The past four weeks have been surreal. The S&P500 lost nearly 30% of its value with extreme volatility day in and day out, and the busiest cities in the US and most of Europe are in lockdown. What happened in China is happening to a lot of us, and we didn’t expect that. No country can fully prepare for events like this, unless they have experienced something similar before. Singapore, Taiwan, Hongkong, and South Korea have done a commendable job responding to Covid-19, possibly because they had the painful experience dealing with SARS (2003) and learned from it. The US, despite making the right decision to ban travel to and from China early on, underestimated the infection spread in Europe which had an inconsistent response to the outbreak among its member countries, and therefore underestimated the need for mass testing in the US. Thankfully, the US is now fully engaged to fight the pandemic with comprehensive actions, including aggressive monetary and fiscal policies, collaboration between the Federal and local responses, and joint efforts between the public and private sectors.
Just like a war at its beginning, things are gloomy right now and panic is prevalent. We tend to focus on the worst possible outcome and find it difficult to see the light at the end of the tunnel. However, with all the containment and mitigation efforts being undertaken, with the weather getting warmer, with possible cures a few months away, we firmly believe this shall pass and science will win. In fact, just look at China. We were fixated on how bad the China condition was in February but forget to check in to see China’s latest progress. More than 90% of state owned enterprises have resumed work in the country. Yes, that number might be exaggerated but a big part of the nation’s economy is indeed returning to work. Nearly a week ago, Apple opened all its retail stores in China after closing them for 1 month. Starbucks has opened most its stores in China since late February. Schools are still closed but residents are now allowed to go in and out of their residential compounds without strict time limitation. It took China nearly 8 weeks to reach this point. Yes, life is not back to normal yet but we are hopeful, the Chinese economy will indeed resume its full momentum by the end of June. (The shutdown of the rest of the world will now have a dampening impact on China’s economy, but China should be resuming its full capacity considering the outbreak impact alone.) With the US and Europe implementing similar lockdown measures, it is hard to imagine our outcomes will be dramatically different on either continent than China.
In addition, the nation’s experience with the Spanish Flu more than a century ago could also shed some light. According to a paper by the Federal Reserve Bank of St. Louis published in 2007[1], the Spanish Flu, a global influenza pandemic, killed 675,000 people in the United States (nearly 0.8 percent of the 1910 population) and 40 million people worldwide from the early spring of 1918 to the late spring of 1919. The years of 1918 and 1919 also marked the height of U.S. involvement in World War I. Data is very limited regarding the economic impact from the Spanish flu but the author draws a few conclusions: “Local quarantines would likely hurt businesses in the short run. Employees would likely be laid off. Families with no contact to the influenza may too experience financial hardships. To prevent spread, quarantines would have to be complete (i.e., no activity allowed outside of the home). Partial quarantines, such as closing schools and churches but not public transportation or restaurants (as done in Philadelphia, St. Louis and Washington, D.C.) would do little to stop the spread of influenza”. “Some businesses could suffer revenue losses in excess of 50 percent. Others, such as those providing health services and products, may experience an increase in business (unless a full quarantine exists).” “The influenza of 1918 was short-lived and had a permanent influence not on the collectivities but on the atoms of human society – individuals.” “Society as a whole recovered from the 1918 influenza quickly, but individuals who were affected by the influenza had their lives changed forever.” We know “short term” feels very long as we grind through each day right now, but we all have to take a deep breath, hunker down, and let the virus and our counter measures run their course.
When we say no country can be fully prepared for a pandemic event like this, it is not an excuse. No company can either. The reason is simple – Enormous resources would have to be set aside, permanently, in order to be well prepared for a 2 or 3 standard deviation event like this. That will likely be an enormous waste of resources and capital, especially at the corporate level. Investors will not allow that to happen either. After all, responsible companies are expected to operate based on a reasonable range of assumptions for macro economic conditions, centering on normality and sustainability, not extreme stress or exuberance. That said, companies are expected to be prepared for rainy days and their fundamental strength is critical in determining how well they survive difficult challenges like this, and recover, prosper again.
When we assess the 50 and Dividend strategies, we see our holdings in the hospitality, and travel related industries being painfully crushed. Darden Restaurant (DRI), Carnival Cruise Line (CCL), Host Hotel & Resorts (HST), have lost an average of nearly 70% of their value since the beginning of the year. In fact, the selling has been very indiscriminate, and financial, energy, and broad transportation industries have all lost a significant portion of their market capitalization in the past weeks. Did we recommend investing in our holdings based on the assumption that, in a given year, some of them may lose 50% or more of their revenues? No, we didn’t. We didn’t think that would be a possible scenario. Nor do we believe if we assumed any outlook remotely like that, there would be any company investible in the SP500 from a valuation perspective, just a few months or a few years ago. What we did make sure is, we need to be confident the companies we invest in have: a sustainable business model; a good management team; and strong balance sheet. In the case of those three companies, Darden is the largest restaurant chain in the US and has been in business since 1968. Carnival is the largest cruise line operator in the world and was founded in 1972. Host is the largest lodging REIT in the US and one of the largest owners of luxury and upper-upscale hotels. It was founded in 1993 and was spun off from Marriott in 2005. All three companies have their short and long term debt rated investment grade by all three rating agencies as of the end of the last fiscal quarter or less than 3 months ago. They have the best balance sheet in their respective industries. We have generally been very satisfied with how each management team has executed their stated strategies. Among the three we had the most reservation regarding Carnival’s growth strategy, which they adopted a year ago but would need to be revised amid today’s crisis.
Entering 2020, the dividend strategy had an average yield of 3.2%. Right now, it is nearly 6.5%. Price appreciation, dividend cuts, or a combination of both will likely take place to bring the strategy’s dividend yield back to a more normal level. While we hope price appreciation will start to happen soon, we cannot ignore the possibility of a relatively broad based dividend cut among our holdings and all of corporate America. This health crisis is fast evolving into a temporary economic crisis, and very few companies will escape. While we regret the absolute income our investors receive may decline in the coming months, we are confident the yield on their investment will remain superior in the current environment. More importantly, we believe odds are high the absolute dividend payout will rebound in the years ahead. When companies experience a short term shock, they have to and should preserve capital and liquidity by halting share buybacks and paying smaller dividends. The good news is, if their fundamentals are intact, their operations will bounce back, and they can resume dividend payments to the prior levels sooner rather than later. This is very different from the scenario when a company’s long term prospect is in danger and they have to pay a lower dividend indefinitely. In April of 2015, Freeport McMoran (FCX) cut its quarterly dividend from 31.15 cents to 5 cents a share. Today, it is still paying 5 cents dividend a share. In December of 2015, PG&E (PCG) suspended its common dividend, which remains 0 today. In both cases, the dividend strategy replaced those holdings immediately, as we believed those companies’ long term prospect was gloomy and a successful turnaround would not likely happen in the foreseeable future.
Equity investing is about assessing history and more importantly projecting into the future. When we look at our holdings in the dividend strategy, most of them fared well in the 9’11 aftermath, with only Hasbro (HAS) and Norfolk Southern Corp (NSC) trimming dividends. In the great recession, financial companies cut dividends across the board, and it took a while for them to resume attractive dividend payouts. Darden (DRI) kept its dividend after 9’11 and raised during the 2008/2009 era. Carnival (CCL) suspended its dividend in 2009, resumed its dividend in 2010, and returned its dividend payout in 2012 to the level comparable to 2008. In the next 3-6 months, the demand shock to some of the companies in our strategy will likely be more severe than what they experienced in the two prior events. Therefore, we don’t know if the historical precedent can serve as a perfect reference today. We think the dividend cutting might be greater this time, but we are also hopeful a bigger dividend raise will follow thereafter. We still believe the economic recovery can be V shaped in the US, with the Fed cutting interests to nearly zero, restarting QE, launching the Commercial Paper Funding Facility, and the federal government likely providing a fiscal stimulus package with a price tag of at least $1 trillion, nearly 5% of one year’s US GDP. In fact, more will likely be done to curtail the current panic. As always, we will examine our current positions and compare them to the alternatives carefully. Amid this ongoing self-fulfilling sell off, we will stay put and stay disciplined.
Long term equity investors are all inherently optimists. To invest in long duration assets like equities, we have to believe that the future will be better: for the companies we own, for the country we live in, and for the world. As we grind our days though this crisis, that optimism is particularly valuable and called for. We will stay calm, get through this quickly, and start our rebuilding process. This Covid-19 crisis is a wakeup call reminding us, how connected we all are, in this big yet small world. We are all in this together. We are hoping, when all is said and done, our country will emerge as a more united nation, shepherding in a brighter future. The novel coronavirus is very democratic, and people regardless of wealth, race, or political belief, are all at risk of infection. It is heartening to see the Trump administration working closely with the New York, California, and other blue states’ governors on this fight. They actually have nice things to say about each other. Maybe there is hope for everything, after all. Another silver lining is, when all is over, the country will be much more capable of handling epidemics. We will likely be able to deal with the seasonal flu with much better containment and mitigation capabilities, save lives and save money in the long run.
This shall pass and we will be at a better place.
[1] Economic Effects of the 1918 Influenza Pandemic, Federal Reserve Bank of St. Louis, (https://www.stlouisfed.org/~/media/files/pdfs/community-development/research-reports/pandemic_flu_report.pdf)
