East Los Capital’s Thoughts & Perspectives on Markets
1) Can the Federal Reserve and other central banks provide a successful encore to their 2008-2009 performance in which they introduced monetary tools never used before to shorten a downturn that many believed could have lasted for years, and
2) what will be the speed and trajectory of an eventual recovery?
Many have prognosticated in recent years that should we have a severe economic downturn, the Fed would be less able to effectively address it since it had not normalized interest rates or shrunk its balance sheet in the manner that it had initially planned. Over the past week the Fed has slowly been addressing many of the same concerns that predominated in 2008 and has been rolling out some of the same “fixes” it used previously. Interest rates have been lowered to zero, commercial paper facilities have been put in place along with repo programs, primary dealer credit facilities, expanded dollar swap lines, QE 5, and talk of helicopter money, stimulus and bailouts (loan guarantees) for hard hit industries. Some of these can and have been enacted by the Federal Reserve while others require Congress. Investors’ reactions to these announcements have been uneven at best ranging from despair to euphoria while 1,000 point up/down days have become the recent norm on Wall Street. Whether these fixes will be as effective the second time around is something that we will not know for months if not years.
- Recession: The Wall Street consensus appears to be well over 50%.
- L-shaped recovery: A severe recession that takes years to return to trend line growth.
- Stagflation: High inflation coupled with high unemployment.
- V-shaped recovery: Similar to December of 2018 when the Fed changed course on tightening.
- U-shaped recovery: Gradual with a less defined trough.
How are we looking at the world at East Los Capital:
For context, we have been cautious and skeptical of the indefatigable stock market for some time. We had experienced one of the longest economic expansions and bull markets ever and much of this seemed to be built on artificially low interest rates, multiple expansion, and what seemed like the endless appetite of CEO’s to repurchase billions of dollars of their own stock at higher and higher valuations. As recently as January, famed hedge fund manager Ray Dalio claimed that “cash is trash” and recommended that investors stay in the stock market to protect against dollar devaluation. Now, we have record dollar strength and shortages worldwide. Many companies that used their cash to repurchase stock at all-time highs would undoubtedly like to have some of that cash back. Other investors such as Warren Buffet routinely told retail investors that it was fine to buy as long as they had a long-term perspective while Berkshire Hathaway sat on billions of dollars in cash due to “unattractive valuations”. Economic data from around the world including the U.S. was uneven and in some cases downright bad and growth was unimpressive which may be why the Federal Reserve cut interest rates 3 times last year. Now given recent events, we have no doubt that Mr. Buffet is putting some of the gigantic cash hoard to work as we speak.
Something was going to derail this bull market and the coronavirus was the catalyst, but we do not attribute all of the violent selling in recent days solely due to the virus. The implication is that even once the virus issue is behind us, we will be left with many of the economic issues that were present beforehand and with an even weaker economy.
We are of the belief that we will experience a definitional recession followed by a u-shaped recovery. In our most optimistic scenario, testing kits become widely available in the near future and counterintuitively as the number of reported infections increase, and presumably most people recover in a reasonable amount of time, the uncertainty that Wall Street hates will be removed. During past health related market sell-offs the market decline has tended to bottom as infection rates peaked. In this scenario we would still likely experience at least 2 quarters of headline GDP contraction, but people and businesses would be able to return to their normal activity levels faster than expected.
How does this affect our investment philosophy and strategy:
We continue to favor asset-light companies which provide the opportunity to improve growth and efficiencies through the better use of technology (e.g., techification) via East Los Capital technical partners.
The need to be able to work remotely and have data secured and available to everyone reinforces our focus on cloud infrastructure. A renewed focus on internet security has emerged as people work from out of the office which is consistent with our bias towards cyber security.
While we do not invest in biotech or anything directly related to drug discovery, we do look at companies in the health care IT space as well as those featuring telemedicine capabilities. Both of these areas will continue to garner much investor interest in the years to come.
We have previously expressed a philosophy of using conservative capital structures with minimal to moderate levels of debt. The recent devastation of highly leveraged companies reinforces this thinking.
We have not been willing to chase valuations and now valuations have come down rapidly with the potential double whammy of multiple compression and reduced earnings in the future. We believe that it will take time for sellers, who unlike the managers of publicly traded equities, are not used to seeing their valuations marked to market on a daily basis, to come to terms with the fact that the value of their businesses may have come down meaningfully.
We believe that the dramatic decline in public market valuations may provide a new area for sourcing potential deals, especially in the lower middle market as many of the publicly traded companies in this segment arguably should not be public companies and have struggled with the cost and regulatory burdens associated with this. Now will be the opportune time to have conversations with these companies about going private should their existing capital structure allow for it.
What are we still trying to figure out:
Will the massive amount of “dry powder” that has been on sideline limit the decline in valuations as this money finally commits to transactions?
What is the real damage to supply chains and how long might this take to recover?
What is the damage to animal spirits and risk tolerance? Some Wall Street professionals have never seen a down market and this could dampen valuations for an extended period of time.
What will be impact on private market allocations after pension funds have lost so much of their recent performance. As of today, we have given back almost all of the gains from the last 3 years in the public markets.
Many of the industries that are currently seeking assistance from the federal government bought back billions of dollars of their own stock in recent years. Share buy backs were already controversial in some corners and now there is talk of eliminating or restricting this activity going forward. What would this do valuation metrics going forward?
We know from our 2008/09 experiences that a recovery in the debt markets will be a sign of a valuation bottom for equities. Investors will not be aggressive in buying the equity portion of the capital structure when higher priority debt on the same companies can be purchased at a significant discount to par.
What will be the impact of the massive interventions being implemented and discussed by governments and central banks. Personal balance sheets are important. Corporate balance sheets are important. This logic should extend to central banks and governments which will be growing deficits and possibly stoking inflation to levels that finally exceed their “2% targets” to a degree that is unhealthy.
The environment that we are currently experiencing reinforces our belief that companies optimizing their businesses around technology will be the most agile and best poised for growth in all market environments. We will continue to look for opportunities consistent with this thesis and at reasonable valuations.
Beaten down publicly traded micro-cap and small cap companies which would be better served as private companies may prove to be a new area of deal sourcing for our firm.
Research, research, research. The importance of fundamental company and market/industry research will continue to be a priority. Companies which have held up the best during the recent market downturn have been those possessing the best underlying fundamentals along with competitive moats and/or markets with strong secular tailwinds. We strive to find these companies in the lower middle market.