Too many companies could be taking a short-term approach to getting through the coronavirus crisis by concentrating on liquidity when they should be focusing on solvency, according to Fidelity International’s Andrew McCaffery.
But this approach has blinkered some into forgetting that they need to make sure they can survive once the world re-opens for business, said the Fidelity global chief investment officer (pictured).
He explained: “Huge injections of liquidity by central banks, and ‘whatever it takes’ interventions by governments, have kept companies afloat since the March crash. .jpg)
“But we are moving into a phase where solvency - as opposed to liquidity - is becoming the priority for companies and investors.”
The fundamental difference between liquidity and solvency is their timelines: solvency is the company’s ability to meet long-term financial obligations, and liquidity is being able to pay for more short-term needs.
And while central banks around the world have injected billions into economies that has helped keep many companies afloat, it doesn’t guarantee their long-term survival or prosperity.
And that is the reality some companies might have to face up to if the lockdown ends relatively soon, the chief investment officer said.
But the risk of companies folding could be amplified if lockdown is extended or if a second wave of infection sees lockdown re-introduced.
“Companies with high levels of debt going into this crisis, often used to fund share buybacks or maintain earnings, may now struggle to get the capital required to weather a phased return to activity,” said McCaffery.
“While many may have sufficient funds to come through the initial lockdown, sustaining businesses through rolling lockdowns, if infection rates oscillate, will be harder.”
And ensuring solvency will all have to be managed and achieved whilst consumer confidence is being restored amid times of high unemployment, with both the US and UK seeing huge rises in the unemployment levels: numbers that would have undoubtedly been worse without government support schemes and stimulus packages.
And this could have a long-term impact for companies. This need to ensure short-term liquidity has also played a role in the cutting of dividends by companies.
This has become a “political issue”, according to McCaffery, as companies that received direct or indirect government support up to scrap dividends.
“Now companies are making strategic decisions about whether or not to cut, even if they have no liquidity issues,” he said.
Indeed, companies such as BT and Royal Dutch Shell have cut their dividends – for Shell this was the first time they have been cut since the secondworld war – so they can redirect capital elsewhere, said McCaffery, and “perhaps reset their dividends at a more sustainable level”.
He added: “In the case of Shell, it has chosen to invest more in renewables as a hedge against the lower oil requirements of a low-carbon economy. BT has taken the opportunity to invest more in the rollout of 5G.”
Whilst dividend cuts are a major blow for income investors, McCaffery pointed out that this could be beneficial going forward as he expects markets to become more astute about which companies have the most long-term sustainable business models and which are too cyclical with distressed balance sheets.
“Observing this divergence, investors will probably revise up the cost of equity for companies that are not sustainable over the long run, but maintain the cost of equity for those that are, influenced by lower for longer interest rates,” the Fidelity chief investment officer said.
But not every sector faces the same solvency issues according to McCaffery, as the recovery could vary from sector to sector.
“Winners from the crisis such as technology and healthcare firms may see an acceleration in growth – along a J-type curve – while industrials and durable goods may initially benefit from pent-up demand, but only recover to 70 or 80 per cent of their pre-Covid levels, following a square root shape.
“Finally, hotels, airlines, banks and energy stocks may experience more of an L-curve, where they trend along the bottom for an extended period.”
This, McCaffery added, will be mirrored in the private markets where he expects similar solvency and cashflow analysis to be take place.
“While public market valuations corrected sharply following the outbreak, it will take longer for the devaluation of private assets to play out, but with no less risk of insolvency,” he explained.
“Public markets have been flooded with liquidity, but private companies may find it harder to access liquidity quickly from the authorities’ various schemes. Sustainability and resilience will, therefore, be equally important for private companies until economics recover.”
And while some investors may have already started to mark down private holdings and factor what it could mean in terms of asset allocation, it remains too early to tell what impact coronavirus will have on valuations.
He finished: “I think we will see some real pain in certain parts of the economy and for many of the private companies.”