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Ian New
Ian New
Articles (12) 

The Corona Effect, Part 2

In part 2 of this series, I will discuss my stock investing strategies to weather the storm

April 26, 2020 | About:

Don’t just look at the rearview mirror

In the stock market, there are two types of forecasters: the mean-reverse forecaster and the momentum forecaster. Your prediction often relies on what type of forecaster you are.

The market, however, is neither of these two types. The market has no memory when it charges forward or drops backward. In the short term, the stock market is more like a random walk, a Brownian movement that is pushed only by surprises. In the long term, the overall market goes up. For individual stocks, in the short term, there is more volatility than the general market. In the long term, some deliver monster returns, while some might drop to zero.

During a crisis, the division of the two types of forecasters is even more obvious. They might even laugh at each other. Both approaches are not very rational and could be dangerous. The mean-reverse forecaster might mistakenly feel at $3 stock price like AMC entertainment (NYSE:AMC) is very cheap because it was $10 just three months ago, ignoring the high bankruptcy risk. The momentum forecaster, on the other hand, could have sold most of the stocks when the S&P dropped to the 2,300 level in March, only to buy back at 2800 level now.

The stock market never has only one big drop from the peak. There was a deep one of about 34% in a single month. The reversal was also as volatile, rebounding 27% in less than a month. Is the stock market out of the woods now? in my opinion, it is unlikely.

A prolonged battle with Covid-19

The question of how long the virus will last depends on when the economy is reopened. It seems the U.S. will choose to reopen earlier due to pressure from the Presidend and businesses. This "business friendly" approach means we will likely see some breakouts in certain areas for a long time until a vaccine is available. There is light at the end of the tunnel, but the tunnel could be longer than we originally expected.

If the battle drags into 2021, the market cannot continue its recent upward reversal, in my view. The "business friendly" approach is likely to backfire on businesses, from my viewpoint, due to larger numbers of people being infected.

Corporate earnings reports

The second half of April is earning season. When most companies report their declined financial performance for the first quarter of 2020, they might also paint an even greyer picture of the second quarter. The lower than expected guidance of earnings could drive prices lower.

The bankruptcy tsunami

An avalanche of companies filing for bankruptcy will also be bad for the markets. On April 19, the day I am writing this article, Reuters reported that Neiman Marcus is preparing to file for bankruptcy protection as soon as this week. JCPenny is reportedly considering a bankruptcy filing too, though these rumors are unconfirmed.

In one or two months, we could begin to see the largest bankruptcy wave in decades due to how heavily leveraged U.S. companies have become relative to history. Never before have we gone into a recession with such a high percentage of corporate leverage.

Second wave of layoffs

The 2nd wave of laying off will also hit the labor force soon. The first wave hit business at the frontline of this crisis. It began with the travelling industry, including airlines, cruise ships, hotels, car rental, etc. Then when the economy was shut down, it hit retailers, restaurants and all types of manufacturers. Eventually, banks who lend to business could fall under as well. For firms who remain operational, the employees have been spared so far, but with few exceptions, firms will eventually be affected because of lower demand, and employees will thus have to be let go.

The last pandemic-driven recession

The end of the Covid-19 health crisis could potentially signal a severe recession. The 1918 flu did not do as much damage to the stock market as the following Great Depression. I think it wasn't a coincidence that the Great Depression happened less than a decade after the 1918 flu pandemic.

The stock market will rebound eventually

Although the market might dive again if thing get worse than expected, it will eventually turn around far before the economy touches the bottom. The stock market is a leading indicator of the economy, but it does not always sync with the economy. When the market turns up, it won’t be gradual. It might rebound fiercely and unexpectedly for many investors.

Given the uncertainty of a second market drop and eventual rebound, I believe investors should carefully balance their portfolios between a defensive strategy and an aggressive strategy.

Defensive strategy

My defensive strategy usually means investing in stocks that have a negative beta and low expected return. These firms are not cyclical and should do better than the market during economic downturns. During the current crisis, beta might not be a good measure. In theory, it measures the extent to which the individual stock and the market move together. In practice, beta is calculated by running the regression of past returns of individual stocks on the past returns of a market index. In other words, it is measured based on past relationship between the stock and the market. Such a relationship could be broken when we have a major shift in the market paradigm. Below are a few of the names can I consider defensive now.

Amazon (NASDAQ:AMZN)

Amazon is among the few corporations that might financially benefit from the crisis. However, most of its increased sales are likely from low margin groceries, and its supply chain could face the risk of partially shutting down. Once the crisis is over, many of its retail competitors may not even reopen, giving it more advantages to dominate. Amazon Web Services (AMS), the industry leader in the growing cloud computing market, would also benefit when isolated people and business need to be more connected. At $2,000 plus per share, it is a $ 1 trillion Gorilla, and I think there is still some upside.

ATT (NYSE:T) and Verizon (NYSE:VZ)

Both telecommunications companies would not see significant decreasing demand of mobile connection services or streaming media. That said, ad revenue from media assets will be hit. By my estimates, these stocks are not expensive and pay good dividend yields. The dividend, however, might get suspended at these companies, especially AT&T with its high financial leverage and vast media assets.

Tencent (TCEHY)

China seems to have the virus under control for now, and the growth of Tencent won’t be dented by the crisis, according to my analysis. It is not as cheap as it was several months ago, but it is still worth holding.

Aggressive Strategy

The worst performing stocks could turn out to be the best performing ones with the rebound of the market. In the second half of 2009, many stocks that had freefalls during the financial crisis delivered monster returns when the downward market reversed. There is one condition though: the company must have the liquidity to avoid bankruptcy when the storm hits. Here are some of my picks.

Groupon (NASDAQ:GRPN)

Earlier in January, Groupon reported a disappointing 2019 fourth quarter. The stock dropped 40% after the announcement, and that was before Covid-19. The company will discontinue its “goods” services and focus on local deals. I think the restructuring is the right move. Competing with mega players like Amazon in goods markets is a loser’s game, in my view. Groupon’s local deal business model makes sense and is sustainable. It is still the king in this market and sits on millions of cash. I think the company will survive, and its stock is worth investing in at a cheap valuation. Its total market cap is only around $500 million. It might become a good acquisition target for big internet and retail companies. I feel the potential reward outweighs the risk.

Carnival (NYSE:CCL)

Carnival now carries with it a stained reputation because of the "petri dish" Covid-19 outbreaks in a few of its ships. The company will stop sailing for several months, but it still needs to pay the hefty maintenance costs for ships and interest costs on its massive pile of debt. However, it successfully raised about $6 billion from financial markets recently, and I think the risk of immediate bankruptcy is low. External financing comes with interest as high as almost 12%, with convertibles potentially diluting the common shares further. However, the cruise business still has a huge unaddressed market, and the long term growth potential could return when the pandemic settles down.

Disclaimer: the numbers, analyses and opinions here are subject to errors and human biases. Those opinions cannot substitute your own rigorous research. You are responsible for your own investment decisions.

I own some or all of the shares mentioned in the article.

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About the author:

Ian New
Finance professor, CFA, and passionate practical investors. Investing is at the intersection of science and art. It would be wonderful to bridge academic wisdom with street guts, Wall Street or Main Street, right? That is why I write for GuruFocus.

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