Company fundamentals far more important now than macro analysis.
Around midday last Thursday, the U.S. stock market successfully retested, for the second time, its March 23 lows. We said then and we’ll say again now, those will prove to be the lows of this short-term bear market and are very unlikely (i.e., less than 10% chance) to be broken. The bears believe the retest remains ahead of us, particularly because on March 23 the S&P 500 touched 2,191 intraday and on May 14, its intraday low was a far-higher 2,852. (The previous retest of March 23, on April 1 when the index declined to 2,498 on the back of the Congress’ initial failure to pass the CARES Act, was judged “too quick” by the bears.) The flaw in the bear case, we believe, is the failure to appreciate fully the winners and losers game that is currently playing out in the market, stock by stock. For this level of analysis, it is helpful to group stocks into three broad categories: winners, losers and survivors.
The winners are grabbing market share during the lockdown, growing revenues and earnings, and are setting up for more gains as the economy emerges from the crisis. Even these winners dropped precipitously in early March, when it was unclear if the Fed and Congress would step in to stop the economic meltdown that was underway. But once both did so, these companies’ strong market positions led to stellar fundamental and financial results, with their stocks reacting positively. Call me confused, but I honestly can’t understand why the bears believe great companies that are winning the game need to have their stock prices back to Armageddon levels when Armageddon clearly is not going to happen for us or them.
The losers, on the other hand, are companies that entered the Corona lockdown already competitively weakened and have seen their downfalls accelerate. The stocks of these losers in many cases have continued to languish at the Armageddon levels of March and, in many cases, have traded lower still as the bad news keeps getting worse. There are a lot of these companies, particularly in small-cap land, so their ongoing demise makes statistics about market breadth particularly gruesome. This makes good fodder for the bears, who love to complain (they’ve been doing so for years) about “market breadth.” But fortunately for the averages, the amount of market cap in the losers was relatively low even before the lockdown. So from a market average perspective, the losers effectively have become irrelevant. Good stories, for sure, to tell the bear cubs around the campfire, but irrelevant otherwise.
The third set of stocks are perhaps more interesting. Many have solid businesses and are reasonably competitive, with big, somewhat leveraged balance sheets. Most will make it through the current crisis, as long as the economy does not melt down. Some, the cyclicals, require more, i.e., a solid economic rebound. Collectively, these survivors are the stocks to watch, in our view, if you are trying to gauge investors’ perception of the economic future. While the bears complain the “market level is detached from what is happening to the economy,” the problem is they are looking at the wrong market. If they looked at the performance of the survivors, they’d see more clearly that the stock market is doing a fair job of pricing in economic risk. For example, as the jobless claims data and other bleak economic news rolled in last week, along with Chair Powell’s comments that things looked bleak, most of these stocks did react negatively and in fact retested their Armageddon lows.
Let me illustrate this point with three well-known stocks that broadly represent each of these three categories.There are many more I could have chosen within each category, but I’m using names most readers know pretty well.
First, representing the “winners” group, I give you the most obvious winner of all, Amazon. Amazon is an online retailer that has been winning the retail wars against more traditional brick-and-mortar competitors for years as consumer buying habits gradually shifted to internet shopping across more and more categories. Its pristine balance sheet sports $49 billion in cash and a mere $78 billion in debt against an enterprise value of $1.3 trillion. In the three years ending December 2019, it grew its gigantic revenue base an additional 27% per year, reaching $280 billion in sales. Cash flow expanded quicker yet, from $12 billion to $39 billion, and free cash flow, net of capital expenditures, exploded higher. This was BEFORE the Corona crisis hit. With the crisis accelerating the trend toward online shopping, it expanded its revenue base in this year’s first quarter by 26% year-over-year—the same annualized pace it had been doing over the last three years when there was no economic gloom. The current consensus among analysts is that in 2021, Amazon will generate $40 billion in free cash flow, DOUBLE its 2019 level. Priced at roughly 20 times cash flow, Amazon’s stock is not cheap and I’m not necessarily making the case to buy it. But I can understand why investors own it for the long haul, even at these levels. And for Amazon to fall 30% to its “Armageddon sale” price of $1,676 of early March (in its case, March 12 and 16, to be precise), just to satisfy the bears that “the market is pricing in economic reality,” seems extremely unlikely. Given its demonstrated resiliency to the Corona scare, far too many longer-term investors would be stepping in to scoop it up at far higher levels if it were to start falling.
Second, representing the loser’s team, I present J.C. Penney. I don’t want to bash this venerable retailer. It is a fine company employing 90,000 hard-working Americans that has served all of us for many years. And most people know the story, which has been difficult to say the least. But suffice to say, J.C. Penney’s stock, which has been declining since 2007, made a new low on March 23 and has been declining almost daily since, as bankruptcy proceedings begin. Sad, but this is a story that was well underway prior to the Corona crisis. The crisis simply accelerated the endgame.
Third, from the survivor camp, we present AT&T. There are many names in this camp, so I’ve picked a less controversial, non-cyclical one that is owned in some of our value-oriented portfolios and is widely known. AT&T is one of the largest companies in America, with revenues about $180 billion and operating cash flow of $46 billion, higher than Amazon’s $39 billion. But its growth rate has been anemic at best, as its legacy wireline business gradually declines against its growing wireless offering. And its 2019 acquisition of Time Warner, while possibly improving its forward growth prospects, added considerably to its debt load, now $189 billion. Though considerable, its enormous and stable cash flow covers the interest on this debt by almost 5 times, and even after ongoing capital expenditures, its dividend seems pretty safely covered, at 2 times the dividend. This is not a growth company for sure, but as long as the economy is alive and not melting down, its customers are going to keep paying their phone bills and watching its media content. And investors should be able to keep clipping its substantial dividends that should at least grow with nominal GDP going forward. But last Thursday, AT&T, just like most of the stocks we classify in the survivor camp, completed its second retest of the March 23 lows, hitting $27.61, just above its previous levels in the dark days of March and early April. News flash: that was a retest. And that was in line, we’d argue, with the bear view that the U.S. economy is ruined and will not recover any time soon.
Since last week’s March 23 aftershock, investors have begun again to get their bearings and realize that the world is not ending. The Fed’s Jay Powell, on cue, came out over the weekend qualifying his comments that caused such a stir, noting that his base case is not bearish but emphasizing that the Fed stands ready to act if the economic recovery takes longer than expected. Live analysts took a second look at Thursday’s jobless claims number and noticed something the algorithms had missed: even while the unemployment applications exceeded already gloomy expectations, the ongoing level of unemployed workers, though high, was actually far lower than expected, implying that many gig workers already shifted to other gigs (an aspect of flexibility within the “gig economy” that we’ve been pointing out, by the way.) And then, over the weekend, more good news poured in. Across the country, lockdown or no, Americans were coming out of their homes. As a nation, we’ve voted: it’s time to begin the slow, and hopefully careful, process of getting back to work; early indications from the states starting the reopening wave actually have been pretty good. And finally, to complete the good news cycle, more health-care treatment news, specifically on biotech company Moderna’s vaccine trials, came in positive on Monday. Increasingly, our “U shaped recovery” scenario looks more and more reasonable. Not a “V,” to be sure, but a choppy restart as we collectively get used to operating in a Corona world, as health solutions develop, and as the drags from the accelerated declines of the losers are at first not fully offset by the quickened expansion of the winners.
As noted in previous market memos, at Federated Hermes, we are remaining constructive on equities and more importantly, on stock picking. It’s a winners and losers game. Up until now, frankly, it’s been enough to own the winners and not own the losers, and that has been our focus. The real action ahead, at least at the margin, will come among the survivors. That’s where the value is in this market, but discerning the best among them is difficult. I know. No tears. It’s our job.
So while the bears are pulling their hair out watching the movements of the S&P, we’ll keep doing what we’re good at doing. Picking stocks.