Former advisers to Gazprom, Vodafone and the World Bank, Quentin Anderson and Dr Peter Stanbury look at the investment implications of Covid -19, through their perspective as Political Economists, and devise a three step investment process.
A recent article by members of the Private Equity practice at Bain Consulting published an assessment of the Covid-19 outbreak on the PE sector. As well as looking at the impacts so far – for example on returns and exits – the piece also speculated about the future. According to Bain “funds most prepared to weather this crisis—and the next one”, will be those who recognise that “sector expertise will become more critical than ever”, and that “the scope of due diligence will change.”
Whilst the Bain article was aimed particularly at the private equity sector, the issues it raises are relevant to the investment community as a whole. Put simply, how do you assess value when all the bases used in the past are so uncertain?
ESG – we’re alright, Jack!
One part of the investment community which seems to be doing relatively well in the Covid crisis is the ESG (environmental, social and governance) sector. These funds been growing rapidly in the past 18 months or so. According to an article in the Financial Times, “investors ploughed a record $20.6bn into US sustainable investment funds, almost quadrupling the $5.5bn of net inflows gathered in 2018.” The growth has been so significant that the US Sustainable Investment Forum claims that “more than one out of every four dollars under professional management in the United States today…is involved in sustainable investing.”
There is also strong evidence that ESG funds outperform their conventional rivals. According to Interactive Investor, “data comparing ethical funds with their in-house equivalents found that five out of six ethical funds produced superior returns than their in-house stablemates over the past three years to 31 August 2019”. This is a trend that seems to have continued into the Covid-19 period. In early April, a study by investment research firm Morningstar reported that 62% of ESG funds had outperformed the underlying MSCI World stock index during March, as the pandemic took hold.
What explains this outperformance? Most obviously, ESG funds were underweighted in the oil and gas sector, which has been amongst the worst hit by the pandemic. However, the evidence suggests that the outperformance is due to more than just a matter of sector weighting. Speaking to the Financial Times, a representative of Morningstar, Hortense Bioy, explained it by saying that “ESG funds tend to be biased towards higher quality companies with a stronger balance sheet, companies that are run better and operate more efficiently.” An article in Responsible Investor magazine argued the same point, that “companies that incorporate these ESG strategies tend to be managed more efficiently and more thoroughly, [so they] can weather the storm and are a success factor in both good and bad times.”
ESG fund managers have, arguably, the luxury of being able to avoid stocks they believe will be adversely affected by Covid-19. Indeed a recent report by a Frankfurt-based investment firm DWS argued just that, and that ESG investors would increasingly be engaging with companies on issues related to the pandemic, the issues it raises, and its aftermath.
A sea-change in investment analysis
A huge challenge exists, however, for the rest of the investment community. Covid-19 and its aftermath will affect all companies in all sectors. What does this mean for making investment decisions, or establishing ‘fair value’ for a stock when the normal parameters for assessing these things have been entirely turned upside-down? For the reality is that Covid-19 fundamentally impacts on the most basic metric used in making investment decisions: earnings projections.
Under normal conditions, investment analysts spend their time examining the future prospects of different companies. This might include looking at the impacts of new technologies, extrapolating changes in consumer behaviours and the implications of this for a company’s sales, and examining the robustness of a company’s balance sheet. All of these and other deliberations are then brought together in an assessment of a company’s anticipated earnings for forthcoming years. Whether a company represents good value can then be assessed by the price/ earnings ratio – the price per share of the company’s stock market listing divided by the per-share earnings figure.
But these are not normal times. How therefore are investment analysts to calculate a company’s potential future earnings when the Covid situation means that the variables affecting a company are so uncertain? Bain Consulting’s assertion that “sector expertise will become more critical than ever” is true, but what ‘sector expertise’ means now has changed utterly. Investment analysis will now need to include consideration of a raft of issues that previously would be have been considered at all.
So how is this to be done? A new approach could be based on a 3-step process like this:
- A company needs to be looked at through three ‘Covid lenses’ for stock analysis: issues that might affect a company, and therefore its earnings potential at, respectively, international, national and intra-national levels.
- The information from this analysis then needs to be drawn together into an overall assessment of the ‘Covid-19 footprint’ on that company, and the implications for its business model and therefore its long-term earnings stream.
- Finally, an assessment needs to be made of the company itself, and the likely ability of its management team to respond effectively to the challenge posed by Covid.
Step 1: ‘Covid lenses’ for stock analysis
Analysts will need to assess, in a systematic fashion, how Covid-19 and its aftermath might affect different commercial and industrial sectors, and individual companies. The process needs to be systematic and logical given the complexity of the situation. Importantly, this is not just about the here-and-now of the pandemic. At some stage, the disease will be past. What is needed therefore is to anticipate is what the longer-term changes are that Coronavirus might engender in areas such as political power, consumer behaviours, and social dynamics, such as the following:
The first set of issues to be considered are those which affect companies at an international level – issues which are significant given the effects in recent decades of globalisation. Covid-19 can be expected to have serious implications for what a ‘new normal’ might look like.
There has already been much speculation, for example in the Financial Times, about the potential implications of Coronavirus for global supply chains. Over recent decades more and more businesses have become used to sourcing commodities, goods and materials from all over the world. This means that manufacturing companies can operate a ‘just-in-time’ approach to inventory management, and that European supermarkets can source out-of-season fruit and vegetables, as well as non-indigenous products such as bananas, coffee and tea.
What we do know is that, according to the World Trade Organization, Covid-19 is expected to hit global trade volumes by anything up to 32% during 2020. What we don’t know is how different the environment might be for global supply chains in a post-Covid world. What, for example, would happen if the merchant shipping industry were to be significantly constrained by the pandemic? Already this sector is facing a significant challenge in the shape of the monthly total of 150,000 seafarers who need to be changed over to and from the ships which they operate. In April, the International Maritime Organisation issued guidance as to how this might be achieved in ways compliant with addressing Covid-19. Guidance has also been issued about interactions between ships’ crews and shore-based personnel. Yet, the situation could become even more problematic with the possibility raised that entire ships could be quarantined to control spread of the virus. For example, the Colombian National Maritime Authority has already issued a series of ‘circulars’ that enable them to quarantine, for 14 days, ships which have called at ports in China, and that “the same procedure could be applied to ships coming from other countries if a coordinated evaluation so suggested.” If such policies became widespread in the world’s ports, global trade would be severely affected, which would put considerable strain on the types of frictionless supply chains which companies have been used to for so long.
We are also seeing the impacts of Covid-19 on global geo-politics. Most obviously, anti-China sentiment has been rising. At the forefront of this trend have been President Trump – who in news conferences has referred to Covid as “the Chinese virus” – and his administration – for example a statement by Secretary of State Mike Pompeo that, “there is a significant amount of evidence that this
came from that laboratory in Wuhan.” However, others have also been in on the act. For example, in mid-April, British Foreign Secretary, Dominic Raab warned that there is “no doubt” it will not be “business as usual” with China once the coronavirus crisis is over.
Apparently, the Chinese leaders themselves are aware of the risk. According to Reuters, a report presented early last month by the Ministry of State Security to senior Beijing leaders including President Xi Jinping, concluded that “global anti-China sentiment is at its highest since the 1989 Tiananmen Square crackdown.”
There are significant implications for many sectors if this trend persists, or even worsens. What might happen to companies exporting from China if a trade war escalates? For companies operating in China, or employing Chinese nationals in other countries, what happens if rhetoric leads to changes in visa arrangements? What happens to companies supplying goods and services to bars and restaurants in the China towns of New York, London and other major cities if anti-Chinese sentiment leads to changes in consumer behaviour?
Nor is this the only issue which has the potential significantly to affect the realities for businesses in all sectors. Examples include the serious questions raised about the future of the Euro and what Foreign Policy magazine called “a global game of chicken” between Russia and Saudi Arabia over oil production.
Companies, and their earnings potential will also be affected by developments wrought by Covid at a national level in the countries where they operate. The types of issues will vary from country to country, and between the countries from which companies source, and to which they sell or are headquartered.
The threat of ‘resource nationalism’ is one that companies in the extractive sector have wrestled with on-and-off for many years. The British Government defines the term as encompassing behaviours by governments of natural resource-rich countries such as “nationalisation and expropriation of foreign companies, export restrictions, cartel pricing behaviour or high taxation.” Research firm Maplecroft operate a Resource Nationalism Index, which currently lists the most risky countries in this regard as including Tanzania, Venezuela and Zimbabwe.
Recently, the highest profile example of this problem has been Tanzania. As an analysis from the Danish Institute of International Studies explained, “in May 2017, the country’s President John Magufuli declared ‘economic warfare’ on foreign mining companies, which he accused of draining the country’s mineral wealth.” Subsequently, new legislation has been passed to restate the country’s sovereignty over its natural resources and the Government has forced revised contracts onto investing companies. Perhaps the firm worst affected has been Barrick Gold, the world’s largest gold mining company, whose Acacia Mining subsidiary which, in 2017, was presented with a demand by the Tanzanian Government to pay approximately $190 billion (yes, billion) in revised taxes, interest and fines. The row between the company and the government rumbled on for more than two years, and was settled only in January 2020 with the company agreeing to pay $300 million in taxes and other charges, and ceding to the Government stakes in three mines.
What would happen if the Covid pandemic led other countries decided to take similar positions, and perhaps on other commodities than just those which are mined. We’ve already seen Cote d’Ivoire and Ghana introduce a so-called ‘living income differential’ of $400 per tonne on cocoa exports, ostensibly aimed at easing farmer poverty. It is not hard to imagine how moves like this might be ramped up in the aftermath of the Covid turmoil. One can imagine the rhetoric that leaders of resource-rich countries might use – “in an uncertain world, our people need us to make the best of the riches our country possesses.”
The third ‘Covid lens’ which needs to be applied is at a sub-national level – how companies, and so their future earnings – will be affected by differing conditions and situations within the countries where they operate. As the example of the USA demonstrates, Covid has affected different parts of countries in different ways: companies ought therefore to anticipate the same of the pandemic’s aftermath.
The issue of, literally, ‘corporate citizenship’ may, in the developed world, become a key issue. How companies are responding now may well have significant implications for them in future. As PR firm Weber Shandwick told its clients, it is important during the pandemic to “demonstrate a sense of purpose but it must offer genuine public value and stand up to external scrutiny.” One company which failed this test is the UK pub chain Wetherspoons, whose boss, Tim Martin announced early in the lockdown that he would not be paying his staff until the UK Government’s furlough scheme kicked in. This led to a furious backlash, with a number of pubs, for example in London and Nottingham being vandalised with graffiti reading, “pay your staff.” Although Martin later backed down, the long-term impact on the chain is unclear. Will people want to drink in its pubs, or to work for it? Union leaders have also been attacking companies they believe are not providing Covid-safe working environments. For example, online fashion retailer ASOS was criticised by the GMB union after “98% of more than 460 workers who took part in a survey … said they felt unsafe at the group’s warehouse in Barnsley.” As with the case of Wetherspoons, the long-term impacts of these behaviours on long-term reputation are uncertain. By contrast, firms like healthy fast-food chain Leon, which is delivering half price hot meals to NHS workers in the UK and donating all profits from a new website to NHS charities, may find their reputation enhanced and their market position in the aftermath of the pandemic greatly improved.
These sub-national issues will also need to be managed in source markets too. An example may be in managing the effects of Covid on production practices, for example in the garment sector. It seems that the concept of social distancing is likely to be with us for some time – researchers at Harvard recently concluded that “some form of intermittent social distancing may need to be in place until 2022.” Yet, how is this to be achieved in the crowded conditions of factories in places such as Bangladesh. A recent report in The Guardian newspaper reported that “workers at garment factories …on the outskirts of the capital Dhaka, said the only new measure was hand-washing at the entrance, and that no physical distancing measures had been enforced inside the factories…Many said they had been worried about returning to the factories, but had no choice, fearing they would lose their jobs.” Apparel companies and retailers are likely to come under pressure to demonstrate what they are doing about these issues. If they do not, it is not difficult to imagine campaigners juxtaposing images of social distancing in retail stores in developed countries with unsafe overcrowding in factories in developing ones.
Step 2: Assessing a company’s ‘Covid footprint’.
The previous section has set out some examples of issues that equity analysts might identify in relation to a company by use of the three levels of ‘Covid lenses.’ The next step in the new a approach to investment analysis would be to draw these issues together to develop a holistic assessment of the implications for that company of the pandemic and its aftermath. At the extremes, that footprint may imply that some business models are no longer sustainable, but also that new commercial sectors open up.
An example of the former – a business model that may prove not to be viable in a post-Covid world – is industrial agriculture. As reported by Yale University, over the past 50 years, increased usage of chemical fertilizers, irrigation systems, pesticides, and mechanized technologies has doubled agricultural productivity. Greatly increased food production is obviously welcome, but the negative externalities have become increasingly apparent. As long ago as 2014, CGIAR, a global partnership of international organizations engaged in research about food security, warned that the fact that many crops are now grown in monocultures, “makes agriculture more vulnerable to major threats like drought, insect pests and diseases.”
Those warnings are now being reflected in reality: supplies of many foodstuffs are facing an existential risk. The very existence of several key commodities is threatened by diseases which are able to spread with alarming rapidity. A fungus called Fusarium Tropical Race 4 (TR4), long present in banana plantations in Asia has now spread to Latin America, the world’s largest exporter of bananas. As one observer commented last summer, this “deadly fungus is on the verge of wiping out the banana forever.” Citrus crops – including oranges, lemons, grapefruit and limes – also face an existential threat in the form of Citrus Greening (also known as Huanglongbing (HLB) or yellow dragon disease). According to the US Department of Agriculture, “once a tree is infected, there is no cure…It has devastated millions of acres of citrus crops.” Coffee too is under threat. Writing about that industry in Colombia, a BBC analysis concluded that, “coffee rust is a disease with the power to cripple, or even wipe out, the country’s national product.”
We do not yet know how the experience of Coronavirus will affect consumer behaviour. However, panic buying in the early stages of the pandemic were driven by popular fears of food shortages. It seems entirely realistic that if the general public were made aware of just how realistic those fears are, that panic would ensue. The industrial agriculture sector looks likely to face a dilemma of how to continue to produce foodstuffs in volume, but in ways which address the factors which drive the risk of existential threats to key commodities.
However, it is equally possible that other sectors will be presented with new opportunities as a result of the pandemic. An example of this might be the off-grid power sector, particularly in Africa, a market already estimated to be worth $24bn. The circumstances of a post-Covid world could easily see this increase rapidly.
It has long been acknowledged that lack of access to reliable power supplies represents a major constraint to African businesses. A 2018 report by the Centre for Global Development found that “power outages cost some companies as much as 31 percent in sales.” This fact constrains companies’ ability to create jobs – the World Bank estimates that “electricity shortages reduce the likelihood of an individual being employed by between 35 and 41 percent.”
Power shortages reflect the lack of investment by African governments, over decades, in on-grid electricity. The effects of Covid-19 suggest that this situation is not about to change any time soon given the economic challenges likely to face the continent – the World Bank estimated in mid-April that Africa’s GDP would decline by more than 5% in 2020.
Yet, Africa desperately needs to create jobs. Strong population growth means that, according to the African Development Bank, 12 million young people enter the continent’s job market every year. If national governments are unable to fill this void alone, it may be up to local initiatives to do so. An example is the recent announcement by the State Government of Katsina in Nigeria of a plan to establish “ an integrated textiles and garment park” to create jobs. This type of industrial ‘cluster’ could well see companies on-site collaborating in the installation of reliable, localised power provision. A report last year from the Overseas Development Institute demonstrated, for example, how solar mini-grids could transform the lives of people and businesses in rural Africa. This type of development could provide huge opportunities in the post-Coronavirus world for companies manufacturing and installing off-grid renewable energy infrastructures.
Step 3: Can the company respond?
So far, this proposed new process for equity analysis has used three ‘Covid lenses’ to assess, in a systematic fashion, the issues which a potential investee company might face in a post-coronavirus world. It has then developed a ‘Covid footprint’ to understand how these issues in toto impact on that company, its prospects, and therefore future earnings. The third, and final, step is to assess how well the company is likely to be able to respond to the challenges it faces.
The most obvious issue to explore here is whether the management team of the company is aware of the post-Covid issues that they face. If a company is blind-sided, or refuses to accept the challenges which need to be addressed, there is little chance of an effective response to them. As research published in 2018 by the UN Principles for Responsible Investment demonstrated clearly, central to the success of ESG investors is the depth and extent of their engagement with the companies in which they invest, or might invest.
This may be a lesson that technique which mainstream investors will increasingly need to use too. As this article has argued, Covid poses a myriad of different challenges to each company, and one of which might have significant impact on business models and earnings streams. Investment analysts need to engage with the management teams of companies in which they invest, or might invest. This will enable those analysts to take a view about how well-sighted management teams are on the Covid-related issues they face.
However, it is not just whether a company is sighted on the issues it faces, but also is able to manage them effectively. This means that businesses will have to demonstrate that they are serious about addressing Covid-related issues, rather than simply paying lip service to them. This will need to include amending ways of working and internal policies to ensure that operational managers are properly focused. In this regard, investment analysts need perhaps to learn from the experience in relation to corporate codes of conduct. Such codes are only as good as the strength of their implementation. As one compliance blog makes clear, a Code needs to be “embedded in the organization’s practices and backed up with enforcement.” ‘Soft’ approaches to implementation are also extremely important – for example, the mood and tone which a management team engenders amongst its staff. As a study reported in the Journal of Business Ethics concluded that “informal methods (namely, the “social norms of the organization”) is perceived by employees to have the most influence on their conduct.”
The clear lesson here for investment analysts in the post-Covid world is obvious. They need to know whether senior managers of the firms in which they invest are setting a proper tone in their handling of the issues that the pandemic has raised for their company, and that this is backed up by robust management processes to address challenges that arise. Companies which fail to rise to these challenges are likely to struggle in ‘the new world’, which suggests their prospects and future earnings will be negatively impacted.
Implications for investors
What then does all of this imply for investors? Is Bain’s assertion correct that sector knowledge and improved due diligence will be the keys to successful investing in the future. Well, the answer is both yes, and no. Yes, these factors will be critical for successful investing; but no, in that what sector knowledge and due diligence will involve will be entirely different than in the past.
Deep sector knowledge will be critical for investors in a post-Coronavirus world. However, that sector knowledge will need to encompass insights into a much wider set of issues than has been the case hitherto. In the case of the agribusiness sector, for example, Covid-19 has starkly highlighted the negative externalities caused by business structures that had come to be seen as normal. Already leading investment firms like M&G are making the link between the value of companies in this sector and their ability to manage the issues highlighted by the pandemic.
Yet the same will be true too in almost every sector. The link between business processes and the wider context in which these exist will now be under greatly increased scrutiny. Investment firms will therefore need to revise what they understand as ‘sector knowledge’ to reflect this.
Expanding due diligence
Once again, it is true that due diligence will continue to be of key importance, but what that due diligence will need to include will be significantly different than before if it is to be effective. Traditional assessments, of things like finance and tax, people and management, and legal compliance will continue to be important.
However, due diligence will now need to include assessments of how well a company understands the wider context in which it operates. In future, agribusinesses which do not address issues such as their potential link to zoonotic diseases will be vulnerable. Investors will need to create processes for ‘societal due diligence’ relevant to each sector. This will need to include considerations such as whether a company has a good understanding of the societies in which it operates, and have processes in place to manage these interactions.
To some degree therefore, Bain is correct in its conclusions about what key skills investment firms will need to have in order to be successful in the post-Covid world. However, if they are to be of any use at all, sector knowledge and due diligence processes need to be entirely reconceived in the new world in which we are all living. Covid-19 has made is blindingly clear that companies and business processes are inextricably tied up with the wider social, political and environmental contexts in which these operate. Investors who fail to realise this will fail.
Investment firms therefore need to evolve their existing analysis techniques to include consideration these wider contextual factors. To do this will require hiring different people, and taking different advice. Those working in in investment firms typically have backgrounds in finance, commerce and business. These skills-sets remain valid, but other skills are needed. In future, investors also need to include others with experience in areas such as political science, development economics and ethnography.
The investment community has successfully navigated previous storms: this is how it can respond to the one caused by Covid-19, and come away from the situation stronger, more resilient, and more insightful.
About the authors
Quentin Anderson is Executive Chairman, DVC Consultants and CEO and Co-Founder of BankTotal. He has decades of experience in advising companies, and for 18 years was a CEO of companies in the WPP group.
Dr Peter Stanbury is Co-Founder of both DVC Consultants and Banktotal. He has worked all over the world for organisations as varied as NATO, The World Bank, Anglo American and the Governments of The Netherlands, UK and Switzerland.
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