By Francesco Curto, Head of Research House, DWS
As an equity investor, you are the owner of a small part of a company. You provide capital, and expect a return. This is fine in normal times, but, when businesses come under strain, then the risk is that a company may need support, often by turning to you and asking for more cash. And, as you reach into your pockets, you may not be enamored of the request, but you might also reflect that the alternative is worse. You may lose the entire value of your investment. It is a “between a rock and a hard place” situation, but, if it enables the company to continue to operate, then it’s potentially better than that alternative. At this point, the onus is on management to prove that the company has a long run future, that this request won’t become habitual, and that you’ll eventually see the money returned in some form.
With the pervasive and deep impact that the covid virus is having on economic activity, we may soon be at that throat-clearing moment when management teams have to test the loyalty of their owners, and broach the topic of this so-called “dilution risk”. However, in a fascinating follow up to a piece that our CROCI team published a few weeks ago (History Lesson I: Why Do Markets Selloff and then Rebound), there is some evidence to suggest that the market may prove a little more resilient this time around, and there are at least three good reasons for believing that (see the full report, History lesson II: Estimating the dilution from a COVID-19 recession for equity investors).
In thinking about this, the team established two scenarios, the first a repeat of something similar to the Financial Crisis of 2008/09, and, the second, an even worse outcome of a three standard deviation move, effectively designed to represent a one time in 100 years event. Now, to be clear, we are not forecasting that we are squarely in that latter world (at least not yet). In fact, current dynamics suggest that even if economically this will be a worse recession than in 2009, the impact on corporates may be in line with what we saw in 2009. Still, building such a scenario represents the type of rigorous stress test for equities that can help to glean some powerful insights.
To assess such risks, the team distinguishes companies into two groups – bricks and sponges – based on their ability to ‘absorb’ the impact of an economic shock. “Sponges” are companies that have ample room to maneuver to absorb shocks without capital raises. “Bricks” represent companies that might break under economic strain.
The team argues that there is scope for optimism as (i) traditional companies in the nonfinancial part of the market have increased their level of flexibility (they are more like sponges), (ii) companies with high level of intellectual capital have high flexibility, and (iii) banks are much better capitalized than in the past.
The increased sponginess of traditional businesses
Looking at Figure One, two points stand out. The first is the sharp bounce backs in free cash flows that firms have been able to achieve following prior “capital eroding” episodes in markets. And, the second point is the upward trend in the chart. If one thinks of this ratio as an economic shock absorber, then the fact that companies have become more adept at crisis management, along with the realization that global equity investors hold this basket of sponges, should provide cause for a glimmer of optimism during these turbulent times. In fact, the team estimate that for this group there was no need to raise capital at an aggregate level in 2009.
Figure One: Free Cash Flow to Sales over Time
Source: DWS, CROCI. The Chart shows after tax free cash flow to sales of companies for which CROCI has comparable data going back to 1989. Data as available on 9 April 2020. For illustrative purposes only, past performance is no guarantee of future results.
The rise of the intangible economy
The intangible economy is playing a growing role in today’s equity markets. Companies’ business models today are less based on hard assets (factories, machinery, and real estate) but, increasingly, on intangible capital (R&D, and brands). This reduces capital intensity. Figure Two clearly demonstrates some of the inherent advantages. Note the higher margins, stronger cash flows, and lower indebtedness that companies can achieve by operating in this more fluid manner. All this combines to make them less prone to be affected by crises.
Figure Two: Operating Characteristics of companies with and without Intellectual Capital (IC) assets
| 2019 | IC | Ex. IC |
|---|---|---|
| EBITDA Margin | 20.3% | 16.8% |
| R&D / Sales | 6.5% | 0.0% |
| Capex to Sales | 7.7% | 9.5% |
| FCF / Sales (post tax) | 9.9% | 4.8% |
| Dividend to Sales | 5.4% | 3.4% |
| Net Financial Liab. / M. Cap | 19.1% | 53.7% |
Source: DWS, CROCI. The table shows selected operational characteristics of non-financial companies with and without Intellectual Capital assets that are covered by CROCI. Aggregate 2019 data as available on 15 April 2020.
Bricks are on average better capitalized
So much for the sponges, what then are the bricks? Well the main area of concern that the team identifies is in the banking sector. And, the argument is that, with their relatively high, and fixed, cost structure, and the leverage which they employ in order to drive their profitability (recall that leverage can be used to boost the Return on Equity) banks are not well placed to withstand economic shocks as easily as the sponges described above. Indeed higher leverage necessarily means more risk on the balance sheet, and a greater chance that an already quite slim equity buffer can be depleted. That would leave banks needing to rebuild their balance sheets with the help of willing shareholders (or via government intervention as we saw in some countries in the financial crisis).
The team goes on to describe how banks in the U.S. might look under their two scenarios, and why they are relatively more concerned about the situation for financial companies in Europe, and in Japan. However, as a result of the significant increases in capital post the 2009 crisis, banks are better equipped to sustain the strain of an economic crisis then they might have been.
All good but expect some pain on the dividend front
Companies have been quick to react to this crisis, and to save the pain of needing to go and ask for additional capital from their shareholders. But that means investors ought to expect lower dividend payments and stock buybacks. Partly this will be due to regulatory mandate, where we have already seen the central banks in Europe and the UK insist, or request (which may be the same thing when it comes to a central bank), that the banks they oversee stop returning capital to shareholders (the Fed hasn’t insisted yet, but we note that some U.S. banks have halted their buybacks voluntarily). And, partly, it will simply be common sense, or necessity, that firms will need to retain capital to prioritize the rebuilding of their balance sheets. Figure Three shows our expectations for such dividend cuts under the two scenarios outlined above.
Figure Three: DWS Research Institute’s expectations of dividend cuts
| Scen. 1 | Scen. 2 | |
|---|---|---|
| S&P 500 | -16% | -42% |
| MSCI Europe | -34% | -54% |
| MSCI Japan | -16% | -56% |
Source: DWS, CROCI. The table shows DWS Research Institute’s expectations of dividend cuts under the two scenarios. These estimates are relative to the trailing twelve months dividend per shares figures for these two indices as available on 15 April 2020. For Illustrative purposes only. Due to various risks, uncertainties and assumptions made in our analysis, actual events or results or the actual performance of the markets covered may differ materially from those described.
So some pain is required, but not as much as one would have expected. If interested in learning more, I invite readers to engage with the full report – it’s a fascinating read.