Confused bear

I’m about as bearish as I’ve been on the medium term prospects for the stock market. Like many others, I feel that the stock market isn’t fully reflecting the risks to the economy from the lock-down measures currently implemented around the world. It is already evident that the magnitude of the economic shock is unprecedented. And that’s even if we manage to lift the lock-down measures soon. It seems unlikely that we will to do so fully given the high probability of the dreaded ‘second wave’. In the meantime the economy will continue to suffer. Why then does the stock market seem to be defying gravity at the moment?

confused bear

The recent bounce in share prices seems to suggest that the market as a whole is ‘looking through’ the current disruption to greener pastures on the other side. This would make sense if economic activity bounces back quickly following a much-vaunted ‘V’ shape, rather than a more prolonged ‘U’ shape or even a miserable ‘L’, where growth is permanently thrown off-track.

The speed of the recovery depends on the extent to which there are more permanent, less easily reversible effects, such as businesses going bust because they run out of liquidity or workers becoming unemployed. Governments are trying to mitigate these effects with interventions to loan money to businesses and pay for workers to be furloughed rather than made redundant. However, this will only be partly effective. Administering these schemes is difficult and they are likely to be insufficient or too slow for many businesses. Even for businesses that are kept afloat and manage to keep their workers, there is little to prevent the damage to balance sheets caused by months of reduced revenues. This results in little choice but to cut back on costs and capital investments until uncertainty is resolved and balance sheets recover. The vast majority of businesses that have updated the market recently have withdrawn guidance and seem to be in capital preservation mode in light of the uncertainty they are facing. 

These problems will be amplified throughout the economy by ‘knock-on’ effects. Some of these happen via the real economy. Uncertainty about future revenue forces businesses to cut costs or curtail capital expenditure. One business’s curtailed capital expenditure is then another business’s lost revenue. Other knock-on effects happen via the financial markets, as bad debt is passed through the system. As we know from recent history, financial contagion can have pretty serious consequences. It feels like we are in a better place now than at the time of the Financial Crisis, but with a shock of the magnitude and truly global nature of the current pandemic the risks seem very high. The structural imbalances in the Euro area look vulnerable, as do emerging markets with dollar-denominated debt.

The complexity of these feedback loops means it is very hard to predict what the overall impact will be or how any individual business may be affected. It may take some time for things to play out. Obviously, the longer lock-down measures go on for, the worse the impact will be. I don’t have a clear idea of how long they need to go on for before knock-on effects really start to add up and a sharp recovery is no longer possible. I suspect not very long – the damage could already be done.

It doesn’t seem controversial to have a gloomy outlook at the moment. It’s strange to then see the stock market rebounding so strongly. I suspect the monetary stimulus being applied by central banks must be playing a role but I’m not really sure what to make of it or what might happen next. The link between the stock market and real economy can be quite tenuous, especially at times of stress. There is no clear benchmark for where stocks are fairly valued. This leaves room for collective market psychology and liquidity effects to distort prices for extended periods of time.

Overall, I’m not in a rush to reinvest my hefty cash balance while there is so much uncertainty and the risk of substantial further price falls seems high. However, I’m by no means certain that these price falls will actually happen. I’m not feeling very confident in my market timing ability at the moment.

As I set out in last post, my plan is therefore to slowly reinvest my cash balance over the coming months. As a result of my house deposit also becoming available to invest, my cash balance has grown to an all time high of around 70%. This is probably too high, so despite my bearishness I have been starting to reinvest a little, taking the cash balance closer to 60%.  I intend to apply some discretion about how to time further investments. While prices remain high I’ll move slowly and if they start falling I’ll speed up.

Trades

At the moment I’m mainly sticking to businesses I think will be less affected by the current crisis but if prices fall more significantly I may look more for bargains instead.

Over the past few weeks I’ve bought five small new holdings. I bought back Boohoo, after reading reports from workers that business was booming. The share price has since rebounded strongly and this week Boohoo confirmed in its results that trading is indeed going well. I’ve been a big fan of Boohoo for some time. It’s resilience in the current crisis has only strengthened this view. I also bought back Liontrust Asset Management and Keywords Studios after positive recent trading updates. I’ve covered Boohoo, Liontrust and Keywords Studios previously so won’t do so again here. Finally, I bought two new positions in Netflix and Canada Goose.

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Netflix

Netflix needs no introduction as a platform for streaming video content. While the catalyst for me buying it now is partly that it is an obvious beneficiary of the current crisis, I’ve liked the look of Netflix for some time.

Quality

  • Business economics: this is the weak point. The financial statements don’t look very attractive at all with huge negative cash flows spent on producing content. This doesn’t look likely to slow down any time soon, particularly since Netflix has transitioned to relying more on producing own content rather than licensing third party content. However, underlying this I think there looks like a highly scaleable and potentially profitable business. Its subscription model mean revenues are stable. Production costs are fixed while revenues can scale up with subscriber numbers at little additional cost. On top of that it seems pretty clear that Netflix has a huge extent of untapped pricing power. Netflix’s subscriptions seem pretty incredible value given the amount of time people spend on it and that it allows customers to share logins.
  • Track record: Netflix has an excellent track record of sustained rapid growth in revenues as it has expanded globally. The share price has done spectacularly well over recent years.
  • Competitive advantage: I think this is the main attraction. Fears of increased competition from the entry of other video streaming services, such as Disney and Apple, seem widely off the mark to me. First there is the point that subscribers are likely to be quite happily multi-home across several streaming services, while they each offer unique content and continue to offer such excellent value for money. Disney’s content looks highly differentiated and it’s hard to see it driving much switching from Netflix – indeed the very successful rapid expansion of Disney+ so far looks to have had little effect on Netflix subscriber growth. Where customers are forced to limit their budget on streaming and choose between providers, it is clear that quality and quantity of original content will be the key competitive variable. The fact that content costs do not vary with the number of subscribers creates very powerful economies of scale. Netflix seems to have recognised this early and now seems to be miles ahead of competitors in taking advantage of cheap finance to invest very heavily in developing its in house content production. Netflix is currently spending around three times its nearest rival Amazon on content production.
  • Growth prospects: even though Netflix has already grown a lot I think there is still excellent growth potential ahead. The market as a whole is growing tremendously and I think in the long run Netflix’s scale advantages should allow it to keep a high market share. There is latent revenue generating potential from pushing up prices over time and tightening sharing of subscriptions. The huge share of attention Netflix derives from its platform allow for many other possibilities too. Demand looks to be highly defensive too (at least at the moment).

Price

Momentum is excellent with the price recently breaking out to new highs after several years consolidation. The latest results showed that subscriber growth is resilient to the entry of rivals. The valuation is demanding, though I think warranted by the long term growth prospects.

 

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Canada Goose

Canada Goose is a relatively small (£2bn market cap) fast-growing luxury fashion brand focused on down jackets, similar to Moncler but a bit more functional and less high concept fashion.

Quality

  • Business economics: Canada Goose already has a highly profitable business. In common with other luxury brands this derives fundamentally from the fact that the brand affords pricing power which drives very high sales margins. Canada Goose has decent operating margins and returns on capital. However, it is generating relatively little free cash flow at the moment. I’m comfortable with this given the brand is in the early stages of a growth phase and cash is being reinvested into expansion.
  • Track record: the predecessors to the current Canada Goose brand have actually been around since the 1950s, though it’s really only exploded into ubiquity over the last 15 years or so. Since then it has a fairly spectacular track record of rapidly growing revenues.
  • Competitive advantage: as for most luxury fashion businesses, it’s all about the brand. I don’t have any special insight here, though am reasonably confident in it based on the track record. I like that the brand is associated with high functional quality and has a classic timeless feel to it despite being relatively newly invigorated. It seems like a brand that can grow and last if it executes well.
  • Growth prospects: growth prospects seem excellent as the brand is still relatively small with plenty of scope for geographic expansion. I think the current high growth rates can persist for some time yet.

Price

Momentum is weak, in part because of the current crisis, but the share price has actually been falling since late 2018 and is now almost 70% off the peak. I think this is just because the valuation at the time became over-inflated by excessive speculation over the extreme growth it was experiencing. The price has bounced a little over the past few weeks but is still not too far from the lows.

Unusually for me then, this is more of a value than momentum play. While the business is going to be severely impacted by the current crisis, it is financially robust and luckily makes most of its sales in winter when lockdown measures will hopefully be alleviated somewhat. I think it is going to look seriously cheap once we start coming out the other side and growth resumes.

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