Here’s the news of the week – and how we see it here at McAlvany Wealth Management:
An Earnings Season Like No Other
It is that time again. We are just entering corporate earnings season, and, of course, we know it will be the worst in our collective lifetimes as the world economy has ground to a screeching halt. We will get a first look at exactly how badly companies have been impacted and a glimpse of how they envision moving forward after the COVID-19 crisis passes, as well as what the new normal may look like.
This is going to be the first detailed look at how company-specific fundamentals have been affected by the crisis. It is an interesting exercise to consider the following analysis. On a trailing 12-month basis, the operating margin for the S&P 500 was 13.4 percent – for every dollar in revenue, you earn 13.4 cents in profit. The rest, 86.6 cents, is cost. Every company and industry is different due to size, scale, and the necessary inputs to running the business. However, let’s say that, hypothetically, 50 percent of those costs are fixed. They do not change relative to production. If revenues are cut in half, profits are wiped out. For many companies, fixed costs are a much higher percentage of total costs, and can quickly drain balance sheet liquidity as profits become losses very quickly. Very few business models are set up for this kind of demand destruction, particularly in a world where, prior to the COVID-19 crisis, cheap capital was abundant and liquidity was readily accessible if needed.
Therefore, one of the most important things to listen for on our quarterly calls, in our view, will be commentary around liquidity management and preservation, as well as capital allocation beyond the immediate measures they may have already taken. Some companies have the ability to slow discretionary capital spending to ensure that they can exit the crisis much healthier than they started, and possibly be able to capitalize on opportunities that present themselves during this time of crisis. Others have no such luxury, and will struggle to find their way forward as they are faced with very limited alternatives and difficult choices in terms of personnel, closing particular lines of business, and asset sales to survive as a going concern. Whether proactive to preserve the balance sheet, or reactive for survival, it is likely that we will see continued dividend cuts as well as the suspension of share buyback programs in order to have options coming out of the crisis. This is going to be a very key test of corporate resilience, and, for us, where the real thinking about “margin of safety” comes into play.
To us, one of the biggest challenges facing the C-suite is how to give guidance and set internal goals with absolutely zero visibility. There will unquestionably be significant changes to behavior and consumption patterns, and industries for which demand will remain impaired long after this crisis is behind us. Many companies have either revised guidance significantly lower or withdrawn it altogether in the absence of any clarity. Companies may delay reporting for as long as they are able in the hopes that they might be better able to project what the future has in store. Asset write-downs and impairments will unquestionably be abundant, and there is likely more pain coming in the second quarter given that much of the impact on demand occurred after March 31, 2020. We will also get a look at “softer” cultural issues at a company, and we see this period as a litmus test of corporate priorities and values. Most CEOs have never been through a crisis such as the one we are facing today, and their ability to adapt and be nimble may very well be a key determinant of survival. We look for companies whose leadership aligns their interests with that of their employees, stakeholders, and communities.
Ultimately, we think that the most resilient companies will be those that have the ability to hunker down and preserve capital, but also retain their key people during this disruption so they can not just come out of it with ten fingers and toes, but be more competitive going forward. Capital discipline, sometimes criticized as having a “lazy balance sheet” (too much cash, not enough leverage) is now showing its relative strength, and we applaud the companies that have played the long game both financially and culturally.
Best Regards,
David McAlvany
Chief Executive Officer
MWM LLC
