CMCnotes

Research in a time of uncertainty
Dan Pickett

Research in a time of uncertainty

A framework for making decisions

I hope you are all doing ok. Obviously, there is a lot going on with the coronavirus and it may seem insensitive to talk about investing during a global pandemic, but you should understand that if you choose a career investing, you will be required to make decisions in times of great uncertainty. Having an investment process is essential to making good decisions and especially so in times like these.

Wealth managers with individual investors are spending a significant amount of time with their clients helping them try to make sense of what seems inexplicable and discussing their portfolio positioning. Even if they were prepared with what seemed like a well-diversified portfolio, when extreme market volatility hits, most asset classes move together (i.e. correlations approach 1) and there are few places to hide.  Investment managers have client service professionals doing the same, although the conversations are different as most clients have in-house professionals overseeing their portfolios.

For analysts, it is difficult to tear your eyes away from your screen but obsessing over the market swings is not productive. Aswath Damodaran’s Musings on Markets blog had a couple of nice posts discussing his framework for thinking about how to invest in the face of uncertainty.  In the first (here), Damodaran emphasizes the importance of having a framework for your analysis and investment decisions. His framework centers around a discounted cash flow valuation (DCF) and in the post he describes how the effects of the coronavirus might affect the forward-looking inputs to his DCF.

The second post (here) was written after a few additional days of historic market volatility and considers the difference between price and value, something we talked about in the first CMC training session. As fundamental analysts, we believe the value of a company and its stock is related to the cash flow the company can generate over time (note this is independent of the valuation framework you choose). Our focus is on understanding how businesses operate and developing a view about how they are likely to perform over time, which we measure in years not days. We expect that over time, as the market comes to understand how the company will perform, its stock price will approach the value warranted by that performance. Of course, how long that over time will take is not well defined. Ideally, we look for a catalyst to help the market realize the potential we see.

For many professional investors, and for the CMC portfolio, the question isn’t whether to be invested in stocks or in cash (or some other asset). The CMC portfolio is part of the Hawk Center’s equity allocation and invested in equities all the time. The CMC stock decision is relative to the sector in which a company operates, so when we buy a stock, we offset that with the reduction in the corresponding sector ETF, e.g. if we think Pfizer is attractive, we buy PFE and sell the Health Care sector ETF, XLV.

Even considering that relative decision, dealing with the economic uncertainty can be very challenging. My approach is no different than what we discussed in the accounting and company analysis training session (link here). The steps are:

  • Understand the business
  • Assess the competitive position
  • Identify key stock drivers
  • Evaluate current trends
  • Estimate market expectations
  • Identify and diligence tension points
  • Articulate investment thesis and forecast
  • Value the view

Given the heightened uncertainty in the current environment, I pay even greater attention to how well equipped the company is to withstand a prolonged shutdown in my understanding of the business. This involves an assessment of the company’s balance sheet and fixed obligations. Companies with excessive debt and near-term maturities and/or negative cash flow are particularly vulnerable. Factset’s Credit Analysis application can help you assess a company’s debt capital structure. The Financials Use of Cash report and the Credit Analysis DCS Detail report grouped by maturity can give you an understanding on ongoing financing and re-financing requirements for your company. Given the significant leverage Capri Holdings took on with the acquisitions of Versace and Jimmy Choo, we’ll need to discuss these issues in our next training session.

Next, I consider how the disruption is likely to affect the key drivers of the company’s operations (taking into account the company’s financial strength). I focus on the underlying business - what does the company sell, how discretionary is the purchase, what alternatives are there, etc. Using history as a guide, I consider how the company or industry (if the company has not been operating long) has performed operationally, particularly in past economic downturns. It is important to understand that the downturn we are likely entering will be different because it is driven by different forces, but this analysis can at least give you an idea of what might happen. While there is likely to be significance weakness in current trends for a time, at some point the economy will recover and I want to consider how well the company will perform in what might be a new normal environment. I’m looking at least a one to three years out in my analysis.

When estimating market expectations using forward EPS or cash flows forecasts, it is important to recognize that the “consensus” forecasts in Factset and elsewhere probably do not fully reflect the weaker economic activity and we need to make an adjustment. There are many ways to think about adjusting. One approach might be to adjust forecasts lower by an amount similar to the decline observed in the last recession. Sometimes valuation can be useful in estimating the expectations that might be reflected in current prices, e.g. assuming a historical multiple as the “right” multiple, given the current price, calculate what that might imply for EPS or cash flow. For example, in the chart below the current NTM P/E for CPRI is 2.67X with the estimated NTM EPS $4.37. That estimate suggests analysts have not yet significantly adjusted their published forecasts for work stoppages, even though the market clearly expects them. If we assume an 8X to 14X multiple, which is where the stock traded from 2016 to 2019, that implies the “market” NTM EPS estimate is something like $0.83-1.45 not $4.01. Obviously, the market may think the multiple is different than 8X-14X and you can adjust your estimate based upon your analysis, but this is a more reasonable approach to considering consensus than just accepting the median or mean estimate that is published.

As we discussed in the advanced valuation training session earlier this semester (link here), both the absolute and relative valuation of stocks are important to  consider and relate to perceptions of growth opportunities, profitability, and risk. While most stock valuations have declined during the market sell-off, we should be looking at how the valuation changed relative to the company’s prospects as well as relative to comparable companies and the broader market.

So, even though there is a greater than normal amount of uncertainty affecting the markets today, our underlying investment approach shouldn’t change. We should focus on understanding the key drivers of businesses, evaluating how trends are likely to affect the drivers and company performance over time, and compare that to what we think the market expects based upon our estimate of consensus expectations and the stock’s valuation. When our research and analysis of the drivers suggests trends will be more favorable than the market seems to be discounting in the current price, we have an attractive buying opportunity for the CMC portfolio. The recent market decline is creating an environment where careful, systematic analysis should be well rewarded (eventually).

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