Crisis Is a Test; Some Companies Will Do Well On It – March 28, 2020

Crisis Is a Test; Some Companies Will Do Well On It – March 28, 2020
Morgan Lewis Posted on March 28, 2020

Here’s the news of the week – and how we see it here at McAlvany Wealth Management:

Crisis Is a Test; Some Companies Will Do Well On It

Today we’ll take a brief break from the constant 24/7 coronavirus conversation and the ensuing damage in the capital markets. We’ll instead discuss how we think about more company-specific developments and fundamentals in this environment. One thing we can say is that fundamentals tend to not be a tremendous differentiator when it comes to stock price performance in a financial crisis. Eventually, however, fundamentals will matter again. This is a great time to preserve capital while monitoring company specific developments because in this environment it’s easy to separate the wheat from the chaff.

We think it’s important to stand back and observe how companies handle a crisis, and how leadership is demonstrated in what is basically an entirely different business environment than it was 30 days ago. Early communication with investors in a crisis is a tremendous differentiator, as it speaks to the culture and priorities of the company. That’s ultimately where the future value of an enterprise flows, though you can’t quantify it in an earnings or cash flow model. You also get a picture of how adaptive a company can be. It is here that we learn about the resilience of the business model, as well as of those charged to lead the company. We can also see how they might utilize creative solutions to the extent possible to pivot their business operations to new realities.

One of the key concerns for leadership of any company is human capital – how to protect their workforce and manage through a crisis. Most executives have not experienced a business environment such as the one we are facing today, and there is no blueprint or playbook. We saw early leadership from companies who chose to stall operations in an abundance of caution for their people rather than later being mandated to do so – this value that their people were put first was clearly communicated by deed, and not just word.

Side by side with the conversation about people and human capital is capital allocation and liquidity, which tend to be most important to investors. We would contend that people and culture ultimately drive value. Warren Buffett famously said that, “only when the tide goes out do you discover who’s been swimming naked.” Again, we note who took quick, decisive, and ethical actions. Leadership was shown by those who cut capital spending budgets very quickly and focused on preservation of the long-term business model. We commend those who took pay cuts as they asked their workforces for huge sacrifice.

Dividends are unquestionably part of the capital allocation thought process. By and large, companies who issue dividends have the philosophy that this return of capital is sacrosanct, but we must recognize that not all dividends are created equal. In the decade-plus we have experienced of very cheap capital, it was easy for a company to pay a dividend while maintaining significant balance sheet leverage because it always had access to the capital markets if needed. Ultimately, when the business cycle ends, this proves an unsustainable strategy. We expect to see many of these dividends reduced or eliminated completely. Other companies may look at the liquidity options available to them, which are limited at this time, and, despite having solid balance sheets, choose to preserve as much liquidity as possible given the uncertain nature of the business environment and the timing around “getting back to normal” – whatever that new normal may be – and reduce their dividend in an abundance of caution for liquidity management purposes. We note that there are likely tremendous opportunities for companies that will develop on the other side of this crisis. It is perhaps Darwinian, but “survival of the fittest” will certainly come into play, and those who entered the crisis in a position of financial strength are best positioned to avail themselves of opportunities to grow and consolidate their businesses. This is the lens through which we approach our company-specific thought process today.

Best Regards,

David McAlvany
Chief Executive Officer

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