Pandemic Trading Action Reinforces Importance of Simplifying One's Investing Approach

With the stock market rallying in recent weeks over optimism for a relatively smooth nationwide reopening of the economy, and daily trading becoming a little more calm (day traders speculating in bankrupt equities notwithstanding), I am able to take a breath now that earnings season is mostly over and reflect on the past few months. Of course, a second wave of virus could quickly bring back volatility and fear, but let’s stay positive.

The tables have turned pretty quickly and I am now actually finding opportunities to lighten up on securities that I was buying during the height of the recent market meltdown. As was the case when I was bargain hunting with fresh client cash in March, I am trying to keep things simple.

Take a stock like Starbucks (SBUX). Great business. Blue chip stock that typically fetches a premium (and deservedly so). Today it trades 8% below its February 19th (market peak) level. Seems about right to me, as their business is likely not permanently impaired at all by the pandemic, but sales volumes and margins will take time to rebound to pre-covid levels. At its worst point SBUX was 45% below its $90 pre-covid print, which was most certainly irrational given that about half of their locations remained open during the stay-at-home orders. Buying SBUX in the 50’s was obvious and came with minimal risk. Paring it back in the 80’s seems obvious too.

It can be easy to get stuck in the weeds during massive market drops, but when most securities are on sale, it is best to stick with the simplest stories. Take a company like Bright Horizons (BFAM), a leading daycare provider. Sure it is financially stressing for the company when the bulk of its centers are closed, but the bearish thesis for BFAM over anything but the short term seemed odd at best and downright silly at worst; post-pandemic everybody is going to work from home, care for their children in the next room, and maintain the same level of productivity and/or sanity? I don’t think so. And yet BFAM shares sank from $175 on February 19th to the mid 60’s in March. Down by two-thirds for a leading daycare company with a strong balance sheet? These are easy and simple bets to make if we look out 6 months or a year.

One last example is Vereit (VER) a commercial landlord for single tenant buildings. While tenants like drugstores and dollar stores kept paying, VER still only received 75-80% of contractual rent payments for April and May. Should the stock have fallen on that? Of course. But how much should a REIT fall if they are collecting the bulk of rent and are still fully covering operating expenses and debt service? In this case, investors felt that 65% was the right number, as the stock fell from $10.00 to $3.50 per share at its low point. In fact, the entire real estate universe fell by 50-80% regardless of actual rent collections.

In each of these examples, the simplicity of the story should have given investors a sense of confidence when allocating capital into falling markets. The leading global coffee retailer is a survivor. Parents will keep sending their kids to daycare post-pandemic. A landlord collecting 75% of rent should not see its stock trade down by 65%.

Now, this is all easy to say and harder to do. Did I also find myself delving into more complex and riskier bets, rather than putting all of my capital into BFAM, SBUX, and VER? Yes. Consider taking the plunge into an airline, cruise operator, or hotel company and ask if the undervalued nature of the stock was as easy to see (and pinpoint to an exact figure). It is rare to be able to maintain such focus and discipline and only target the most obvious buys in a sea of bargains. But as value investors when we look back and grade ourselves a year after a bear market, it is usually the case that the simplest stories brought with them the best risk-adjusted returns.

Full Disclosure: Long BFAM, SBUX, and VER (as well as CCL, LUV, and PEB) at the time of writing, but positions may change at any time

Yes, Amazon Should Buy AMCX, not AMC.

If you were baffled by the rumors in recent days that Amazon (AMZN) had held talks about acquiring movie theater giant AMC Entertainment (AMC), you were not alone.

Putting the general strategic rationale for Amazon owning theaters aside, AMC is in serious financial trouble. Loaded with more than $5 billion of debt, the company’s meager free cash flow generation put it on thin ice even before the global pandemic. AMC booked $162 million of free cash flow cumulatively in the decade ended December 31, 2019. The company’s interest expense in 2019 alone was $293 million and they recently added $500 million of high cost debt (10.5% per year) just to stay solvent through the rest of the year.

The idea that Amazon would be dumb enough to make a buyout offer (which would need to top the debt load in dollar terms simply for the equity holders to get anything) during this pandemic is questionable reporting, at best. Given that movie production is shut down, there will be a big delay in new releases even after theaters reopen and consumers get comfortable visiting them. It sure seems like the pandemic is only going to accelerate AMC’s path to bankruptcy, and as a result, Amazon should just wait it out and try to buy the assets during the court proceedings.

Late Tuesday there was a spike in shares of AMC Networks (AMCX), on unconfirmed reports that the content production and distribution company was running a sale process, and that Amazon was actually kicking the tires on that company, not the similarly named theater chain. That rumor makes sense and it was actually nearly 2 years ago that I suggested the combination in an article for Seeking Alpha (Amazon.com Should Buy AMC Networks To Beef Up Content Business). Full Disclosure: I own shares of AMCX personally and for clients, and recently added to the position around $25 per share.

While publicly traded, AMC Networks is controlled by the Dolan family, who have shown a willingness to sell when it makes sense and the price is right. That latter point may be a tricky issue. AMCX brought in free cash flow of $6.60 per share in 2019 but the shares trade in the 20’s, which highlights the reason going private or selling the business makes sense.

As long as AMCX gets a lot of revenue from cable television advertising and distribution fees, Wall Street is likely to continue painting it with the “cord-cutting” brush and mark the stock at a discount to intrinsic value. That discount has only gotten deeper lately, but the Dolans are not dumb; the company bought back $86 million worth of stock during Q1 despite the pandemic and continued buying into April. There aren’t many companies executing buyback programs right now but AMCX’s financial condition is rock solid.

AMCX generates a ton of cash and despite lower ad revenue this year, projected on their Q1 call that free cash flow in 2020 is expected to be above 2019 levels of $377 million. Paused production is helping offset lost revenue and say what you will about the cable business, but per-subscriber fees keep rolling in.

Wall Street is also not paying attention to AMCX’s move into streaming, likely due to the fact that it is a drop in the bucket compared to Netflix or Disney+. Still, AMCX just pushed up the timetable for its goal of 3.5-4.0 million streaming subscribers (across multiple platforms: Acorn, Shudder, Sundance, UMC). Due mostly to the pandemic, the company expects to hit that level by year-end 2020, versus prior expectations of year-end 2022.

If we value those subs similarly to Netflix’s current valuation (AMCX will make a profit on them , whereas Netflix is still losing money), and adjust for the delta in monthly cost (AMCX’s plans run $5-$6 per month), AMCX’s streaming business alone would be worth $1.2-$2.0 billion by the end of the year. Not bad for a company with a current equity market value of $1.5 billion.

The Amazon rumor continues to make perfect strategic sense. They clearly want to beef up their Prime Video offering to compete with Netflix and Disney+ and adding shows like The Walking Dead and Better Call Saul would only help that. Toss in a few million streaming subs, whose plans are already sold on the Prime Video platform, and AMCX instantly bulks up Amazon’s content library and media executive team. Heck, having AMCX CEO Josh Sapan take over the entire Prime Video operation would be a wise move too.

All in all, I am glad there is some speculation that Amazon is kicking the tires on AMCX. I hope that it is not getting more press than it deserves simply because the AMC (no X) rumor didn’t make sense given their precarious balance sheet. If Amazon is willing to pay a fair price, I think the Dolans would sell. As a shareholder in AMCX, it is frustrating to see the public markets mark the stock at such a big discount to any reasonable estimate of intrinsic value.

So what is a reasonable price? It’s a great question, obviously. And a fascinating one given that Amazon likely doesn't want to pay a big premium, even if it is justified on paper. They played hardball negotiating with Whole Foods Market years ago.

This type of deal reminds me of Discovery’s purchase of Scripps a couple years back. Scripps was also heavy into cable, with its ownership of networks like HGTV and Food Network. Still, they were able to get their shareholders a big premium and a decent price of 12x free cash flow and 10x EV/EBITDA. Not sky high prices, but levels that shareholders could live with since the public market was not going to give it to them anymore.

I certainly think that AMCX is worth a similar price on paper, which would come out to at least $80 per share. They won’t get that. Cord cutting has gotten worse in the last 2 years, we have a pandemic right now, and digital video platforms are only getting more competitive. Still, if I were the Dolans I would probably not sell for less than 10x free cash flow or 7.5x EV/EBITDA; which equates to $60-$65 per share.

As you can see, the recent price in the 20’s is kind of silly, but investors are simply uninterested in owning this stock regardless of the profit the business churns out year after year and the streaming products they are building. Hopefully Mr. Bezos will take us out of our misery. If not, we will just wait for the cash flow to come through and fund stock buybacks at insanely cheap prices (having peaked at 74 million in 2014, the share count is now down to 54 million).

Virtual Annual Meetings and Premature Bankruptcies

A list containing the number of ways this recession is unique is quite long, which is making navigating these waters as an investor much more difficult. While unrelated, below is a brief mention of two that are on my mind.

1) Virtual annual meetings

With in-person annual shareholder meetings cancelled, every investor can now attend meetings online without booking a flight and a hotel. Not all meetings are created equal. Some have long Q&A sessions for shareholders and in-depth slide decks, while others stick to business and offer little in the way of helpful data points for investors. So while it may be a hit and miss activity, for those companies you follow closely and are contemplating adding or shedding shares, look to take advantage of virtual meetings this year.

2) Premature bankruptcies

Navigating the corporate bond and preferred stock markets these days is really tough, as liquidity and solvency are tougher to drill down. Making it even harder is the fact that many companies appear ready to file Chapter 11 before they need to. They probably figure that the pandemic offers a great excuse and management can keep their jobs after the businesses emerge. Why not take the opportunity to clean up the balance sheet and be stronger coming out of this?

Consider Diamond Offshore, an offshore oil driller than just filed. The company disclosed assets of $5.8 billion of assets, $2.6 billion of debt, and cash onhand of $435 million, according to Bloomberg. In addition, DO announced that they do not need any debtor in possession financing and will use existing cash to operate while proceeding through court. I cannot recall a time when a company has filed with so much cash onhand and didn’t need a loan to continue operating. And they are not alone, JC Penney is reported prepping for bankruptcy despite having $1 billion of existing liquidity.

These are truly unique times. Good luck out there everyone.

Full Disclosure: Long puts of DO and JCP at the time of writing, but positions may change at any time

Loose Merger Agreements Are Causing Corporate Clashes Among Partners

It is being reported that Sycamore Partners is trying to get out of their $525 million deal to acquire a controlling stake in Victoria’s Secret, claiming that the chain violated the agreement when they closed their stores due to the pandemic. I have not read that particular agreement, but I was curious whether there was a MAC (material adverse change) clause in Simon Property Group’s deal to buy Taubman Properties and extend their lead as the dominant shopping center REIT in the country.

The language in their merger agreement is likely similar to most that were drafted during a bull market (light on conditions that would allow the buyer to walk away). In fact, I was pretty surprised to see what events were listed specifically that would under no circumstance warrant exiting the deal. Form page 82 of the agreement:

That’s right. Why should a pandemic impact the closing of a merger between shopping mall giants? :)

I wonder if lawyers will leave pandemics on that list in future merger agreements or if Covid-19 really will come and go without leaving a trace longer term in the corporate world. Hopefully buyers will get smarter and protect themselves against long tail events.

Interestingly, TCO stock is currently trading around $41 per share (22% below the deal price of $52.50 in cash). As a Simon shareholder, I hope they are able to negotiate the price down but still use their vast liquidity to scoop up Taubman’s trophy assets. With the deal supposed to close around mid-year, we should find out soon enough.

No Wonder $350B of Small Business Aid Dried Up So Fast: Public Companies Are Getting Huge Loans

Initially it seemed like a great step forward when Congress approved $350B of small business aid through the paycheck protection program (PPP). Use the funds for employee wages, rent, utilities, etc and the loan is forgiven. For small businesses, it seemed like one of the few times the federal government puts the little guy first. Well, so much for that.

We are now getting reports that publicly traded restaurant chains are getting PPP loans. Shake Shack (SHAK) and Potbelly (PBPB) got $10M each. Ruth’s Chris (RUTH) got $20M. No wonder the money ran out so fast, leaving actual “small” business owners out to dry.

Sure, large restaurant chains will use the money for wages and rent, but that’s not the point. It is about giving the money to businesses who actually need it to survive. Shake Shack just announced that after tapping their credit line, they have $112M in the bank as of April 16th. On top of that they plan to sell additional shares of stock to raise up to $75M. As if $177M would not be enough to keep them going (the company estimates they are burning through $1.4M per week, so they would have more than 2 years of cash on hand post-equity offering), let’s give them another $10M of taxpayer funds.

How many mom and pop restaurants could split that $10M? At $50,000 each, that’s 200 restaurants that are likely close to bankruptcy. Unless Congress approves more money and literally approves every loan application that is legitimately submitted, the idea that public companies can drain a small business aid package is a disgrace.

As Markets Stabilize While Peak Infection Rates Loom, Where Should Fresh Capital Go?

My last post highlighted the fact that the U.S. stock market in recent times has tended to find a lot of support around 15x trailing earnings. It appears that equities have calmed down a little in recent days, with a bottom having been made (perhaps temporarily) on March 23rd. On an intra-day basis (2,192) the valuation at the bottom was 14.0x 2019 S&P 500 profits. On a daily closing basis (2,237) it comes to 14.2x and on a weekly closing basis (2,305) the figure is 14.7x.

I am not going to predict that we have seen the lows. Even the experts in the field are merely guessing as to Covid-19’s ultimate infection path and even scarier to me is that I doubt health and government officials even have a plan for a slow loosening of social distancing guidelines, so we really don’t know what to expect from a economic rebound perspective. On one hand, I am comforted that the market did find a bottom around similar levels to recent years’ corrections, but on the other hand this situation is so much different than prior instances that I am not sure it is a very strong comparable event.

So rather than try and guess these things, like so many pundits in the media insist on, I think it is more helpful to think about where fresh capital could be deployed on a long-term basis as we wait this whole thing out. I am finding it too early to average down on more controversial existing holdings (travel-related, for example) because companies have not given us much data yet. Most have disclosed cash balance and credit line availability, but without knowing cash burns rates that only tells us so much.

So then the attention turns to businesses that are publicly traded, beaten down, and are less reliant on credit availability even if they are shut down. Essentially, high quality businesses that are on sale now but typically are not. Sure, there are examples in sectors where headwinds abound (Starbucks down 35%, for example), but there are more obscure ideas too. How about the few publicly traded professional sports teams? How confident are we that sports franchise values will continue to rise over the next 5 years? Even if seasons are cancelled, will the franchises lose 25-35% of their value for a significant amount of time? How often can small investors buy into sports teams at a big discount? Not often.

I know rental income in the near-term is problematic, but seeing owners of hard assets like real estate down 50-70% in a month is startling (and likely an opportunity). And you don’t need to go out and buy mall owners if you don’t feel inclined. How about Ventas, one of the leading owners of medical facilities? The stock is down 65% since February.

How about the big banks that were forced to be well capitalized so they could weather something like this? Jamie Dimon just went back to work after emergency heart surgery and JP Morgan Chase is widely considered the best-run bank in the world. It’s stock is down 40% from its 52-week high.

There are many companies I feel like I need for information from before I can decide whether to cut them loose or buy more shares. There are others where I feel like I can get comfortable given the low price, no matter how the next few months shake out. If you find unique situations where the franchise value is likely very secure and yet the stock is still down far more than the market itself, take notice. You might be surprised what you find. I mean, honestly, should Target stock be down 30% in this environment?

Happy hunting!

Full Disclosure: Long shares of Starbucks at the time of writing, but positions may change at any time

Market Strategists Focus on December 2018 Lows For Support, Does That Make Sense?

It might surprise many investors to know that despite the violent stock market correction over the last few weeks, the S&P 500 index remains above the trough made during the late 2018 decline. Recession fears during Q4 2018 led to a 20.2% bear market from peak to trough over a three-month period, resulting in an intra-day low for the index of 2,346.

Given that 2019 corporate profits were only modestly above 2018 levels, and considering that the economic weakness from COVID-19 is tangible and not just a “growth scare” (like 2018) market watchers who believe a drop back to that 2,346 is possible, or even likely, do not seem out of line to me. Even at this week’s low point (2,478) it would mean another 5% lower and a full 31% drop from the February market peak.

So if the market today is still above the 2018 low, how does it compare to recent years’ lows? I decided to take a look and the data really sheds light on how far the bull market had come before the novel strain of coronavirus crashed the party.

Below you will see the yearly low for the S&P 500 going back to 2014. I have included the peak-to-trough decline in percentage terms, assuming the current bear market reaches each of those price levels.

Despite an enormous drawdown in 2020, the market remains above the December 2018 lows.

While the percentage drops are severe, it is interesting that even a 34% decline only takes us back to 2017 levels. While that might not sooth investors’ anxiety at the moment, having some context about where we have been does serve to reinforce the long-term equity market trends we have endured during the latest bull market.

I suspect we would see material buying pressure if the S&P 500 dipped down to the low points of 2017 and 2018, unless the virus was truly getting out of control even after governments around the globe took strong and decisive steps to mitigate its spread.

*****

The next logical question to me is what the valuations were at each of these market’s troughs, which can possibly shed some light as to the ultimate magnitude of the current bear market. Below is a chart that shows the P/E ratio on the S&P 500 at each of the low points shown above. I used the actual full year profit figure for each respective year (e.g. the 2014 P/E reflects the low price no matter when during the year it occurred, paired with actual full year 2014 earnings).

Based on the last 5 years, buyers tend to jump in whenever the market P/E nears 15x.

I have heard a lot of commentary in recent days about how the market might actually be more expensive now than it was a month ago, despite a 25-30% market decline. Their reasoning is that earnings are likely to fall dramatically in 2020. For instance, at the high near 3,400 on the S&P 500 stocks fetched 21.6x trailing earnings. However, if earnings fall 25% this year, the S&P at 2,600 would trade at 22.2x earnings.

I find that argument bizarre. The stock market is forward-looking and during a recession really doesn’t trade based on real-time earnings because those figures are depressed and temporary. I much prefer to use actual 2019 earnings to value the market right now, since we don’t know what 2020 profits will look like and they likely won’t stay depressed for very long. While we also don’t know what 2021 earnings will be, a good starting point in my view would be 2019, if we think the world will normalize again sometime within the next 12 months.

At any rate, if we take 2019 S&P operating profits of $157 and use a 15x multiple, we arrive at a level of 2,355. That level just happens to be right at the December 2018 low (2.346) and 31% below the 2020 all-time high. We will see if that kind of level brings out buyers in force in the coming days and weeks. I would guess the virus pandemic/economy would have to get really bad to materially break those levels for an extended period, but that is only an educated guess and prices can pretty much touch any level on any given day.

As Plummeting Oil Prices Compound Economic Concerns, Here Are 2 Things To Do This Week

Two weeks ago we saw a severe stock market decline, which was followed up with whipsaw volatility but a leveling off of prices overall last week. We are starting this week off with what appears to be somewhat of a panic by short-term market participants, with stock trading halted within minutes of opening Monday morning after a 7% drop (due to a exchange-imposed “circuit breaker” 15-minute trading halt - a rule in place, but never triggered, since 2013). As if the virus was not enough, now we have collapsing oil prices threatening the viability of an entire sector of the economy.

If this week is the first time during the coronavirus scare that stock prices meaningfully diverge from the underlying businesses they comprise (a 2,000 point drop in the Dow in a matter of minutes can do that), I would offer two actions investors should consider:

1) Don’t sell stocks simply to try and relieve the pain and prevent further paper losses in the near-term

While it is never reassuring to see stock prices diverge from corporate fundamentals and traditional company valuation metrics, selling securities when prices are irrational rarely pays off. In order for that bet to work, you need to be able to buy back the stock at lower prices (i.e. at even more irrational prices) in the future.

Not only is such a task extremely difficult when it is one’s main objective, but the very fact that somebody wanted to sell during a period of intense pain probably greatly reduces the odds the same investor would be able to buy back those shares after that pain has intensified.

The two smartest options during periods of near-term market dislocation/panic are to either buy mispriced securities with the intention of holding them for (at least) a year or two if needed, or wait things out until normalcy returns and any transaction you want to consider can be consummated at a fair price.

2) Strongly consider refinancing your mortgage

Mortgage rates have now hit all-time record lows, with the average 30-year fixed rate pushing towards 3.00%. I recommend getting a quote from your mortgage broker to see if the monthly savings from refinancing now is meaningful for you. To get judge the return on investment, I always try to see what mortgage rate I can get that offers a lender credit roughly equal to the closing costs. That way, the deal not only costs you close to nothing out of pocket (excluding the funding of an escrow account, if required by the lender), but also maximizes the ROI on the transaction.

Coronavirus Correction: How Far?

So how far will the U.S. stock market fall as the fear of a coronavirus pandemic tightens its grip on daily trading activity? Since there is no way to know, there is little sense to making a prediction on that front. But that does not mean that we cannot set our expectations based on market history, even if there are no assurances that the actual result will be no worse than said expectations.

Without full blown recessions, market corrections are typically in the 10-20% range. Today I updated a graphic that I had last posted on this blog in early 2016, which summarizes recent corrections in the S&P 500 index. The data now goes back 10 years:

If the virus starts to slow in the coming days and weeks, the market might stabilize soon, whereas an acceleration will stoke more fear and likely result in moving towards that 20% threshold. A full blown global recession puts 20-40% declines on the table based on historical data.

Editor’s Note (3/6/20): To put these levels into perspective, the S&P 500 peaked on 2/19/20 at 3,393. Corresponding corrections are as follows: -10% (3,054), -15% (2,884), and -20% (2,715). The low point reached so far during the virus-induced market decline was 2,856 (-16%) on 2/28/20.

I have no idea how this virus will play out. If we look at SARS from the early 2000’s, the 10-20% range was adequate and assets rebounded quite quickly. The same is true of the zika, ebola, swine flu, and bird flu outbreaks. An important aspect of investing is using historical data to inform probability-based decisions. Without a crystal ball, all we can really do is try and stack the deck in our favor as much as we can with that data and prior experience.

All in all, my inclination is to buy quality companies on sale, expect that the market decline will mimic those of the last decade, and take a multi-year view on my investments as things get back to normal. While there are no guarantees that strategy will play out as I expect, making an alternative bet of some kind does not have a better chance of success based on market and economic history, which means I have little interest in exploring such paths.

When my clients reach out and ask if I am worried, my simple answer is “no.” Barring a permanent material change in how we live our lives, or how many people there are to fuel the global economy, the economic and financial output of the corporate sector is likely to snap back after a number of months, in which case the market will move on and look ahead to the future.

Plenty of Travel-Related Stocks Ripe for Bargain Hunting with Multi-Year Outlook

I find it interesting that the financial community is making much about the various drug companies working on coronavirus vaccines. History suggests that 90-180 days from now the outbreak will be off the radar and the global economy will be bouncing back. I am not sure a SARS vaccine, for instance, has much financial value these days. These strands of virus tend to have one-off impacts.

Much like during the SARS outbreak, or after the 9/11 attacks, travel stocks are taking it on the chin right now. As a long-term contrarian investor, I cannot help but allocate some existing cash balances into these stocks. 2020 will be a throwaway year from a financial perspective and the markets should relatively quickly refocus on 2021 and a more normalized operating environment.

Does it matter which companies one targets? In many cases, probably not. Having already held Expedia (EXPE), and being only more excited after hearing Barry Diller’s plan to reinvigorate the company’s business, I can’t help but be elated that the post-earnings rally we saw earlier in the month has now been given back completely. I am modeling $10 of free cash flow per share in 2021 (assuming a normalized economy) and the stock is fetching $105. Plug in your expected multiple of FCF and calculate the upside accordingly.

Booking Holdings (BKNG) has more international exposure and reports after the bell today. At $1,675 and about $100 of per-share free cash flow, that one is worth watching as well.

I have also been looking at the cruiseline sector and already had global market leader Carnival (CCL) on my watchlist pre-virus due to a depressed stock price (due to a large capex cycle depressing free cash flow generation). I have begun accumulating shares, as the single digit P/E ratio and dividend yield north of 5% (payout ratio of less than 50% on normalized earnings) appear favorable to historical levels.

To be clear, I am not predicting how bad coronavirus will be, or when travel-related stocks will bottom. Instead, I am taking my normal 2-3 year (minimum) holding period assumption and making a bet that buying high quality travel companies during times of near-term distress will pay off over the long-term. History suggests it will.