Watchlist review

It’s been a wild few weeks in the markets. My response has been less wild, and has mainly been an attempt to review the companies on my shopping list to try to ascertain what the impact of COVID-19 might be on these companies. It’s not just a matter of what might happen over the next few weeks, but whenever we get past this virus, what sort of shape these businesses are going to be in.

Assuming we have another year or so before a vaccine is available to make COVID-19 go away, the intervening period could involve various business disruption, social distancing, further lockdown measures, and public testing protocols. So when I’m considering making a purchase, I now need to think about how the business in which I’m investing is going to make it through this? Part of my review over the past few weeks was to look through my preferred list and ask myself some questions:

• how has the company management responded to the crisis?
• are they still making money today?
• will they still be taking in cash throughout this crisis, even if cash flows are disrupted?
• how will multiple waves of infection affect them?
• how will public testing protocols affect them?

As an example, Greggs, the low key tasty pastry seller, has quietly been making investors very happy over the past few years. It’s been churning out great results, keeping a really simple business, just rolling out more of it. They are currently closed and making zero revenue. They went into the crisis with no debt, as of 9^th April had £47m in cash and were taking up the Government offers of support, so will very likely still be operational once we all emerge from our homes. They are likely to serve up tasty grub to millions of punters once again, and the management team have acted and communicated clearly. But what will be the cost of being closed for the length of time that they are required to do so? What is the impact on their finances, staff, suppliers & partners. How would they manage getting customers into their stores after lockdown - if we all have to wear masks, do they think customers would just pop up the mask to take a bite of their sausage roll? Will they test each customer before letting them into the shop? The impact and cost is unknown, so for me it makes investing in such a company very difficult.

Rightmove is (was?) another business on my shortlist. An incredible investment with operating numbers off the charts and a genuine moat. On 18^th March they stated they would defer part of their subscription for up to 6 months for some estate agents, had a strong balance sheet, but were not buying back shares (revealing the flawed logic in shared buybacks – if now wasn’t a good time when would be?). 2 days later another announcement stated that they would reduce their subscription fees by 75% for 4 months, which superseded the deferment offer. 7 days later another statement cancels the dividend. A company that has looked so astute, suddenly looks indecisive, dithering and panicked. The extent to which they make it through this in a position of strength is largely dependent on the survival of the estate agents and their subscriptions – so why ask them to pay anything if the Rightmove balance sheet is so strong. A strange series of statements that do little to endorse the management of the business, just when you need clear heads.

Admiral insurance as a 3rd example – the share price has hardly moved over the past few weeks. Amazingly resilient share price – doesn't seem to give a monkey's about COVID-19.

There are no answers to any of this, markets may get cut in half, or may surge to new highs. It’s difficult to work out if share price falls constitute bargains or not. After all if businesses are making less money, and the share price has dropped by an equivalent amount, the value of the business has arguably stayed the same.

Using Price to Earnings (P/E) values as a short hand for valuation:

Price = 150

Earnings = 10

P/E = 15

With a 20% reduction to price

Price = 120

With a 20% reduction to earnings

Earnings = 8

PE = 15

In other words the valuation is unchanged.

To flip the P/E into the earnings yield (E/P - earnings divided by price) we can show the same as the above:

Price = 150

Earnings = 10

Yield (E/P) = 6.7%

With a 20% reduction:

Price = 120

Earnings = 8

Yield (E/P) = 6.7%

Valuations are unchanged.

The problem is most companies don't know what impact the measures to inhibit the spread of the virus will have on them.

What adds to the madness is not knowing what is supposed to be baked into the share price. If it is supposed to be all future discounted cash flows, losing a quarter or two of earnings shouldn’t make much difference, so why the large moves in share prices?

Taking a simple approach to the Rightmove example above, the reduction in fees will apparently lead to a £65m - £75m cut in revenue for 2019. They made £289m in revenue in the prior year, taking the midpoint of the revenue impact as £70m, leaves us with around a 24% drop in revenue. The share price dropped over 40% from mid February to the low on the 23^rd March, the cancelled 4.4p dividend would only have accounted for a small % of the loss (the share price dropped to around 400p – equating to cancelling a 1% payout). It looks as if the market is pricing in bad news for Rightmove, is it a margin of safety? As noted above the condition in which the business comes through this is predominantly about their customers, it’s not something that Rightmove control. This makes it very hard to invest into.

Banging a few numbers into spreadsheets to get some back of the envelope calculations has helped, but it has also been useful to revisit these companies and try to think through not only will they survive, but in what shape. It’s certainly led to some movement on the shopping list, with a few companies being removed completely. Strange times.