Monday, April 6, 2020

CoVID-19

This is probably the most important quarterly memo I’ve written since our inception. Let’s cut to the chase – here are some of what I’ll be addressing:
  1. Why the market is down
    • COVID-19 has shut down the economy
  2. Why we are down more than the market so far
    • Liquidity has dried up, investors have fled financial stocks, but I am stepping up our purchases in anticipation of an inevitable recovery
  3. Why we must stay the course
    • We have been waiting for this moment!
  4. Why this time is (not) different
    • This is not the financial crisis
    • We’re betting on humanity and betting on America
Why The Market Is Down

“The only thing we have to fear is fear itself – nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance. In every dark hour of our national life a leadership of frankness and vigor has met with that understanding and support of the people themselves which is essential to victory.”
- Roosevelt, 1933

COVID-19 has forced most of the western world into lockdown. Business has essentially stopped, but bills continue to come in. A business’s expense is another business’s revenues. Once a business cannot generate revenues, it cannot pay expenses, which impacts the revenues of another business which cannot pay their expenses, and so on and so forth. What we are now experiencing is akin to an automobile crash pileup, where the lead car brakes suddenly and all the cars behind crash into the one ahead of it.

Financial markets have reacted with a panicky speed never before seen. It took less than 20 trading days to drop -20%, whereas the average and median time historically has been 255 and 156 days, respectively1. The VIX index, which measures volatility and is colloquially known as the “fear index”, spiked to 82.69, a record high that surpassed even the 80.74 number that marked the scariest days of the 2008 crisis. I never thought I would see that record broken within a single generation.

Terror is feeding upon itself. The SARS-CoV-2 virus deserves every bit of gravity and seriousness it has generated, but we cannot lose sight of the fact that it is imminently beatable. We have swung from too laissez-faire to national panic virtually overnight. The rational response is in between. We must treat the virus seriously enough to enact policies that do not overwhelm our hospital systems. But we also must not burn down the house to kill the termites.


Why We Are Down More Than The Market So Far

Firstly, we own mostly stocks that were under-appreciated by the market going in, and their under-appreciation only widens during times of broad panic. During times of terror, people rush to the safest, most liquid asset on the planet: U.S. dollars. As a result, there have been reports of liquidity problems throughout all kinds of financial markets. There have been days when all asset classes outside of cash — stocks, bonds, gold, even bitcoin – declined simultaneously, a truly rare phenomenon2. The smaller, more obscure or more unpopular the security, the wider the bid/ask spreads, and the more intense the sell-off3. Most importantly, our declines are not the result of any of our companies deteriorating due to idiosyncratic factors.

Secondly, a significant portion of our portfolio are in financial stocks, and financials have sold off more than twice as furiously as the wider market as the fears of 2008 looms large in investors’ memories. Fears of laid-off people skipping mortgage payments, fears of businesses skipping loan payments, and fears of a frozen market that will force banks to mark down assets to a level where they become insolvent. However, as I will explain in greater detail below, this time really is different, especially for banks.

Banks have sold off more than twice as much as the broader S&P 500

And finally, I am increasing our stakes and adding new investments in consistent, methodical increments, which will inevitably make our short-term results look worse as long as stocks continue to decline. But on the flip side I also anticipate our recovery to outpace the market, perhaps significantly, once it takes hold. And it will take hold; we just don’t know when.
Why We Must Stay The Course

“What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.”
- Buffett, October 20084 

To put it bluntly, this is what we have been waiting for. Nearly every quarter, I lament the endless bull market that has made outperformance so difficult for value investors like myself. Sure, we’ve experienced some harrowing dips along the way, but all have snapped right back within a few months, never once really threatening to derail a decade-long bull run. But now, in a violent fashion, the bull has definitively died and we will enter a deep recession. Finally.

I began my investing career in the wake of the 2008 financial crisis. I experienced first-hand how bear markets are where true wealth is created. Bear markets wash out the weak. The weaker companies, the weaker investors, they are forced to fold in an environment where consumers are more discerning, where bankers clutch their purses tighter, where capital is hyper averse to risk. The grittier ones survive, and when things inevitably bottom and start turning upwards, they are there to reap the spoils, the extra market share vacated, and emerge exponentially stronger.

Without a doubt, things look scary and terrible right now. When you open your statement, you will probably experience a jolt of cold sweat, an atavistic fight or flight response. This is perfectly normal, but let me assure you, individual stock prices right now do not accurately reflect any semblance of reasonable value. What they reflect is a fire-sale value. It reflects that fear you feel, of scared sellers overwhelming buyers.


There is no reliable method to pick market bottoms during recessions, but one saw is inviolably true: stocks always bottom well before the recession is over. If you don’t stay the course and pull out to wait for rosier economic indicators, you will miss out on massive gains. The graph on the right shows the return on stocks from the bottom of each bear market until the official end of each recession. Such returns average an astonishing 64% compared to long-term annual returns of 9.8%5.

Another way to look at it is what that long-term annual return would degrade to if you miss just a handful of the “best days” in the market. Missing just 10 of the biggest up days reduces your annualized returns by 2.7%. And missing the 50 best days… you might as well just leave your money in a checking account. Translated into dollars, if you invested $1 at the beginning of 1992 and held until the end of 2019, you would have $13.66. Missing the 10 best days nets you only $6.82, and missing the 50 best reduces that all the way down to $1.31.

Source: Goldman Sachs Portfolio Advisory Group “Rebalancing and Market Entry in Down Markets”; Bloomberg

According to data compiled by Charlie Bilello of Compound Advisors, -20% bear markets occur, on average, every 4.4 years, -30% every 9 years, and -50% every 20 years6. And yet, through thick and thin, stocks reliably outperform every asset class in the long run. To enjoy long-term returns that equity securities offer over fixed income, the price of admission is volatility—sometimes mind-numbing, cold-sweat inducing, vomit-reflex engaging volatility.

With that said, I will not put us in a position where we would risk margin calls. In other words, we will always be net cash positive. In this environment where prices gap up or down by double digit percentages with no fundamental reason, anyone on margin could get involuntarily liquidated by their broker. Enough money can be made with no leverage whatsoever, and besides, careful use of options, hedged or covered or in-the-money ones provide us with plenty of asymmetric return opportunities.


Why This Time is (Not) Different

What causes economic recessions? Traditionally, it is caused by an imbalance between allocated resources (capital and labor) and resulting productivity (profits). In other words, resources that do not produce profits. That results in losses in capital and layoffs in labor. For example, dot com bust happened because too many then-newfangled internet companies had no pathway to profitability and yet sucked up large amounts of capital and labor. The process of reallocating those resources into actual, productive endeavors is what eventually digs us out of a recession. 

In 2008, the financial crisis was precipitated by overinflated real estate prices. Capital and labor poured into the housing sector, building more homes and generating more mortgages than was needed by magnitudes. Eventually the mortgages could not be paid, which led to foreclosures, which drove down real estate prices, which halted new construction. The value of mortgage-backed securities collapsed, which decimated the banks which held large amounts of such securities, which led to a huge pullback in lending activity, which caused the intense recession. Digging out of it required a long and arduous process of reallocating the substantial amount of resources previously dedicated to housing and banking.

This time, it isn’t the popping of an asset bubble that is driving capital losses and mass unemployment.  It is, instead, an artificial halt to the economy. Instead of the invisible hand of free markets working to reallocate resources from unproductive sectors to productive sectors, it is a deliberate act of government policy to stop the spread of a pandemic. Once the pandemic is under control, labor and capital will mostly return to where they were needed prior to this recession. People will eat at restaurants again. People will travel again, probably even on cruises again. This is self-evident.

Compared to 2008, all the excess labor and capital left the housing and mortgage industries permanently. People were buying houses they could not afford by borrowing money that banks should not have been lending. Once that popped, all those people needed to go find real jobs or start other businesses that are actually sustainable. That created a prolonged period of pain.

Another significant difference is the government’s response. Typically in asset popping recessions, the government can be reluctant to step in and bail out those who had wasted all those resources to no end. The right thing to do is to let failure percolate, allowing painful memories to fester, which will discourage the same bubble from forming again. 

This time, since the government is directly “responsible” for the cause of the recession, they are 100% incentivized to bail out whomever is necessary. Already, over $2 trillion in stimulus have been approved to enter the economy to bridge us past this pandemic. The Federal Reserve immediately cut rates to zero and are committed to buying however much assets as necessary to keep liquidity and credit flowing. 

This difference cannot be emphasized enough: there is a bright green light to print money and hand it out. If the $2 trillion is spent and we are all still quarantined, they will print another $2 trillion, and it will again be overwhelmingly bipartisan. Of course, the mechanism by which this payment transfer is effected will inevitably run into snags as handouts of this size have never been attempted before. But the incentive is there and it is unwavering. That’s the key.

In this sense, we are experiencing a “crisis” more similar to World War II than any other typical recession/depression/panic, where the majority of citizenry and governments drop business-as-usual and participate in a joint effort to defeat a common enemy. WWII, of course, was also the definitive event that jolted the U.S. to slough off the Great Depression once and for all. 

***

How does this affect fundamental valuation of individual stocks? Without a doubt, earnings this year for most corporations will decline dramatically. But for most corporations, especially those that will survive this pandemic, one or even two years’ worth of earnings is merely a blip in the overall calculation of intrinsic value.

Intrinsic Value = Present Value + Future Value. PV roughly equates to tangible book value, e.g. cash on hand, owned assets, working capital, etc., minus liabilities plus current earnings. FV essentially equates to the accumulated future earnings stream from now until Judgment Day. What this recession will impact most skews much more towards PV than FV. It will certainly damage near-term earnings. It will surely damage the tangible book value of banks who will have to deal with troubled loans. But if you own shares in a company that will survive this crisis with no loss of reputation or human talent or brand value – in other words, no loss on their ability to generate profits in a normal functioning economy – it will continue to enjoy a long and growing tail of future earnings stream. The importance of FV in almost all typical going-concern operations far outweigh the importance of PV.

Another way to think about this is to invert: which kind of companies are unlikely to make it? It is companies that were already weak going into this crisis. Companies that were perched on a tipping point and needed some good luck to make it. Companies that are heavily indebted, whose intrinsic value are actually held by bond holders rather than equity holders. In cases like these, this recession will wash them out like every other recession. This time would not be different for them.

The major holdings in our portfolio, if my assessment about this being a maximum one to two year event with heavy and eager government support throughout, should all comfortably make it to the other side. Their intrinsic value may be nicked by temporary losses and mark downs, but that’s why I purchased our shares at discounts to intrinsic value. In other words, when I invested in our companies, I already baked in the certainty of future recessions and unknown catastrophes. I have not and never will invest in anything based on “blue sky” scenarios.

***

Some Extraordinary Commentary on a Specific Stock

The biggest contributor to our decline this past quarter was, by far, CIT Group. CIT, if you recall, is a mid-sized commercial bank with about $50 billion in assets, which entered the quarter as one of our top two positions. Shares went from $39.71 to $17.26 during March, but that doesn’t even account for the true magnitude because in late February it traded as high as $48 per share before hitting an intra-day low in March of $12.02 per share. That, if you’re morbidly curious, is a -75% drawdown. Ouch. The KBW Bank Index (BKX) over the same period of time (late Feb. to March lows) “only” drew down -49%.

The proximate reason for the shellacking of bank stocks is the fear of investors who believe we might be reliving the 2008 meltdown nightmare. However, banks are dramatically different today than they were twelve plus years ago. First and foremost, they hold much more “buffer” against losses now thanks to an rule called Basel III. Basel III forced banks to keep more capital on their balance sheet to defend against unexpected losses. How much more? Prior to 2008, banks routinely borrowed up to 30 times their capital base. These days, it’s down to around 10 to 12 times. This dented their earnings power post crisis, but it has them well protected coming into this pandemic.

Additionally, banks are now playing lead roles in recovery effort vs. being lead villains in 2008. Government guaranteed loans from the $2 trillion stimulus will be underwritten and distributed by banks to help businesses pay their bills and debt. Banks can then securitize these loans, plug into the Federal Reserve, and dump the credit risk onto the Fed’s balance sheet, which may be able to accommodate up to $4 trillion7 in such guaranteed low interest loans. This mechanism should theoretically act as a bridge for companies who otherwise would default on loan payments to get to the other side of this crisis intact.

With regards to CIT specifically, there were no fundamental reasons for it to decline with such a velocity outpacing the rest of the financial sector. The only probable explanation is their history, which saw them succumb to bankruptcy by the financial crisis – perhaps institutional memory had folks dumping CIT in fear of a redux. However, as I’ve explained in my annual letters, CIT is a completely different beast these days. Back then, they were encumbered by a mish-mash of random assets, including subprime lending, manufactured housing loans, aircraft leasing, etc. They weren’t even a bank holding company! Today, they are a legitimate, regulated, vanilla nation-wide commercial bank with an investment grade balance sheet, pure and simple.

Furthermore, as recent as 2017, CIT was required to undergo annual “stress tests” administered by the Department of Treasury8. The stress test scenario envisioned a prolonged, 9-quarter recession with double-digit unemployment and a nearly flat yield curve. In such an environment, CIT would suffer cumulative losses of -1.8% of assets, or just under a billion dollars9. It hurts, but it is a fraction of the $3.5 billion discount to book value CIT is currently trading at. In other words, shares are priced as if the losses will be over 3.5x the severity of the financial crisis. This is not to mention the fact that CIT is an even stronger bank today than it was three years ago.

Don’t just take my word for it. In light of these facts, insiders acted aggressively to buy stock on the open market. Twelve members of the board of directors and the management team spent over $1.6 million of their own money on CIT shares last month, with the two largest blocks coming from the CEO and the CFO. In a nutshell, the very people who are evaluating the company’s risk in real-time are the most bullish.

And so: I’ve been adding to our stake all the way down, which has temporarily made our results look rather dour but has me quite excited about the potential returns on the upside. I don’t typically disclose this much detail about individual stocks in quarterly letters, but during this extraordinary time, it is only fair to be transparent about my most aggressive moves so you understand I am making my decisions with rationale and logic rather than that four letter word h-o-p-e.


8 The requirements were changed in 2018 to only stress test banks with over $100 billion in assets.



To Sum Up

It is an extraordinary time to be living through right now, both as an investor and as a regular human being. I am in awe of the might of humanity aligning together against one objective: beat COVID-19. From the doctors and nurses on the front line, to the restaurants, grocers and essential workers working to feed us, from the scientists and researchers who have dropped everything else to focus on this virus, to the career government employees responsible for crafting policy and guidance that will help bridge us across these tough times – heroes one and all, but individually destined to be unsung.

Our companies have stepped up in kind, doing what they can. Our banks will be front-line distributors of loans and grants that shore up business cash flows and keep people on payroll. GM has retooled plants and leveraged their formidable supply chain to build ventilators and masks that will literally save lives. Dish is donating spectrum to T-Mobile and AT&T to ensure there will be enough bandwidth to communicate on and even giving free Sling TV access for 14 days to ease the burdens of quarantining. BlackBerry is providing 60 days free access to remote workplace tools that have become critical for white collar workers. Added together, the reputation of our companies will surely be strengthened on the other side of this crisis.

Soon the infections will peak, and soon we will have antibody tests to administer far and wide. Soon there will be targeted therapies that will save a majority of even the highest risk cohort. And then, there will be vaccines, and then it will be over. Although the timing is unpredictable, victory is inevitable. I will never understand the pessimists who bet against humanity and against America, those who may achieve a temporary thrill when their contrarian bets pay off once per decade but spend the rest of the time reliving past glories and hoping for future doom.
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