Letters

Investing in the Wake of a Shock

March 2020

Investing in the Wake of a Shock

It is not the strongest of the species that survives. Nor the most intelligent. It is the one that is the most adaptable
to change. – Charles Darwin

In nature nothing is created, nothing is lost, everything changes. – Antoine Lavoisier

Long periods of low risk and volatility lull people and societies into complacency. For the past 10 years both investors and companies have reduced the buffers that would soften the impact from a sudden crisis. Companies levered up, thereby reducing their options if a sudden reduction in the business climate happened. Investors have increased their commitments to long-term illiquid instruments and also moved away from active investment favoring instead passive / formulaic investment.

At Somar we faced the COVID-19 selloff with a portfolio that is virtually 100% liquid within 5 trading days. We also levered our accumulated detailed analysis of the fundamentals of each company both in our portfolio and their competitors, suppliers and customers in adjacent sectors.

Once it became apparent that the contagion would spill out of China into Europe and the US we had to decide how we would protect capital and pursue opportunities in a potential pandemic scenario. We evaluated 3 options.

Option 1: Go to cash and wait for the dust to settle
Cut your losses and go to cash is always the first option to consider. We discarded this option because we were confident all our accumulated work could be leveraged to build a short book that would protect our long investments. We also realized that a pandemic would impact different sectors in an asymmetric way.

Some companies were positioned to benefit from the pandemic. Figure 2 from the recent JP Morgan Chase earnings call shows that while sales of Supermarkets, wholesale clubs & discount stores accelerated after the
shelter-in-place orders took hold in the US, spend on T&E (Travel & Entertainment) virtually ground to halt with spending declines of almost -100% vs. the same period in 2019.

Debit and Credit Sales Volume Q12020

Figure 2
Source: JP Morgan Chase

 

One of my mentors repeatedly says: “Every problem is an opportunity!” We feel well equipped to hunt for the opportunities opened by this crisis. Our fundamental work allows us to identify which companies will thrive and which will get hurt by the pandemic spread and to position our investments accordingly.

Option 2: Follow the playbook of a previous crisis
We searched for potential parallel scenarios that could guide us through how this pandemic may spread and how it may impact consumer behavior and the economy. No previous crisis fits the bill, with the recent Ebola and SARS crises too small on their societal impacts, and the 2008 financial crisis fundamentally different on its causes and propagation mechanisms [1].

Besides reading on the Influenza pandemic of 1918, there is little more that history can assist in our analysis. The 1918 economy is very different from the current one.

Option 3: Company selection based on bottom-up, fundamental analysis
We chose to leverage our deep research to capture the emerging opportunities we see from the strong market dislocations. We found several great opportunities both on the long and the short sides.

At Somar we are very consumer focused. We start our analysis always from the eyes of the consumer: how does the world look to her? How do the  available competitive, substitute and complementary offers look to her? How is the consumer changing her behavior in light of the changing circumstances?

Do the changing company valuations capture the change in the consumer behavior that we observe? Are there attractive investment opportunities (either long or short) available? To find these opportunities our starting point is a detailed company analysis of its fundamentals, including competitive position, liquidity, management quality and valuation on a “business as usual” basis. We then layer additional considerations
to our model to account for the following:

  • How much is their industry likely to be impacted from COVID-19 both in the short and long term? Impact will not be uniform across industries. Some are virtually wiped out in the short term while on
    the other side of the spectrum some are actually benefitting from a strong rise in demand (see Fig 2).
  •  How flexible is the business in order to adapt to the new operating environment? For example, bricks and mortar retail, or lodging have limited ability to repurpose their fixed assets in the short term,
    while e-commerce retailers can keep operating and readily adapt their range to the consumer demand needs.
  • Is the COVID-19 and its ultimate resolution going to increase or decrease the company’s ability to offer a superior value to its customers vs. its competitors? Will COVID-19 cause weaker competitors to exit the market and therefore decrease competitive intensity and increase margins? Will the COVID-19 crisis cause customers to switch to substitute products on a temporary or permanent basis?
  • Does the company have adequate liquidity to see through a long interruption of their business from the COVID-19 crisis? What is the cash generation ability of the business in an adverse scenario? Can
    the company access the capital markets at attractive rates or at all? Can it access government sponsored bailout funding lines?
  • How leveraged is the company coming into the COVID-19 crisis? Highly levered companies have limited ability to play offense by investing in the business during the downturn. They may also be
    forced by their creditors to sell part of their operations to raise funds. Any sale during the recession is likely to be at a low valuation, hurting shareholder value. In the limit, the company may be forced to raise capital at very dilutive valuations or even file for chapter 11 protection.

We analyze these and other considerations and confirm our findings with their management teams and those of their competitors. We stay hungry for incoming information and continuously re-evaluate our conclusions based on incoming information.

 

All the best,

Pedro Ramos

 

***

[1] The 2008 Financial Crisis originated in the fall of US real estate prices which had raised to bubble levels. It was propagated through the failing of undercapitalized and highly levered financial vehicles and institutions. This constrained lending to the non-financial economy and launched the US economy into a deep recession. In 2020, the COVID-19 crisis finds a well-capitalized and sound financial system that is able to keep lending to the non-financial parts of the economy.

 

Disclaimer: This website is for general information purposes only and is not intended to be, nor should it be construed as investment advice, nor a solicitation or offer to buy or sell any securities, related financial instruments, or  interests in the Somar Master Fund, LP (the “Fund”) or its feeder funds. The information contained herein is not complete, and does not contain certain material information such as disclosures and risk factors about the Fund or its feeder funds. Opinions expressed are current opinions as of the date of this material only and are subject to change without notice.Hedge funds: (1) often engage in leveraging and other speculative investment practices that may increase the risk of investment loss; (2) can be highly illiquid; (3) are not required to provide periodic pricing or valuation information to investors; (4) may involve complex tax structures and delays in distributing important tax information; (5) are not subject to the same regulatory requirements as mutual funds; and (6) often charge high fees.

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