PERS VIEW – What hurts
PERSONAL VIEW – What hurts – 23/09/21
?STRICTLY MY PERSONAL VIEW ONLY – THIS IS NOT RESEARCH
As per usual when I drive back to London on Sunday, I listen to a great podcast – The Macro Hive with Bilal Hafeez – and this time it was with David Dredge of Convex Strategies on the confusion between measuring risk and managing risk. What convexity is and how it should drive your hedging position. Why 60/40 multi asset allocation doesn’t work from a risk perspective and the role of central banks in shifting equity-bond correlations.
An hour well worth listening to. What struck me most was David Dredge’s comments on how VAR doesn’t work (history is not a great predictor of a volatile future event). And especially how risk should be defined, or as David put it “a view is what you think will happen, risk is what hurts when you are wrong”.
He does not take a view on the market, but he did highlight that from a risk perspective fragility matters greatly. And I found a note by him from December 2020 by the European Risk Management Council called Risk Landscape Review 4Q20. In it he explains why it’s the fragility of the financial system that matters most. Do read pages 7-10, below some excerpts.
Random unpredictable lightning strikes do not cause uncontrollable forest fires unless they strike an already fragile forest system. Without an accumulation of dry underbrush and trees, it is pretty hard to get a significantly damaging forest fire. This comes back to the known scientific premise about the relevance of endogenous risk – where fragility exists, versus exogenous events – the shocks that expose the fragility. If you want to avoid the risk of property damage due to forest fires, don’t own property in the midst of forests that are clogged with dry underbrush and trees. If you can’t avoid that, best to buy insurance early, before everybody else realizes the same, and have a well thought out escape plan!
?Maybe the simplest way to define the fragility of the economy is the lack of loss absorbing capital in the food-chain of leverage. What in our world of derivatives we refer to as ‘uncapitalized tails’. We all got to see this very clearly back in 2008 when the decline in the collateral value of US homes triggered losses that could not be absorbed by the global banking elites, forcing an explicit taxpayer bailout and the implicit stealth tax of inflation being imposed on present and future non-asset holders. Naturally, policy makers and regulators don’t see the crisis as being the fragility of the system that they promulgate, but rather explain it off as yet another unpredictable exogenous shock.
?It is not a liquidity problem, but rather an insolvency problem due to the high levels of leverage/lack of loss absorbing capital.
The use of leverage by fiduciary risk takers, fuelled by their ability to misrepresent risk through standardized measures such as VaR and significantly encouraged by the moral hazard expanding practices of policy makers, has built fragility of unprecedented scale. Once again requiring unprecedented policy support ride to the rescue when the spark of the pandemic found the accumulated dry underbrush.
Some weeks ago I wrote about the “Stag Hunt” and the three-party prisoners dilemma, something I was pointed to by a former colleague (ER). The Fed, the Stock Market but also the Housing market. I think everyone now agrees on this path to tapering, and it’s just the speed of it where people differ on. And that in turns depends on your view on inflation. I thought that Robert Armstrong “Unhedged” article in the FT about inflation, Summers and Roubini was very insightful. Martin Wolf gave his views why tapering needed to end too.
I’ve already wrote extensively how “ESG” is in the end inflationary (ETS, FF55). And at the same time this “Green Rush” is causing a stampede of Big Oil and Big Utilities crushing IRRs. I have long preferred the “Picks & Shovels” to avoid being crushed.
I also earlier wrote about how for the first time in two decades on the back of de-globalisation and reshoring, companies are no longer price takers in a global, open economy. Regional price differences are now emerging and so is pricing power.
And then today when we wrote our initiation on Vitesco who is planning a rapid portfolio reshuffle to become a sustainable electrification play, the analysts highlighted his fear that increased competition, higher OEM insourcing, and a faster-than-expected electrification path could result in higher pricing pressure and R&D expenses – lowering Vitesco’s content and profit streams, and weighing on FCF conversion for longer than expected.
Higher OEM insourcing – one example - it seems that they have decided that battery technology will be a differentiating factor going forward, and will need to be developed in house… (IRR crush / Green Stampede).
When I started out as a trainee banker (in the 1990s) a lesson I’ve never forgot was that it is in the rebound of a recession most bankruptcies occur. Suddenly companies realise that they don’t have enough cash-flow to finance working capital.
I believe that as economies come out of lockdown the pull on working capital is likely going to get worse before it gets better, especially in producing industries or highly seasonal sectors, where there will be a lag between the cash outflows from sourcing materials and producing inventories ready to sell, and the cash collected from sales. Ensuring operational working capital processes and accurate cash flow forecasting will be key for the next six to twelve months.
HBR noted: SMEs that have been weakened by years of extended payment terms now have to deal with the challenges of the coronavirus pandemic. In addition to the precipitous falloff in demand and mandated shutdowns caused by the pandemic, outstanding invoices are not being paid. Their situation is precarious.
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As we move from a deflationary to an inflationary environment this matters more. If this insourcing is happening, if inflation is happening, tapering is happening, surely rates will go up, and it will become more difficult to finance working capital. If the green stampede is lowering IRRs this matters. If supply chain issues cause delays that will need to be financed, this matters.
So, looking at especially the SMID universe, do we see any reaction/discussion on working capital financing? How fragile is the system and are some larger players overextended?
In 2007, the era of “covenant light and covenant loose” I recommended a friend (JGW) who was a board member of a large bank, to start reducing their “undrawn committed lines…” He, and his company, were very grateful 18 months later…
I believe this is a great time to start including these kinds of questions and analysis in your debate with the companies you own and cover. With rising rates, and rising inflation and supply chain issues abound – who can deal with a shock to cash-flows and still finance their working capital?
In the words of David Dredge “a view is what you think will happen, risk is what hurts when you are wrong”. Time to really stress test your portfolio for hurt. Forget about VAR, put some wild assumptions in your model, and see where the pain occurs.
An example just as I write this note: Hella issuing a FY2021/22 profit warning due to semi-conductor shortage. Alten (ATE FP) conference call just ended: “salary inflation is starting, a 2% increase has been decided for 2021, challenge will be to pass the increase to the customer.”
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Some key questions for all you active stewards
So is this a call to arms and sell it all. Well interestingly it is not. Again, quoting Dredge, that you better helped keeping your solid longs whilst actively managing your risks – the convexity bit… As a risk manager he is surprised that not as much time and effort is spend at managing the downside, as there is on managing the upside. If you were protected in 2008 and in 2020, then nothing else really mattered. So, if you can, you might want to look at some puts. You certainly want to look at your risks and do a proper stress test.
Pricing power, cash flows, working capital management, leverage, covenants it all starts to matter once more. What companies are irreplaceable, what companies have a “moat”. They could be growth; they could be value. This is about a sustainable business model that will survive a real shock.
What will hurt you when you are wrong?
Pancras