The stock market, particularly in the U.S., had paid little attention to the risks from the Coronavirus, at least until the last week of February, when the virus was shown to have spread to South Korea, Italy, Iran and a host of other countries that had to that point shown no cases.  This became the ‘catalytic event’ for a stock market that was flying high on low interest rates, optimistic views about the economy, ‘buyback induced’ earnings growth and massive money flows into passive index funds.  As stocks typically do when ‘everyone is invested and no one is worried’, they go in the opposite direction.   Also, like most of these periods, stocks effectively ‘take the escalator up and the elevator down!’   That scenario played out in a major way in the past week as the stock market had its quickest 10% correction on record.  We agree that investors should be worried about the economic impact of the coronavirus since the shutdown of manufacturing in China, the inter-relationship of supply chains and the reduced level of consumer spending, particularly on travel, could push the global economy into a recession.  While our view had been that the stock market was overdue for a correction, the additional danger for stock markets now is that these fears will continue to unwind the bubble in financial assets.  We have certainly seen that in the past week as the biggest winners of the past year (big tech) turned into the biggest losers.  The other risk is that valuations had been at such high levels that the ‘ride down’ to fair value is very steep, and markets generally tend to overshoot those levels in the short term.  As an example, the cyclically adjusted price-to-earnings ratio, or CAPE, which compares current stock prices with their underlying earnings over the past decade, had been more expensive than at any time since the height of the dot-com bubble in the late 1990s.

Market volatility has also shot up to record levels in a hurry, from all-time lows.  While that increase in the ‘fear index’ and the fact that stocks have sold off so hard and so quickly may increase the chance for a short-term bounce, we are still concerned that the economic and profit fallout is still in the very early stages.  One key problem is that central banks don’t currently have the levers to buffer the decline.  After years in which policy makers cut interest rates to support their economies, there is now very little room to cut rates further when ‘something’ goes wrong and the coronavirus looks like that ‘something’.  While it’s probably still too early to fully assess the economic impact of the coronavirus, we hear many comparisons to the SARS outbreak in 2003, which lead to a short-lived fall in stock prices and very little impact to global economic growth.  We differ on that view and see this as more reminiscent of the Fukushima crisis in 2011 in terms of potential stock market and economic impact.  At that time, we effectively saw a shutdown of the world’s 2nd largest economy (Japan was in that position in 2011) but China is even more impactful now since it has been responsible for most of global growth and trade over the past decade.  With 60% of China’s population now in urban areas, compared to 60% rural in 2003, and passenger journeys by air increasing from 80 million to 660 million, the cost of shutting down huge cities has not been properly priced in.  It’s not just that production facilities have been shuttered, flights cancelled and travel activity sharply curtailed, but the big and enduring macro risk is that the fear of infection is likely to keep many people at home long after this crisis ends.  The global economic impact will also be larger since China not only commands a much higher share of global output than it did during the 2003 SARS scare (19% now versus 9% then), but the consumer in China accounts for a much  larger share of their own  GDP as well (accounting now for half of the aggregate growth in the economy), compounding the hit to the overall global economy.  The potential fallout could also be worse now because growth is in a danger zone.  Big shocks for weak economies that don’t have cushions to withstand them could lead to unexpected recessions.  In 2011, the market impact was a cyclical bear market as stocks dropped by over 20%, while gold and bond prices rallied.  Cyclical and resource stocks took by far the largest downward hits in that period, but it should be noted that it also coincided with Greek financial crisis and was hence made even worse.  Investors, until this past week, had appeared to be assuming that this risk would pass quickly.  That period has clearly ended but the sell-off has been so sharp and so fast that we have added some higher quality technology (more software and communications than hardware or semis), telecom, communication and gold stocks to the portfolio.  We are still wary on financials since the record low interest rates will put further pressure on profit margins.   We are also still concerned about the massive level of corporate debt, the rising level of loan losses and the deterioration of credit conditions.   We also think its too early to start looking at any cyclical/resource/industrial stocks.  Global demand will take a hit and the slowdown in Asia will turn off the biggest buyers in that sector.   However, we do expect that central banks will once again try to come to the rescue of the market with more interest rate cuts.   Those will do very little to alleviate deteriorating economic conditions, but they may be enough to once again put a ‘bid’ under stock prices.   Our worry though is that, outside of the stock market, the signals about economic growth are very negative.  In a dramatic demonstration of how low interest rates have sunk, the yield on the 10-year U.S. Treasury bond hit its lowest level on record this week.  With bond yields and commodity prices back to cycle lows, the message about the economic outlook remains bleak!

If you’re not familiar with the spectacular turnaround at BlackBerry, get acquainted.  A decade ago, the company was one of the largest smartphone manufacturers on the planet. Then that market collapsed as the world moved to only two core operating systems, Apple’s iOS and Google’s Android.  Today, Blackberry doesn’t make a single cellphone.  Instead, it’s turned its focus completely to next-generation cyber-software.  Most notably, BlackBerry creates software for emerging technologies like the Internet of Things, big data, and autonomous vehicles.  That last opportunity is what caught the eye of Amazon.  More than 100 million vehicles are produced every year. It’s one of the biggest markets on the planet but the biggest opportunity of all, however, may be the software behind the vehicles.  Gartner predicts that nearly one million self-driving vehicles will be added to the road each year starting in 2024.  By the end of the decade, tens of millions of autonomous vehicles could be hitting the road annually.  All of these cars and trucks will need to run software in order to drive themselves.  The computing intensity of self-driving vehicles will be increasingly complex and is going to be a gigantic market, and the Amazon-BlackBerry venture appears to have an early lead.  BlackBerry is currently valued at about $4 billion.  Compared to other software companies that are targeting next-gen opportunities, BlackBerry trades at a 50-75% discount. That discount likely stems from two factors: investors haven’t realized that BlackBerry has executed an incredible turnaround, and its products haven’t begun scaling considering the end-markets are still in early stages.   With the Amazon deal, those concerns should be resolved.  The company has stayed cashflow positive during its transition from a mobile phone maker and now boasts an extremely strong balance sheet.  We see it as a great, long-term play in cyber security at a reasonable valuation!

On the other side of the technology spectrum we find Shopify.  While the stock has been one of the biggest stock market winners since its public market debut in 2015, its valuation has risen to ‘nosebleed levels.’   Bulls on the stock of course argue that , like Amazon, its recurring revenue growth will more than offset its lack of profits.  But its revenues are less recurring than they first meet the eye, and worse of all, its valuation leaves shareholders with no further upside potential.  Shopify’s high margin segment, Subscription Solutions is growing at 37% year-over-year.  While this is clearly very fast, we’re not sure it justifies that valuation where Shopify, they point to the fact that Shopify is trading at over 35 times trailing revenues and still not generating a net profit.  Moreover, not all of Shopify’s revenues are worth the same.  Shopify has a high margin segment, Subscription Solutions, that generates attractive gross margins of about 80%, but it also has Merchant Solutions with gross margins of less than 37%.  Thus, only a third of Shopify’s revenue should be valued in the high 10x to low 20x trailing sales.  Because the remainder of its revenues is one-time in nature, with unsatisfactory profit margins, it should not be valued as highly.  Bottom line, not only is Shopify ‘optimistically valued ‘, its revenue growth rate is evidently starting to decelerate.

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