As the COVID-19 pandemic hits global economies, equity investors are redoubling their focus on corporate resilience. But what does resilience mean in the current context – and which companies have it?
The coronavirus pandemic has roiled markets and disrupted business models around the world. One consequence of the crisis has been a renewed focus on what makes a company resilient: from the size of its debts to the consistency of its revenue streams.
But resilience is not a static quality. What it means to be resilient will shift under different market conditions, argues Mikhail Zverev, head of global equities at Aviva Investors.
“You need to ask the question: ‘resilient to what?’,” he says. “Like ‘quality’, ‘resilience’ may sound like an absolute concept, but it depends on context. Whether the risk is a theoretical black swan or a clear and present danger, equity investors need to look at a company’s capacity to respond and adapt to change.”
Winners and losers
In the current environment, a firm’s resilience will depend on the interplay between the fundamentals of the business and the fast-changing dynamics of economic activity and consumer behaviour amid severe coronavirus-related disruption.
Clear winners and losers have emerged in the early stages of the crisis. With global tourism effectively grinding to halt, the travel and leisure sector – airlines, hotels, casinos, cruise liners, and events – has been severely impacted. By contrast, software companies have benefited from the rise in demand for streaming and networking platforms during lockdowns.
While investors cannot have been expected to predict the onset of the pandemic, they should have been able to spot underlying vulnerabilities in the worst-hit sectors. Travel and leisure was already far from resilient: in mid-2019, a KPMG report found almost 12 per cent of UK companies in this sector could be categorised as “zombie” firms, with static or falling turnover, low profitability, squeezed margins, limited cash reserves and high leverage. Faced with such pressures, these weaker firms had little capacity to invest in the new products or equipment that might have enabled them to adapt to a changed market environment.1
Similarly, independent US oil producers were fragile before the recent collapse in energy prices. Many companies were already highly leveraged and dependent on high oil prices to function; it would not have taken a crisis on the scale of COVID-19 to tip them into trouble.
Balance sheets and cash buffers
The troubles in these sectors serve to highlight the importance of strong balance sheets and manageable debt loads. The stock market has been particularly swift to punish companies whose debt includes covenants that would be triggered by a sharp decline in revenues, forcing them to raise equity.
“If a company has a lot of debt – especially debt with covenants attached – and its revenues have fallen to near zero, then its equity will have performed extremely poorly during the crisis,” says Giles Parkinson, global equities fund manager at Aviva Investors.
“Even without the asymmetry of triggering covenants, debt magnifies outcomes. Some regulated utilities, such as UK water stocks, despite being ‘defensive’ businesses, have fallen with the market during the selloff. This is because the high level of debt in their capital structure makes their equities more sensitive to small changes in the overall value of the enterprise,” he adds.
Dominant firms are more likely to be able to sustain themselves during the downturn
By contrast, large, dominant firms are more likely to be able to sustain themselves during the downturn, as they tend to retain access to debt markets at affordable rates, enabling them to roll over existing liabilities when needed.
Stronger still will be those firms that have amassed huge cash buffers in recent years. Tech giant Apple, for example, is sitting on a cash mountain of more than $200 billion, which means it should be able to continue investing in staff, marketing and valuable research and development initiatives during the pandemic – and potentially snap up enfeebled rivals when opportunities arise.
A recent study collated data on companies’ debt-insurance costs, leverage levels and cash buffers to create a league table of the most resilient global companies. Tech and pharmaceutical behemoths dominated the list. Along with Apple, Microsoft (with a cash buffer of $134 billion, or 40 per cent of revenue); Facebook ($55 billion, 51 per cent of revenue) and Alphabet ($120 billion, 34 per cent of revenue) scored highly.2
Supply chains: From efficiency to resilience?
Companies need more than just cash buffers and strong balance sheets to survive a crisis, however, and equity investors are closely scrutinising the impact on supply chains. Consider the share prices of US-based food and ingredients suppliers such as Lamb Weston and Kerry Group, for example, which have fallen sharply in recent months as customers such as McDonald’s close their restaurants during lockdown.
Alistair Way, Aviva Investors’ head of emerging market equities, says it is especially important for investors to monitor the status of international supply chains given the wide disparity in the severity of the pandemic – and government responses to it – across different countries and regions.
“Investors need to ensure companies they invest in have balance sheets, cash flows and capital expenditure commitments that are strong and flexible enough to cope with the massive revenue hit. But they also need to look at supply chains,” he says. “A diverse set of customers and suppliers can help companies withstand sudden shocks.”
Way cites China-based Apple supplier Hon Hai as an example of a company that has taken care to ensure its customer base is properly diversified. Hon Hai’s core business – assembly of Apple’s iPhones – may be vulnerable if demand for consumer gadgets slumps. But the company also make telecoms infrastructure, servers and medical equipment, thanks to a concerted effort by its management to increase the scope of its business in recent years. “This strategy now looks spot on,” says Way.
Companies with complex supply chains are still grappling with the immediate impact of the pandemic
Companies with complex supply chains are still grappling with the immediate impact of the pandemic, and the longer-term implications are yet to become clear. But it is possible the “just-in-time” supply chain model that became the norm during the boom years of globalisation may give way to a more conservative “just-in-case” approach as the pandemic recedes, as companies seek to build larger inventories to ensure they are resilient against sudden shocks.
“Two recent events – the trade war between the US and China, which is far from over, and now this pandemic –have reminded people that global supply chains are not always reliable,” says Zverev.
“Companies in the tech sector are taking the view that if demand returns to normal – at a time when highly complex supply chains are still liable to malfunction – they need to build inventory. Firms in the semiconductor industry have already started building up inventories in the expectation demand will bounce back. This may be a transitory phenomenon, but it’s an interesting development investors should keep an eye on,” he adds.
ESG: A key to corporate resilience
Attention to environmental, social and governance (ESG) factors is another key component of resilience. No company that ignores ESG risks can be described as resilient, when climate change poses a looming, existential threat to business models everywhere.
Better-managed, ESG-conscious companies will also have been more resilient to the specific risks associated with COVID-19, such as vulnerabilities in supply chains. This is because such firms tend to take a more careful and holistic view of their operations and those of the companies they are associated with, according to Jaimie Ramos Martin, global equities fund manager at Aviva Investors.
“Companies that are leaders in ESG are focusing on the resilience and sustainability of their business models,” he says. “Take supply-chain management: in order to be a leader in ESG, companies would have needed to better understand the carbon footprints and labour practices of their suppliers, which will have prepared them for the disruption when COVID-19 hit.”
Over the medium term, governments may seek to allocate stimulus packages on the basis of a company’s track record on climate change, says Martin, which is likely to benefit businesses with stronger ESG credentials (although it is also possible that environmental issues may drop down the list of priorities as policymakers seek to kick-start economic growth in the short term).
What seems certain is that government support for the private sector during the crisis will lead to a renewed focus on social responsibility among policymakers and the public. Aggressive tax avoidance, poor labour and community relations and a substandard environmental record will be harder to defend in a world that has suffered through the collective hardship of COVID-19; companies that have demonstrated they are willing to do the right thing are more likely to retain the loyalty of their staff and customers.
Parkinson says it is important for equity investors to keep track of these kinds of qualitative measures – and take steps to improve them through engagement with company management teams – as they assess the resilience of their portfolios.
Such factors are also important determinants of value. Whereas quantitative factors can be plugged into a Bloomberg terminal and tend to be quickly arbitraged away, qualitative metrics like corporate behaviour are more difficult to assess, and therefore more rewarding for investors willing to do their due diligence.
During the last financial crisis some companies emerged stronger relative to their competitors because they adapted quickly
“Some company executives have pledged to take a salary cut during the crisis; others have extended support to their customers and suppliers. The effects of this may last beyond the pandemic. We saw during the last financial crisis that some companies emerged stronger relative to their competitors because they adapted quickly, continued to innovate and maintain customer relationships, grew market share, and expanded their competitive advantages,” says Parkinson.
Investing on the right side of change
COVID-19 reveals a business tension between efficiency and resilience that has been gnawing away at corporate behaviour for some time. The tension between short-term profit maximisation and long-term success also highlights resilience is not an immutable quality, but a set of characteristics that shifts depending on the market and social environment. A recent McKinsey study tracked how 1,000 publicly traded companies fared during successive crises: it found an ability to nimbly adapt to new conditions was a hallmark of the best-performing firms.3
This ability to adapt can take many forms but a few recurring factors stand out. First is people; flexible, skilled and loyal staff add to a company’s adaptability and resilience. Second is diversification, both in terms of customers and supply chains. Third is cash; having a large war chest improves a company’s chances of withstanding pressure during a crisis. Fourth is culture; a strong management team that is open to change and willing to make tough, but socially responsible, decisions can significantly enhance a company’s reputation and bottom line. Together, these elements can create a resilient business.
However, with such profound changes to society and the corporate world inevitable in the wake of COVID-19, openness and ability to change might have the most influence in separating the weak from the strong. From the increase in home working to rising demand for cashless payments and cutting-edge medical equipment, resilient companies will already be thinking about how they can adapt and respond.
For investors, this may open up opportunities to spot which firms are likely to thrive in the post-COVID era. At these kinds of inflection points, investors tend to overlook the early signs of corporate repositioning, Zverev argues.
“You need to think about resilience in the context of change,” he says. “Change works both ways; it can be an opportunity and a threat. This is because change creates inefficiency. When something is changing in a business, when the future isn’t equal to the past, the market is more likely to misunderstand and misprice it, because when investors can’t continue to extrapolate from the past, they have to work harder to connect the dots.”