Stress Testing Companies for an Impending Recession

The new coronavirus crisis is different than any other seen in our lifetimes. But equity investors who develop a clear set of characteristics that will define resilient companies in the evolving environment can position portfolios to get through the pandemic and benefit from an eventual recovery.

Investors are reeling from the speed of the market collapse. The onset of a bear market in recent weeks happened faster than ever before, and GDP will likely drop precipitously over the next two quarters. However, every downturn throughout history has also provided opportunity. It’s extremely difficult for investors to envision a recovery at a time when the virus is spreading, the death toll is rising and entire populations are being locked down around the world. Yet given the unprecedented level of global monetary and fiscal stimulus, we believe this opportunity could come sooner than most expect.

Identifying Resilience and Staying Power

As investors survey the market carnage, the first order of business is to determine which companies have the staying power to ride out this downturn. This involves taking a close look at a company’s underlying business demand, financial position and ability to cut costs. No one knows the duration of this economic downdraft, but if you can’t be highly confident that a company will still be around when this is over, you’re probably taking undue risk.

How can investors dig deeper into a company’s true resilience? Start by building models of monthly cash burn under various scenarios. For example, how would the company perform in a sharp V-shaped recovery versus a U-shaped recovery? In a V-shaped recovery, a massive short-term demand contraction is followed by a sharp rebound. In a U-shaped recovery, short-term demand also drops precipitously, but the pickup is much slower due to lower personal income, damaged consumer balance sheets and a loss of consumer confidence.

These patterns might also unfold in multiple phases of demand drops and recovery. This is already playing out in Hong Kong, Taiwan and Singapore, which had some success in containing the virus but are now experiencing a second wave of infections. Modeling performance for different scenarios is a challenging exercise but can provide vital intelligence for forecasting the prospects of companies in highly uncertain conditions.

It’s also important to get a better understanding of debt maturity schedules and debt covenants. And ask whether you have enough trust in the management team, since companies will require skillful captains to steer through this crisis. Bankruptcies are clearly going to increase over the next year. But we believe that investors shouldn’t bank on government bailouts, which are notoriously difficult to predict.