February 2nd, 2020

While some well-known large fund managers and medical experts have commented the coronavirus will pass, as does the flu, there will undoubtedly be a long-term impact to corporate decision-making, future free cash generation, credit, and cost of capital. This new deadly virus comes not long after SARS, and so the second important health risk out of China must be weighed, especially as expatriate firms typically set up factories in low cost areas where health outbreaks are more likely.

While some sectors are particularly sensitive to China, almost every large firm will feel some effect. To ignore health-related risks is to understate true cost of capital.

As you know, our portfolio accentuates structurally strong firms seeing normalized real growth in free cash flows, coincident with an adjusted return on capital safely above cost. And so, a year’s shortfall in the otherwise expected free cash flows has a lower than benchmark impact to its long-term current fair value.

Indeed, for the average firm in our portfolio, about 80% of its current fair value is comprised of free cash flows 6 years and out, meaning consistency is a central element of our philosophy, with cash flows more evenly spread. A year’s shortfall in the current year should have about a 2.2% (firm dependent) weight to share price. If the free cash flow were to be recouped, so would market valuation. Shareholders, we see time and time again, exaggerate shortfalls, including those firms with growth in key metrics.
Tesla, to cite a contrary example, due to its higher cost of equity alongside more uncertain cash flows further in time, should see a larger drop in its share valuation if it were to underachieve.
We so prefer the “bird in the hand.”

There are six impactful financial areas of note regarding the coronavirus:

1. Current supply chain-Several large Chinese cities are in effect, shut down, with most large firms haven taken actions to curtail or shutter units. Ports are reporting lower volumes.

Should the virus continue to spread, the effect on both cash flow and credit would certainly be impacted should firms not be able to shift resources. Most firms in the portfolio have, to the extent possible, been diversifying out of China. Our technology related firms, due to the trade conflict, have seen a China “hit” and, off the new base, have been forecasting real growth going forward, being leading-edge on the precipice of 5G. This latest issue could cause additional short-term pressure for the sector given constraints on current supply chain.

2. Future supply chain-The coronavirus will undoubtedly force firms to step up their diversification programs, including customers and supply chain, impacting short-term expense yet reducing longer-term risk. Labor, component and assembly, transportation, pension, tax, cost of hedging, and insurance will feel the brunt. Each firm must be individually studied as to cost and sales relations.
3. Valuation multiple-The virus is impacting, for reasons cited, valuation multiples. The contraction influences firm credit, depending on need to raise capital to tax and cash flow implications.

4. Impact to revenue-This is complex depending on whether sales are customer direct, intermediate or postponed. To the extent consumers reign in current purchasing, sales, employment, and capital spending would be impacted.

5. Impact to credit-Should the virus linger, Boards would halt their stock repurchase programs and perhaps draw on existing lines. Cost of capital would thusly be affected.
6. Increase in trade friction with China-It is conceivable China could claim the virus has passed, yet the US may want a prophylactic period or further proof. This could alienate the Chinese who might then threaten to raise tariffs or refuse to buy goods promised under the phase 1 deal. Firms are also getting tired of Chinese threats.

So, given the above what are we doing?

We are monitoring at this stage, yet expect our firms, regardless of their sector, historical results or prospective expectations, to take measures in furtherance of diversity of the various layers out of China.
We have long recognized the China risk and have so written in the past.
We hope the Congress will practice the “shoe on the other foot” approach, and like China, support the nation’s leading-edge industries. As plainly evidenced, China provides wide support to the likes of Huawei, and the US must do likewise.

Kenneth Hackel, CFA
Eli Hackel, CFA

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