Quick Thoughts: What to Do When it’s Safe to Go Back in the Water

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Tejas Raut Dessai

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March 10, 2020

Quick Thoughts: What to Do When it’s Safe to Go Back in the Water

  • No one knows when the market reaction to the coronavirus contagion will bottom. Expert opinion is equivocal, and the effectiveness of mitigation efforts could prove surprising in either direction
  • History suggests that growth tech recovers much more quickly than the broader market after recessions and corrections (Model Portfolio: Is It Safe?)
  • Given the specifics of the viral outbreak that catalyzed this downturn – geographic concentration, stay-at-home quarantines, etc. – some TMT companies will feel more direct effect than others
  • Categories that we favor: SaaS applications, cloud hosting, internet franchises (e-commerce, digital ads, streaming, etc.), 5G network winners, datacenter components
  • Categories that concern us: consumer electronics (smartphones, peripherals, related components, PCs), travel-related (ETAs, theme parks, movies), consulting-heavy enterprise IT

At the close on Monday March 9, 2020, the S&P500 was down 7.3%, after sinking 5% in the previous week. Gold, Clorox and a handful of bargain retailers were the defensive bright spots during the rout, with high-flying TMT stocks hard hit in the carnage. Obviously, no one knows how long this drop will last or how many times we might test its lows, but history – of previous contagions and previous market crashes – is very clear that the crisis will abate, and the market will recover. There is no shortage of opinions about the possible timing of these things. While we might tend toward optimism and aggressive buying, others will be cautious. In any case, a plan for investing in the wake of this is necessary.

High growth tech stocks have been hit – in most cases, more so than the overall market. 15 months ago, during the 4Q18 tech selloff, we wrote of the behavior of growth tech in previous downturns (Model Portfolio: Is It Safe?). In the 10 most recent selloffs, where the tech index had fallen at least 10%, tech recovered back to the previous peak in just 180% of the time it had taken to fall to the trough, outperforming the broader market by an average of 579bp. That 4Q18 drop was no exception, with tech issues going on to one of their best relative years ever in 2019. We see no reason that this downturn would be an exception (Exhibit 1, 2, 3).

Still, it is important to consider the cause of this drop. Coronavirus hit China first, shutting down major cities, forcing factory closures, and stopping consumer demand in its tracks. The disease has since spread most everywhere, with S. Korea, Italy and Iran the hardest hit outside of China. The hope is that differences in preparedness, population density, cultural norms, and other factors might yield slower spread in other countries, reduce the possibility of overwhelming their health care infrastructures, and lead to less economic disruption.

Exh 1: S&P 500 and Tech Components Rebound Stats after major selloffs

Exh 2: S&P 500 and Tech Components Peak-to-Trough drop during major selloffs

Exh 3: S&P Tech Components recovered much faster than S&P 500 broader index post major selloffs

It would seem that companies that have disproportionate exposure to the hardest hit economies – in their operations, in their supply chain and in their end-market sales – would fair poorly, as would companies that rely on discretionary activity outside the home from a global population increasingly fearful of physical social contact. In the TMT world, that would include much of the consumer electronics sector, perhaps most acutely in the smartphone market. Most smartphones are assembled in China, which also accounts for about 27% of world unit demand. While news accounts suggest that many of the Chinese assembly factories could re-open by the end of March, the potential for re-accelerating the spread of the disease makes this plan tenuous. Moreover, assembly plants require component parts which will also take time to come back up to speed. For western companies, like Apple, this weeks long shut down also slows their timeline for developing new products and even if the Chinese open the factories, it would seem unlikely that the US would support the resumption of commercial flights carrying American engineers to and from China within a couple of weeks. This puts the window for bringing new product production up to scale in time for the holiday season in severe jeopardy.

As such, with new products badly delayed and major end markets cowering in fear, we are bearish on Apple, Samsung and the entire smartphone economy – including much of the semiconductor ecosystem, which depends on smartphones for 25% of its output by revenue. It would also seem a no brainer that companies that depend on consumers traveling – online travel agents, theme park operators, movie theater operators and film studios, etc. – would also be at severe risk. Finally, we are also concerned for businesses that offer consulting or other human capital as a significant part of their offering. For many enterprise IT companies, disruptions in assigning workers could be a major setback (Exhibit 4).

What do we like? Cloud computing reduces dependence on human employees and typically cuts overall costs. Presuming that sales can still be closed in this environment, business ought to see minimal impact from the contagion. This includes SaaS applications and cloud hosting operations, with hybrid cloud activity perhaps more at risk due to the more involved sales process and the consulting aspect of implementation. Components for those busy hyperscale datacenters should also stay relatively on track – GPUs, disc drives, communication gear and the like. Internet franchises, which do not require users to leave their homes, could even see business pick up from this E-commerce (as long as the situation doesn’t badly compromise supply chains or the fulfillment/delivery operations), digital ad driven media, and streaming subscriptions could do just fine through all of this. Finally, telecom carriers are local to their assigned territories. Investors have already picked up on this, fleeing to Verizon and AT&T as relative islands of safety. Still we greatly prefer T-Mobile and Dish, which we expect to be the long-term winners as 5G continues to play out.

Exh 4: Brief summary of winners and losers in the current environment


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