It is not too soon to start imagining a post-virus world. At some point, this will pass into the history books. For now, personal survivability is paramount until whenever that day comes. Surviving means doing everything possible to stay physically healthy. The investing analog holds as well — the key for investors now is corporate survivability. We believe now is the time to play it safe, focus on quality, and avoid buying low-quality, cheap stocks.

Bad News Ahead

The next phase will be full of bad news about the economy. Last week’s 3.25 million weekly unemployment insurance claims report is a taste of what is likely to come. This week’s March employment report and various purchasing managers’ surveys should be abysmal. An early forecast of the WCA Fundamental Conditions Index puts it at levels not seen since 2008 (chart, below). How could we expect better? Vast swaths of the economic landscape are entirely dark and shuttered. Most now accept that a sharp and sudden recession is upon us.

The WCA Fundamental Conditions Barometer Preliminary Forecast

How Long? How Much?

While most seem to understand a recession is here, a wide range of views exists about the nature of the downturn. Some see a short and sharp contraction followed by a fast and full bounce back. For example, James Bullard, St. Louis Federal Reserve President, last week predicted that “after an unparalleled shock, the economy will boom again.” Others see the risk of a severe and protracted recession. The collapse in GDP, a potential financial crisis, damaged confidence, and the possibility of a “second wave” are all concerns.

We tend to fall somewhere in the middle of these two extremes. There has been a significant monetary and fiscal response and a great deal of vested interests in getting the economy open again. However, the size of the shock and other complicating factors suggest it probably takes more than a few months to get all the way back. If it takes more than a couple of months to fully recover, owning quality and durable businesses will be the best way to play it safe.

Quality at Better Prices

The market is looking to play it safe too. We know this because stocks of companies with below-average debt and above-average profitability are doing better. Companies with above-average debt and below-average profitability are doing worse. We calculated the mean return of low-debt / high-profit Russell 1000 companies since February 19. Those stocks are down an average of 25% through Friday. The higher-debt / lower-profit firms posted an average decline of 40%. As uncertainty mounts, the market seems to be favoring safety as we define it.

A Growing Debt Concern

The last month’s worst performing S&P sectors were energy (-36%), financials (-21%), industrials (-19%), and REITs (-19%). Each of these sectors has significant debt and exposure to global growth. Recessions and bear markets hurt household finances, and increase default risk for loans and mortgages. Owning heavily indebted and highly cyclical stocks is an aggressive and risky proposition when business is interrupted.

More rating downgrades are likely for corporations after a decade of rapid borrowing and a deteriorating average credit profile. A recent Reuters article offers a few interesting points:

Downgrade Doom Looms for Coronavirus-Hit Firms and Markets
Reuters (March 20, 2020)

Rapid Global Corporate Debt Growth
Global corporate debt rose by 50% since 2008 to over $70 trillion
More Lower-Grade Debt
The share of bond issuers with the lowest investment grade rating — BBB for S&P and Fitch or Baa3 for Moody’s — has risen to around 45% in Europe from around 14% in 2000, and to 36% in the United States from 29%, according to the Bank of International Settlements.
Questions About Quality
Ed Altman, who created the Altman Z-Score to sniff out companies in financial distress, examined 350 BBB-rated U.S. companies as of the end of 2019. His research indicated that more than 30% of those companies, with $600 billion or more of bonds, should have been rated “junk.”

Credit Rating Agencies Warn

In anticipation of rising defaults, Moody’s Investor Service released a revised estimate of defaults. They now estimate that speculative-grade defaults could rise to 6.8% over the next 12 months if there is a “short and sharp” recession. Under a “severe” recession case, they estimate the default rate could reach 20.8%. The speculative grade default rate was 3.1% in February before the coronavirus crisis hit the United States.

The Other Side

We don’t know how this will play out, but we will “hope for the best” while we “prepare for the worst.” The key here is to play it safe and look for companies that can survive difficult times. Therefore, we focus on owning companies with lower debt, good pre-virus profitability, and consistent cash flows. We can find many good-quality stocks at better prices today than a few months ago. These are the principles of WCAs Victory and Rising Dividend equity strategies.

Someday, when this all passes, we will say we played it safe by focusing first on quality and durability.

Kevin R. Caron, CFA
Senior Portfolio Manager
973-549-4051

Chad Morganlander
Senior Portfolio Manager
973-549-4052

Matthew Battipaglia
Portfolio Manager
973-549-4047

Steve Lerit, CFA
Senior Risk Manager
973-549-4028

Tom Serzan
Analyst
973-549-4335

Suzanne Ashley
Internal Relationship Manager
973-549-4168

Eric Needham
Director, External Sales and Marketing
312-771-6010

Jeffrey Battipaglia
Client Portfolio Manager
973-549-4031

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The information contained herein has been prepared from sources believed to be reliable but is not guaranteed by us and is not a complete summary or statement of all available data, nor is it considered an offer to buy or sell any securities referred to herein. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. There is no guarantee that the figures or opinions forecast in this report will be realized or achieved. Employees of Stifel, Nicolaus & Company, Incorporated or its affiliates may, at times, release written or oral commentary, technical analysis, or trading strategies that differ from the opinions expressed within. Past performance is no guarantee of future results. Indices are unmanaged, and you cannot invest directly in an index.

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To Play it Safe

Bad News Ahead

How Long? How Much?

Quality at Better Prices

A Growing Debt Concern

Credit Rating Agencies Warn

The Other Side

Recent Commentaries

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