will miss numbers and guide lower and sell side will cut estimates and ratings in coming weeks / months.
For portfolio hedges, I also recommend looking at Gold, bitcoin, and cash.
I will close this article by saying that all these thoughts take secondary priority over the health and well-being of our families, our colleagues, and our communities. So please be safe and let’s come out stronger together.
Disclaimer – thoughts expressed are my personal view and subjected to change based on incoming information. I may or may not hold securities listed above. This is not an investment advise. Please write me privately for your feedback / comments.