COVID has certainly open a new chapter in investment strategy

Wall Street versus the rest of the world

Investors rather than simply looking at the world on a Manichean way, the technology and the rest, Wall Street versus the rest of the world, they should consider and analyze the lessons from the current health crisis. We have maybe entered a new era, a new chapter of the financial history. With low interest rates (even negative in many currencies) for a long period of time, with long term rates also very flat and potentially negative, there is less alternative investments: commodities and gold are volatile and risky, private equity attractive but limited to a certain class of investors and real estate could be under pressure after COVID with big shift in behaviors. It explains why equity investors cheer low rates. The stock market bulls might retort that recent equity price records (at least for some companies) reflect a secular shift. The pandemic has amplified the power of digital platforms, GAFA and tech companies in general. Therefore, it is obvious that low rates have fueled part of the rebound of the year. We are also in a new paradigm and have new references in terms of multiples, P/E’s and ratios, which today appears too high. However, a ratio is a benchmark and relative to a situation. If we compare today’s levels to former levels, it looks like exaggerated. If we accept the fact that we entered a new era, the ratios moved up driving to new (higher) references. We should stop comparing the levels pre and post COVID, and mainly pre and post-negative rates. The Private Equities are injecting debt into targets, while demand for corporate debt is soaring. The PE’s will have an important role to play in the post-crisis recovery. These high stock-exchange levels are scarring some investors who start considering possible bubbles. All signs are there. However, I do not think we will get them burst. Markets will continue to grow gradually. Who could nevertheless contest the levels reached: e.g. 10 times the revenue for valuations of roughly 6,5% of companies of S&P500 or the recent IPO of SNOWFLAKE valued the first day of its launching at 140 times its annualized revenue? We could add PALANTIR and TAM. The American are so good in finding these new golden nuggets, which will bring the house (i.e. NYSE) down. We also saw some share splits (e.g. TESLA & APPLE) which were extremely positive for both shares. They have climbed significantly after the announcement. In theory a share split should have no impact on the attractiveness and the valuation of an equity. Nevertheless, the psychological effects are less predictable. They keep price low, make it easier for retail investors to buy a small number of shares and have positive impacts on the stock-trading commissions in reducing costs for small investors. They want to appeal to millennial consumers and might benefit from attracting them as new investors. There are many studies and the impacts are tough to assess. But the facts are there, and splits in general are positive, if accompanied by other good news. Of course the health crisis has nothing to do with splits but we can imagine that any single idea will be used to boost or sustain share valuations in a difficult context.

COVID sparks dividend drought

The health crisis at least for a while (maybe a year) will sparks the dividends drought. Some dividends are cut down for economic and treasury reasons. Some others are not paid because they could not pay them but because of political correctness in the current climate. That is troubling and has real consequences. Companies have over the past three decades become increasingly “share-holder friendly”, returning more and more of their earnings to investors in the form of dividends and stock buybacks. Many have even loaded up on debt to do so, leading to a secular erosion of their creditworthiness. That is now coming home to roost, with many MNC’s forced to abruptly curtail payouts to conserve cash and strengthen their balance sheets. Dividends pay-outs up to a certain limit were achieved but could now be stopped. Furthermore, we support the dividend pay-out strategy to satisfy investors. However, dividends are part of capital allocation but that should not be at the expense of starving a company of investment. Some analysts believe this could end the era of share-holder friendliness. Governments estimate the price for their support in the form of higher taxes and encouragement for higher salaries. Not paying dividends has a cost for pension funds, which count on steady streams to pay pension and retirement obligations. Investors can also fear the debt bubble building, to an alarming level. The debt versus equity question is back. The best rating and WACC are not those students at universities think the best or “most suitable”. A BBB rating is acceptable and limit the debt to an acceptable level. The capital injections can be solutions to avoid becoming sub-investment grades. But economists argue that the greater use of debt encouraged companies to be leaner and meaner. In the saying, “equity would be soft, debt hard. Equity is forgiving, debt insistent. Equity would be a pillow, debt a sword”. I do not know whether this statement is true. What we need is to determine the level of capital to debt, without, in my opinion, searching for maximizing the WACC. Corporate finance is not a pure theory but a matter of fair and reasonable equilibrium. But these days, what is fair and well-balanced, tell me! The equity asset class should remain the best in terms of return (providing we have a minimum time horizon ahead). And even short-term corporate investors are considering funds including equities to boost all-in return, despite onboarding of a minimum volatility. To extract yield these days, there are no magic recipes. Nevertheless, we know that our past referential has changed and some former ratios should be reviewed, and reference levels reassessed to better match to current situation, which should persist.

Bubble gum

The definition of a bubble would be a cut-off world isolated from diverse interaction or plurality of views. If the stock market is in a bubble, it is because traders live in one. Recent equity price falls are raising market, propped up by a herd of bulls detached from economic reality, has been in a bubble. The price bubble is the same decision made by a herd. As said by a study published in 2014 by National Academy of Sciences: “bubbles are affected by homogeneity in the market and can be thwarted by diversity”. Financial markets are supposed to be always right or self-correct. We heard from professors at University that to generate uncorrelated returns, the so-called “alpha”, it requires differentiating yourself from this herd of investors, what Rabelais called the “Panurge’s lambs”. When you are in a bubble and invested in high-valued shares, it is difficult to recognize irrational exuberance and to be able to exit in time. The current equity bubble will certainly soon bring interesting material for feeding behavioral finance theories.

Fran?ois Masquelier - SimplyTREASURY