- While everybody is staring at confirmed cases climbing globally, more important long-term effects of the coronavirus outbreak are in the making.
- Investors that accurately think through potential second- and third-order outcomes could generate significant alpha.
- Here is a first list of theoretical outcomes and how they would effect some businesses and countries.
- This idea was discussed in more depth with members of my private investing community, Stability & Opportunity. Get started today »
Every action has a consequence, and each consequence has another consequence. These are called second-order effects.
While the dramatic coronavirus outbreak in China was already known, analysts and investors were staring at the daily increases of confirmed cases, and, as soon as they noted a slow-down, U.S. stock markets reached all-time highs. – What does this tell us? – Well, the uncomfortable truth for data-driven, math-focused, chart-steering folks like us, is that looking at figures alone can make you blind: Effectively, in the meantime, the obvious happened, as single infected travelers brought the virus to Europe and the U.S., where it silently started to spread.
Therefore, in this article you won't find many figures and statistics, but simply some thoughts on what else could happen because of the outbreak that could effectively produce permanent change. The list doesn't aim to be exhaustive; it simply wants to provide some food for further thoughts.
One simple mistake investors often make is to assume that a crisis is only what it seems and everything will revert back to normal once it's over. While true in many cases, in some cases it is not. For example, after 2009, bank regulations got tougher and Warren Buffett predicted lower returns on equity going forward. When such second-order effects become visible, investors panic and stocks go into freefall, as the feeling of uncertainty becomes intolerable.
So you should not simply buy, say, a luxury goods maker which currently suffers from less travelling around the globe, assuming after the outbreak its business will rapidly return back to normal. It may or may not happen, depending on a few things (among many others):
1. How long the outbreak will last
If it lasts, lasting changes will more likely be the consequence. For example, if mass quarantines become the rule around the globe, school and university teaching will move online – and might stay there even after the virus will be gone. Working from home could become the rule rather than the exception, disproportionally affecting car and fuel consumption. In such a scenario, the Internet giants like Alphabet (GOOG), Facebook (FB) and Amazon (AMZN) should thrive. Regulatory pressures would likely subside, as politicians won't dare to take away key communications and connectivity tools while physically isolating their users. However, privacy and data protection concerns have been there for a reason and shifting even more uncontrolled power to these companies might carry enormous liabilities (i.e. third- and fourth-order consequences).
2. How the outbreak will affect the company's client base
The coronavirus disproportionally kills the elderly and predominantly men. A huge pandemic could literally kill some businesses' client bases. For example, dialysis providers like DaVita (DVA) and Fresenius (FMS) have clients that have a far above-average mortality risk, with usually more than one severe co-morbidity, a weakened immune system and the need to frequently enter high-risk areas like clinics, physician offices and the like. On the other hand, we need to see how these clients are insured: If they are rarely on commercial plans, the loss of these patients might actually benefit the service providers, as they usually lose money on all government-insured patients.
3. What competition can do, while business activity is down for our company
For example, luxury goods retail activity will try to push online sales, but some smaller, leaner, more innovative players might be quicker and better positioned than your typical large luxury goods maker, which could easily depend on virus-decimated duty-free shopping at airports, or on its own physical stores like Ulta (ULTA). Trends can change quickly.
4. Financial flexibility
Not only are debt and cash levels important because they indicate for how long a company may stay afloat without earnings, but the better-equipped companies may also counter emerging competitive threads thanks to acquisitions. Cash-rich companies may buy back shares, buy competitors, diversify - something you can't do if you need to worry about being able to wire the next interest payment.
5. General flexibility and diversification
A company like Berkshire Hathaway (BRK.A) (BRK.B) will obviously suffer from a general slowdown in large parts of its activities. On the other hand, however, it will profit in several ways. For example, car insurers like Geico and Progressive (PGR) will have a good year, if people move around less, thus reducing traffic intensity and accidents. While this is only a one-off gain, Berkshire's large cash reserves would likely be employed if acquisition prices came down, thus permanently improving the conglomerate's earning power.
6. Political / regulatory changes
I would also expect the outbreak to change some of the rhetoric on healthcare and its price. For example, the same politicians that had pushed German hospital operators to reduce bed capacity, are now bragging that Germany is exceptionally well-prepared for a major pandemic as it has among the highest ratio of hospital beds per inhabitant.
Another example: The world will see the difference between the U.S. healthcare system and single-payer systems overseas. While U.S. citizens might be afraid of outrageous costs and avoid getting tested for the virus, overseas everybody gets tested for free, thus reducing the risk of further transmission. Will this affect the presidential election and boost Bernie Sanders' chances?
Will some rogue dictator profit from the general crisis and extract concessions from world leaders that are already too busy with the virus issue to be willing to fight his provocations? North Corea's Kim Jong Un or Turkey's Erdogan come to my mind. Erdogan is already provoking the EU by menacing a massive refugee inflow. Will this increase support for right-wing politicians in the region? Which third-order effects will potential concessions have on global power balances?
As the Trump administration's failure to deal with the pandemic becomes more evident by the hour, Vladimir Putin is also evidently done with helping Donald Trump. The Russian autocrat is deliberately pushing oil prices into free fall, knowing that many U.S. businesses won't survive with such a low oil price.
To panic or not to panic…
Not the coronavirus itself and its near-term financial consequences, but the emerging unpredictability of the post-coronavirus world is causing the panic. The same folks that were just paying sky-high multiples for leveraged "good stories", are suddenly recognizing the need for more solid valuation metrics than expected "Adjusted pro-forma EBITDA" three years out. And the market starts to become more conservative in its assessment. As J.P. Morgan said: "In bear markets, stocks return to their rightful owners" – i.e. the ones focusing on the long term prospects of solid businesses and not on the near-term beauty contest on Wall St.
Effectively, the 2023 world was not that much predictable even three months ago. Yet the stock market chose to ignore many not really outlandish risks. Today, it might be on the way to ignoring some basic, fundamental solidity of select quality concerns that will very likely persist for many years to come and through all kinds of hardships. It is our business to find the babies that are thrown out with the bathwater.
If you want to avoid difficult thought processes (and any kind of alpha), think about slowly building a position in a broad-based index fund like the S&P 500 ETF (SPY) or the MSCI World (URTH). The average business will certainly come back over time.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
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