(May 22): Legendary investor Warren Buffett famously quipped that you only find out who is swimming naked when the tide goes out. Now, in the midst of the global coronavirus shutdown, the tide has gone out. Firms ranging from small family businesses to mega public companies are watching sales and profits plummet. The unprecedented collapse in both supply and demand has exposed a multi-decade trend that favoured shareholders and short-term term profits at the expense of long-term business resiliency.
While the Covid-19 outbreak popped up suddenly out of nowhere, the fragility of large firms has been growing for some time. Forty years of falling interest rates has made increasing corporate leverage too irresistible. “Fortress balance sheets” were no longer valued, they were considered inefficient while a BBB rating — the last rung before “junk” status — is now seen as more optimal. Bond proceeds were used to buy back shares — particularly in the US — shrinking the first-loss shock absorber. But there were very few shocks. The global economy weathered a few minor blows, but the last truly existential threat — the Global Financial Crisis — was fading in the rear-view mirror. In effect, the 11-year equity bull market only served to reinforce the idea that short-term profit growth was paramount while stability and prudence were unnecessary.
But the pandemic has changed this calculus and will likely revive the profitability versus resiliency debate. It has become more obvious that to produce long-term results, companies must survive shorter-term crises. However, increased stability will come at a cost and managing that trade-off will become more difficult.
The first question for CEOs post-Covid-19 will be how they rethink cash flow. Will firms retain more earnings and reduce dividends to increase their capital flexibility — especially in Europe where dividend payout ratios are near 60% of earnings? Likewise, will publicly-traded US companies continue to favour share buybacks, shrinking their capital base, to boost bottom-line earnings? Will companies continue to favour the short-term boost from returning cash to shareholders over long-term capital reinvestment back into the business? Firms that stockpile cash and hoard capital become more resilient over time, but their shareholders may become impatient.
Another choice facing executives is how to alter their balance sheets. Historically, cash had been used to pay down loans and debt, but that hasn’t been happening much in recent years. Many firms have come to believe that it’s better to be a borrower at zero percent interest than a company hoarding an asset with no return (0% interest on cash, for instance). As liquid assets decline and debt rises, growing financial leverage magnifies equity upside at the expense of downside fragility. Moreover, with overnight rates pinned near zero for years, firms will have to choose between higher longer-term rates that can be locked in over an extended horizon or cheaper short-term borrowing that needs to be refinanced more frequently — making firms more subject to the whims of the capital and lending markets.
Finally, operating managers will have to reassess their production function as the outbreak has exposed key vulnerabilities to supply chains. To mitigate these risks, firms can add redundancies, diversify their suppliers or bring them closer to home. However, all of these create additional costs and trade-offs.
Physical plants and office space will also need to be rethought. More remote workers justifies a smaller overall footprint but higher connectivity and IT costs. At the same time, social distancing for those who return to work may require larger, redesigned work areas. Businesses will have to develop new methods and metrics for tracking worker productivity. Regardless, firms will have to build in more flexibility and accountability across suppliers and workers. While production and output may become more resistant to shutdowns and other crises, costs will rise as more friction is added to the system.
None of these problems are new but the global shutdown has exposed the danger of running lean and leveraged to boost short-term shareholder value. Pandemics, natural disasters, supply shocks and other financial calamities are not going away and may occur more frequently. Corporate boards and executives will face difficult choices in the coming years. Building liquidity, reducing leverage, diversifying suppliers and protecting workers all have costs or trade-offs that divert resources away from shareholders. In the long run, a lower risk business should command a greater valuation. However, equity investors may have to accept that fostering a more durable business may stunt near-term profits.
Dave Lafferty is Chief Market Strategist, Natixis Investment Managers