Crisis Investing – Where to hunt?

After the brutal, but not completely irrational, crash across the global indices in the past two months and along with very high volatility, there is widespread pessimism and negative investor sentiment. This was precipitated by the realization that depressing the economy was the only way to contain COVID-19 pandemic.

The equity market and economies across globe will return back to normal like numerous instances in the past but given the fact that it is fundamentally different from previous crashes, it may take seven months or maybe seven years.

Following is the history of the S&P 500 since its inception and identified all instances when the market fell more than 20% below a prior all-time high. From the point of a prior all-time high, the median time until recovery was 645 days. The shortest time was 212 days and the longest 2,423 days. The current bear market took just a few days to arrive. By a very big margin, this is the fastest bear market in history. The recovery can be swift as well.

What stays strong is the first one to bounce back:

The implication is that it will take time to get back to normal and for people to come back to their senses, and when they do, the recovery will be as swift.

There is a belief that what stays strong during the crash is the first one to bounce back and Kumar Saurabh sir did an interesting and insightful analysis on India equity market regarding the same, studying the 2008 GFC crisis.

During the 2008 GFC crisis, out of the total companies, only 2.6% of the companies i.e. just 26 companies fell less than 40%. Nearly 85% of the companies fell more than 60% and almost half of the companies fell more than 80%.

If you held the stocks which fell less than 40%, even at the peak of the 2007 bull run, you would have made decent 25-30% CAGR in the next 3-4 years.

On the other hand, the companies which fell more than 60%, generated -17% to 1% in the next 3-4 years and this universe comprises nearly 85% of the companies. Basically, if you were not part of the top 15% of stocks universe and held stocks at peak of 2007, then, the next 3-4 years return would be zero, rather negative, on a generalized basis.

There would be outliers for sure, but the important lesson is to understand why stock-picking is an extremely difficult task and a very small percentage of stocks will be responsible for nearly all of the returns you get.

Contemporary COVID-19 crisis:

We did an analysis of the meltdown in the last two months for the companies having market cap more than 1000 crores as on 25th March 2020 and there were some intriguing points and observations.

For the 514 companies having market cap more than 1000 crores, the average drawdown was 37% between 1st February and 25th March. Smaller the market cap, larger the drawdown with companies having the market cap between 1000-5000 crores falling on an average -41.6% and the companies having market cap between 5000-20000 crores and the companies having market cap more than 20000 crores falling on an average -35.4% and -29.8% respectively.

Drawdown Distribution:

Only 12.6% of the companies have fallen less than 20% or generated positive return and on the other hand, only 5.3% of the companies have fallen more than 60%.

Though the decline is swift it is nowhere near the 2008 crisis in terms of steepness. However, if we compare the crisis of 2008 with the cumulative fall from 2018 to 2020 across the market cap categories, then it becomes worse than the 2008 crisis.

What is resilient and what is vulnerable?

The decline in the stocks has a strong correlation with Return on capital employed and Leverage: 1) High the median RoCE across the category, lower the decline and vice versa. 2) Lower the median leverage across the category, lower the decline and vice versa.

One interesting point to consider is that companies with higher median sales growth in the past 3 years have fallen much more than companies with lower median sales growth. The reason is that companies with high sales growth have much lower RoCE and higher debt to equity relative to companies with lower sales growth.

Value creation is the function of growth and spread of return on capital over the cost of capital. If the company has high growth and RoCE is lower than CoC, it will destroy wealth.

To study more on this subject, I will recommend you to read: Safal Niveshak: RoCE-Growth Matrix, and Few Potential Wealth Creators and Michael Mauboussin research paper: What Does a Price-Earnings Multiple Mean?

We have done this analysis of the drawdown across the market cap categories as follows:

Companies with the market cap more than 20000 crores:

Companies with the market cap between 5000 to 20000 crores:

Companies with the market cap between 1000 to 5000 crores:

There is a strong correlation of higher RoCE and lower leverage with a lower decline for the companies with the market cap more than 5000 crores. However, the same is not completely true for the companies with the market cap between 1000 to 5000 crores.

There can be possibly two reasons for the same: 1) the profitability for the companies will get affected severely following the crisis and lockdown 2) there are mispriced opportunities. Of the 122 companies which have fallen between 40% to 60%, 66 companies are quoting at a single-digit price to earnings multiple.

Idea generation: where to hunt?

As discussed before, during the 2008 GFC crisis, the companies which stayed strong were the first once to bounce back. Similarly, let us see to which sectors the companies which have fallen less than 20% belong.

Almost one-third of the companies belong to pharmaceuticals from the universe and nearly 50% of the companies belong to pharmaceuticals, consumer non-durables and chemical sector.

Following is the list of the companies which has fallen less than 20%:

Following is the list of the companies which has fallen more than 40% with the last 10 years average RoCE > 15%, Debt to equity < 0.5 and the last 3 years sales growth more than 10%:

Finding the list of these companies is the first step of the investing process and not the last step. This kind of screens can give us a small set of companies on which one can do detailed qualitative research. For all the novice investors like me, these may be a good list of companies to do detailed qualitative research instead of searching out for multi-baggers or playing cycles.

By the time, I write this blog the Nifty Pharma Index is up nearly 40% from the lows of 23rd March. Happy Investing!