What Will the COVID Crisis Affect?

"To finish first, you must first finish" is a motto that comes to mind in the current war with the invisible COVID enemy. As the US rolls out $2 trillion in support along with the Fed's full arsenal of financial weapons, it is clear that the US will survive and better days lie ahead.

However, every crisis has its consequences - some obvious and some unclear. This one started out notably as people claimed that wealthy people were buying stocks while poor people were buying toilet paper. I hope that the behaviors of the wealthy are not as misguided as those of the poor.

It does seem to me that one of the remarkable difference between the Spanish Flu virus of 1918 and the COVID virus is that today's world is connected by debt. At the time of the Spanish Flu virus, the economies of the world did not use debt as its lifeblood, thus limiting the daisy chain effect financially. The US has created support to minimize financial disruption, but are there any likely to be seriously hurt in the long run?

It appears to me that highly leveraged structures are the most likely to experience long-term harm as their funding is disrupted and likely to bear an enduring risk premium. Second, it appears that those structures which rely on subprime buyers are most affected. We had temporarily experienced the highest rate of employment and these new marginal workers were spending and borrowing. Third, it appears that the current crisis is delineating between "luxury" and "necessary" due to huge governmental support.

Despite Neiman-Marcus's likely bankruptcy as an example of funding costs rising and a "luxury" area, the challenges of Signet Jewelers who finance jewelry for subprime borrowers is an even more perfect example of those likely to have the worst business outcome.

Private Equitying To Zero Profits

Downtown Neiman Marcus has been an landmark institution. Over Thanksgiving holiday, I took my family to lunch at the downtown Dallas location to enjoy the famous strawberry butter and popovers as well as the excellent old-timey service. On the way out, we got to enjoy the Christmas cheer. But we, like so many others apparently, did more looking than shopping.

The news today that Neiman Marcus is in talks to file bankruptcy associated with the $4.3 billion in debt is sad. The debt piled up as one leveraged buyout from a private equity fund purchased out another leveraged buyout from another private equity fund. Hefty sums were spent on various fees rather than reinvesting in a storied brand that created shopping as an experience. Some of the past behaviors to the creditors of Neiman Marcus is telling:

(From Grant's Interest Rate Observer) "The department store controversy started in March 2017 when Neiman redesignated its prized online business MyTheresa and other properties as unrestricted subsidiaries, meaning they were out of the creditors’ reach. On Sept. 18, management presented them to the equity owners, Ares Management L.P. and Canadian Pension Plan Investment Board. Such slick dealing has become commonplace in the private-equity world." The article goes on to describe various shenanigans and today's announcement is the logical result. Will the current crisis wake creditors up to the perils of private equity?

Investments as Organisms

Over time, I have reflected on questions such as, "over the long run, what makes equities the best asset class (over bonds and real estate)?" and "over the long run, what equities are the best to own?"

Increasingly, I am taking a biological answer to most of my questions. It appears that equities offer the best asset class returns because of their inherent adaptability. Equities are able to repurpose their physical, human and financial capital more easily than real estate and bonds. For this reason, equities are inherently more uncertain. Berkshire Hathaway (BRK) comes to mind as a company which continually reinvents itself to a degree that almost defies categorization. The result has been much better than if BRK had stayed with its original New England textile focus.

Generally speaking, this adaptability speaks to the importance of low leverage. Debt introduces reduced adaptability, forcing commitments to those most immediately relevant. As a result, little capacity exists to make significant change. Like living organisms with strict dietary requirements, companies with high debt levels are incapable of exploring new opportunities.

At the same time, investors hate this kind of radical adaptability. All too often, investors have seen managements play gin rummy in an impatient and capital destructive way. But the more critical issue seems to be one of managerial competence. It is difficult to argue that competence in retailing would lend itself to competence in finance.

With today's low interest rates and technology disruptions, the rate of change is accelerating. When Philip Morris announces that it is focusing on a "smoke-free world" and BP is focusing on getting away from oil and Nestle is focusing on moving away from food into nutrition, I am seeing more indications of what makes these organisms strong - a willingness to adapt and an ability to suffer.

A Tale of Two Systems: who fares better?

The emergence of the coronavirus highlights the fragility of our systems. As we create more cooperation and interdependence, fragility increases. At the same time, our systems have protective characteristics. In this, I am interested to watch the approach of autocratic versus democratic systems.

The Chinese system has exercised autocratic power in addressing its virus exposure. At first, it began with denial and forcibly shut down addressing the virus. As the Chinese leadership saw the rapid emergence, it vigorously enforced a quarantine - effectively creating the "social distance" required for addressing a contagious virus. At the same time, the leadership created a tremendous healthcare structure to treat the ill. The current stage is to address the financial ramifications - as it capably did in the 2008-2009 crisis. Clearly an autocratic system has its strengths. However, it was an ugly process with individual and family rights disregarded continuously.

The US system as the exemplar of democratic power began in the same way as the autocratic system. As the virus emerged in Seattle, the Federal government and the CDC suppressed further study. But as the virus emerged, news services and information began to proliferate. Unlike the autocratic leadership, the democratic government did not engage. However, private citizens and companies began to act on their own self-interest and create "social distance." This process has continued to develop as news proliferates about this virus, resulting in cancelled concerts and other gatherings as well as hygiene approaches.

The next phase is how the healthcare system will respond. So far, the absence of testing focus has been surprising and seems to point to a paralysis in democratic governance. Further, the slow development of travel restrictions seems to highlight the weaknesses of individual rights protections. As the financial ramifications develop in a highly leveraged system, it will be interesting to see if the government rallies as effectively as in 2008-2009 times.

These trials will continue to compare autocracy and democracy in an increasingly fragile and complex world.

Transition Redefined

In an earlier post, I discussed the movement from manufacturing to services which has followed the prior movement from agriculture to manufacturing. As each of these processes got more efficient and effective, they sowed the seeds of their own profit destruction. Capitalism, for all its benefits, competes to zero profits.

Another way to frame up the drivers of these shifts is to identify the movement from the Industrial Age to the Information Age. The CEO of Softbank, Masayoshi Son, has driven his acquisition strategies based on drivers of the Information Age. Despite his well-known failure at WeWork, his investments have worked out incredibly well (Alibaba $20 million becoming $100 billion).

In a sense the manufacturing process is layered over the Industrial Age and continues to be layered over the Information Age. For example, I grew up on a farm populated with John Deere "A" and "B" tractors. We continually tinkered with and repaired these machines and they lasted forever. Most of these were built in the 1940s and were still operating for us in the 1990s. However, the new John Deere tractors are technically not owned by the purchasers and are ineligible for repair due to its software composition. This is an example of a manufacturing company that has moved from the Industrial Age to the Information Age.

To identify secular drivers, it might be most useful to understand the competitive stack using the farming sector as an example:

Approach:                          Artisanal                         Manufacturing                 Services

Organizing Principle:         Individual                        Industrial                         Informational

Industry:                            Organic Farming             Farming                           Farming

                                          (pre-1900)                       (1900-2000)                    (post-2000)