A grim milestone was reached this week as this country recorded 600,000 deaths from COVID-19 and its offshoots. Still, the trend is decelerating rapidly, vaccinations are being accepted no matter how unevenly, and there is an air of, if not victory, at least hope in dealing with the pandemic.
The effect of COVID on companies is less obvious. Firms show, for the most part, no outward strains from the pandemic save for those in the hospitality and retail industries. However, data shows that companies borrowed around $11 trillion to stay afloat during the time that revenues declined or disappeared. The repayment of this sum, along with the interest it generates, will impact profits and cash flows for years.
Take Norwegian Cruise Lines Holdings as a case study. During 2020 and 2021 year-to-date the company has taken on $7.1 billion in financing. This figure includes a recent $1.6 billion from the issuance of 53 million in new shares. The number of shares outstanding has increased by 73 percent since December 2019. Pre-COVID, Norwegian earned about $1.2 billion pretax per year. Norwegian had and still has several ships on order. In assessing the company’s ability to deliver future earnings, it has a good deal of debt to work through. Norwegian also now has more shares and thus more dilution of future earnings.
This hollowing out of balance sheets and potential dilution of future earnings due to COVID is, in fact, more common than is generally observed. Transportation and retail seemed to have been the most often hit by this erosion of financial health. Outside transportation, a key attribute seems to have been whether an industry or company was considered “essential” during the pandemic. If so, the firm may not have done badly. In some cases, the results were stellar. For firms that were not essential, there was a lot of downtime, lost revenues, and lost profits to absorb.
Companies that carried large dollar amounts of assets per dollar of revenue were the most at risk for material declines in operating leverage. Some demand will be recaptured in the post-COVID era that in some ways seems upon us. Some demand is lost forever.
The current stock market, at least prior to this past week, seemed not to make the distinction between companies that were on the cusp of earning money and those that would be able to keep it. Many investors are fixated on projected earnings per share. Their reason: if earnings are to go up, it must be good for shareholders. While eventually true, if earnings are to pay down the principal of debt, it helps shareholders only indirectly and over time. Additional shares are equally problematic. Once profits are restored, they must be divided by a greater number of shares outstanding. This last fact impedes earnings per share growth.
What about share buybacks? Do they not increase share prices? Yes and no. Buybacks do shrink the number of shares outstanding, but do not help the balance sheet if funds financing the buyback are borrowed. Then there is the issue of whether the funds should be used to reduce debt instead. Debt reduction strengthens the company but does not goose the increase in earnings per share like buybacks do. Management has been lobbied by investment bankers to reduce shares outstanding by buying them back. This aids the industry analyst in making stock forecasts and makes the investment banker look good in the process. A second reason is it makes the stock options issued to management more valuable so long as no one complains about the debt remaining. This act of self-interest, along with the ego trip of not splitting stock to make its rise easier to compute, would seem to indicate that not always is management’s interest aligned with the owners – the shareholders.
Europe takes the concept of stock as a proportionate interest in the business far more seriously than the US does. Here stock is acquired by a company through public transactions. In Europe, stock cannot be bought back unless there is an auction that all shareholders can participate in. Conversely, a company cannot be acquired for stock unless the shareholders vote to authorize the additional shares. Issuing stock to management on the scale allowed in this country is unheard of. The European tax treatment of stock options is more transparent as well. European stocks, in general, pay higher dividends than the typical American share. Such is their way to distribute surpluses to shareholders.
Correcting these mindsets will take more reform than currently exists in terms of political will. The issue here is one of ownership and governance. In the long list of grievances, these matters are not at the forefront, as most do not understand the implications of reforming them.
By most measures, the economy is off the charts. The charts themselves are distorted by the lockdown of the economy last year. Most economists are looking for economic growth in the neighborhood of 6 plus percent for this year and the early part of next year as well. After that, the pandemic will be gone from yearly comparisons, and it will be up to the long-term growth of the economy going forward.
One statistic of interest is the so-called quit rate, which is how often employees voluntarily leave their jobs. It is usually related to the number of jobs available compared to the number being pursued. Employees are leaving in record numbers (about 2.7 percent) for other opportunities. The reasons range from demographic (more people retiring than entering the workforce) to opportunistic (better pay and benefits elsewhere). All this portends to a tighter labor market and higher inflation going forward, especially in service industries that are less prone to automation.
The fastest way to take pressure off the labor pool is through some form of immigration, perhaps in the form of worker visas for a specific amount of time. This has been done in Europe for years. The usual form is for a five-year visa followed by another five-year visa if employed at the end of the first five years. After that, citizenship may be applied for, but oftentimes the immigrant is simply saving to go back to his or her home country.
Inflation is gathering momentum, as the forced savings of the past year meets the limited supply of goods as well as supply chain snafus that drive up prices.
Housing seems to be of special attention. Years of building fewer homes than supply required coupled with the shut down during the pandemic has created a demand that possibly will not be satisfied for years. Lumber prices are coming down relatively, but shortages of workers and zoned land for building are keeping demand from being satisfied. Starter homes are especially rare to build, as higher profits are delivered by building more expensive homes.
How long the Federal Reserve can keep its thumb on the scales of interest rates is anyone’s guess. Some predict 2 percent ten-year Treasury bonds by year-end, up from under 1.5 percent now. Savers in banks and money market funds will have to suffer a while longer.
There is so much money flowing through the system it seems that it will have a judgment day, but there is as of now no financial John the Baptist to say when. Until then, investing in assets that have some return beats no return, so long as there is substance behind them and hopefully the potential to raise their dividend.
The Stock Market
The declines of this past week seem to be a harbinger of something, although what is up for debate. The greatest declines were by the stocks that have gone up the most, which would seem to indicate profit-taking by short-term traders. However, the larger theme of value over growth, and substance over lack of the same, seems to be intact.
Of special note: Tesla’s former President Jerome Guillen, who left the company earlier this month after over ten years there, just sold all his stock in Tesla, pocketing proceeds of $274 million after cashing in his stock options.
Also, the Chinese government is cracking down on the production of cryptocurrency in that country due to the amount of electricity required for its creation. Bitcoin prices are down almost 44 percent since the peak this year.
Warren M. Barnett, CFA
June 21, 2021