This is a letter to the community around Being and investments, concerning the outbreak of the Coronavirus (COVID-19). We will try to give our view of what has happened, present our understanding of preliminary figures and developments, and try to distil key implications for our portfolio and our investment strategy in the short, medium and long term.
What has happened:
In a matter of two months, the Corona virus has spread from China to all continents. After just one month after first knowing of the existence of the virus, with seven to eight thousand confirmed cases, and growing exponentially, the Chinese government took unprecedented measures to try to halt and contain the virus. This resulted in massive “lock-downs” of Wuhan, and subsequently other multimillion-sized cities. This did eventually halt and reduce the number of infected people in China, as more people started to recover than new infected cases where identified. The rate of spread was also reduced within China, yet it continues to spread in the country. Noteworthy, the virus has spread to 64 countries when writing this, ~80th have been infected in China, and ~7th abroad and about ~3th deaths have been confirmed.
Emerging yet preliminary view of the virus:
Although we still know little, we are starting to understand the magnitude and key sets of characteristics of the virus. Unfortunately, the mix of characteristics that is emerging, makes it very dangerous, both from a human and economic point of view.
The current preliminary estimated death rate is at 2 percent (WHO, note preliminary figures).
This is much lower than Ebola (40%), SARS (10%) and MERS (20%), but ~20 times higher than an ordinary seasonal flu (~0,1%). To put this in perspective, roughly one percent of the population dies every year.
Unlike the flu, the Coronavirus not only has a higher death rate, but a much larger share of the infected people needs critical medical attention.
Preliminary figures suggest 20 percent of infected people need medical attention, and a majority of these (figures ranging from ~75%-90% depending on area) of these get “seriously or critically” ill with intense medical attention needed during about one to two weeks.
Third, the virus is very contagious and spreads exponentially without containment measures.
The contamination seems to happen at a rate that is about twice the transmission rate of a normal flu (on average, preliminary figures suggest that every infected person infects 2-3 persons, vs. the normal flu at around 1,4 per person, the numbers impact the speed of transmission exponentially). Also, people seem to be contagious without showing any or very mild symptoms. Lately there have been some sporadic reports of people contracting the virus more than once. In any case, it took only a few weeks to move from about seven thousand cases in China to ~50+ thousand cases (albeit granted the effort to identify cases also increased during that time). While the rate of spread has been halted in China, it is now growing exponentially outside of China, with identified cases moving from one thousand in February 18 to almost seven thousand ten days later. The key thing to observe here is not the nominal increase in cases per each unit of time, but the multiplication rate at which the increase of cases is happening. This is not a linear development. It is an exponential development. This exponential growth is what is most worrisome with the virus, as it means it could infect significant portion of the world’s population in a relatively short period of time, without successful containment.
Furthermore, the measures taken to reduce the speed at which it is spreading in China required draconian measures, measures we believe will be very hard to replicate outside of China.
China is a top-down governed country, where decisions can be made and executed in an instant. They managed to reduce the speed at which the infection is spreading, and indeed the number of “active cases” (currently infected people) is shrinking in China, but they have not managed to stop the spread of the virus. If things continue, the number of active cases globally will start to rise again, as new countries go through the same development as China but without the same means to reduce the speed at which the infection is spreading. In fact, the number of new cases is already higher outside of china than within china.
Also, while there are several different ongoing attempts to develop a vaccine, most estimates predict it will take 6-18 months to reach the population. At best.
The vaccine needs to not only be developed, it needs to be tested and it needs to be produced in large amounts and shipped all over the world. The latter could prove to take as much as a year. (The swine flu vaccine was able to reach the public quickly as it could leverage already existing production units that fabricated vaccines for ordinary flu, which resembles the swine flu virus).
Another option is the development of better treatment for the virus, reducing perhaps both death rate and the time needed to support patients under serious condition.
When considering these preliminary observations, we see a scenario where there is a severe shock to economic activity and labor-intensive global supply chains, as well as a sharp decline into global recession.
The virus could continue to spread during the next 6-18 months. Yet the states and governments will do its most to contain it.
Uncontrollable spread, without containment measures, will, as it looks now, using the preliminary information we got (judging by the exponential speed at which it has been growing in China before the draconian containment measures and the exponential speed at which it is growing outside China) result in a significant portion of the global population infected in less than a year. It is the large-scale spread of the virus that in turn results in a large number of casualties, not the deadliness of the virus per se. A quick back of the envelope calculation means that tens of millions of people could die if no containment measures are taken.
Given the virality, and human cost of the virus, many states and governments have no choice than to try and combat the uncontrollable spread though more or less “draconian” measures, in the hope to halt the spread, until a vaccine and/or better treatment is developed and accessible to the public. Also, as we have seen, the public is voluntarily avoiding public places, as evidenced by South Korea and Italy.
A potential scenario, therefore, is that the containment measures will be adopted by more and more cities and countries, at an exponential speed.
In a month, northern Italy, South Korea, Iran and Japan are having serious problems with the virus. France, Singapore and Hong Kong have numbers exhibited by Italy only a week ago. In total, 64 countries have now cases of Coronavirus. And it has only been two months since the outbreak
This could go on until a vaccine is available (6-18 months), or when the number of infected people is so high that the containment measures seem futile, and governments “give up”
Again, the rate at which the spread of the containment measures will spread will not necessarily be linear but could very well be exponential.
As a result of the exponential spread of containment measures, we believe we might be heading for a severe shock to economic activity, that could in turn potentially move economies towards recession
In a potentially exponentially growing number of cities, the public is told to, or voluntarily decide to, avoid public spaces. Workplaces are being shut down, impacting supply chain systems (as evidenced by the supply chain squeeze within tech as a result of the Chinese lockdowns). Adding to this is of course the resulting negative sentiment, and the resulting impact from this on economic activity. For example, Chinese Purchasing Manager Index has already plummeted to levels below the Great Financial Crisis. In short, as containment measures spread, the global economy might be heading towards a sharp recession.
How to act from an investment point of view
The Coronavirus has had and will potentially have further devastating effects on human lives. Considering how to invest with this as a backdrop is not an enjoyable thing. Yet this is what we are obliged to do at our firm.
We have been cautious in capital deployment, with 60% “dry powder” and a portfolio on the ground with little cyclical risk.
We have followed a very cautious investment strategy, investing only in non-cyclical stocks, and more importantly, investing very slowly, taking our time to build up a portfolio, knowing that a recession might be around the corner. Up until last week, we had 60% dry powder (cash), that has now increased as we liquidated our position at AMC Entertainment (more of that below). Today we only have three holdings, Senvion debt (backed by long term wind power service contracts). Telecom Italia, and Blue Bird (school bus manufacturer in the US).
Going forward, we divide the investment universe along two dimensions: businesses affected and not affected by containment measures and cyclical and less cyclical businesses
When we are now looking on how to act, we make the following conclusions:
The Coronavirus will pass, a vaccine will eventually be developed. As such, the impact from containment is a temporary thing. A potential recession might however be longer than one year, given the drawn-out nature of the containment measures.
We therefore group companies in a two by two matrix along cyclical vs. less cyclical businesses on the one hand, and containment-affected-companies and companies less affected by containment on the other hand (see below).
While we do not encourage investments without looking at the individual business, the exhibited matrix can help guide in differentiating between businesses and businesses, as we enter the coming quarters of what could be a very turbulent time.
Opportunities in defensive companies impacted by containment measures (but avoid high debt):
What is interesting is that companies that hitherto might have seem defensive, now suddenly are at risk with the impact from containment measures. This includes Cinemas, Restaurants, Alcoholic Beverages etc. Although these companies will be affected, we expect these companies to recover once the virus outbreak has passed.
Still, many of these companies, due to their defensive nature, have quite some debt on their balance sheets, AMC Entertainment being one of them. A short-term negative impact might have long-term consequences for equity investors, if the company under consideration has high debt. We therefore urge caution when investing in these companies if they have a lot of debt. We believe this problem might be quite big in some Private Equity portfolios for example.
We believe there might be opportunities in these sectors going forward, with opportunities to buy great companies at depressed valuations.
Safe haven/opportunities in defensive companies less impacted by containment measures
Along with overall market sell off, these companies might also be affected negatively in terms of price, but earnings should remain stable. In some sectors, earnings might in fact increase as more people stay at home (telecoms, online-gambling, streaming etc.). Our investment in Telecom Italia for example has barely moved, despite Italy being the epicenter of the Coronavirus in Europe. Here too we might see some opportunities at fair to cheap prices for great stable companies.
Opportunities in cyclical companies if discipline and timing is applied
Retail, department stores, airlines, travel & hospitality, and some select manufacturing and tech business who’s supply chain might get severely tampered by containment measures might experience a double impact from containment and ensuing cyclical downturn.
Other cyclical industries with less impact from containment measures might experience a similar yet delayed negative impact on earnings.
We have actively shied away from cyclical industries, as we typically only invest in cyclical businesses during a cyclical downturn.
Opportunities here might therefore arise, in market-leading strong businesses, yet we caution investments in the short term and in leveraged business.
Our investments and our portfolio so far
To recap, we have made seven investments, out of which three are still in the portfolio, and four exited.
Our three previous exits: TelePizza was bought out by KKR at a 30% premium (in a quarter), we made 70% on Xerox (in 18 months), and 105% on Perion (in a quarter).
We recently exited AMC Entertainment at 7,07 USD per share and will stay on the side-lines of this company until we know more about how the containment measures develop. We will await a vaccine or see clear signs that containment measures (voluntary and prescribed) are lifted. Although the Coronavirus will be a temporary event, the high leverage at AMC makes us rather err on the side of omission than commission. We knew going into this investment, that leverage was high, and that a black swan event could hurt our investment. Unfortunately, the black swan event happened just as the company started to deliver on our plans.
Our investment in Telecom Italia, despite being in Italy, has only moderately been affected by the outbreak. Many believe telecommunications will increase their revenues and profits going forward, as more people work from/stay at home.
Our investment in the debt of Senvion is insulated from the Coronavirus outbreak and cyclical development. We have recently liquidated assets suggesting we will make a nice return on this investment and are awaiting proceeds from the estate.
Blue Bird is not cyclical but might be impacted by supply chain shortages of parts and materials from China, which could halt production during the current and coming quarter. We are investigating currently how to act in this situation. The company has only a moderate amount of debt.
The outbreak is first and foremost a human catastrophe. We are following the development not only as investors but also as concerned citizens and as a stakeholder in our community. We nevertheless also have an obligation to develop a perspective on how this will impact our environment that we work within, the market for public companies. We have tried to do this with the information about the virus that is available so far, knowing that this can change over time. In doing this we are reminding ourselves that we are in the business of investing in “businesses”, not in “stocks”. We are therefore, first and foremost interested in how the businesses’ fundamental properties will develop, as we have no idea on how stocks will move. Yet by having a clearer perspective on how the fundamentals might be impacted, short and long term, we can better take advantage of how stocks are moving.