Chaos and Covid-19: investor lessons from the pandemic

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?

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 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 huge challenge exists, however, for the rest of the investment community. Covid-19 and its aftermath will affect all companies in all sectors. 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. Bain Consulting’s assertions that “sector expertise will become more critical than ever”, and that “the scope of due diligence will change” are true. But what does “sector expertise” need to include, and in what ways does the scope of due diligence need to change in a world where existing knowledge and assumptions appear uncertain?

In the post-Covid world, companies in all sectors are going to find themselves facing novel and unfamiliar issues, and “sector expertise” will need to encompass awareness and understanding of these.

Some of these issues will operate at an international level – indeed, it looks as if Covid-19 may undermine much of the trade infrastructure which the business community has increasingly taken for granted over the past few decades.

There has already been much speculation, for example in the Financial Times, about the potential implications of coronavirus for global supply chains. 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.

Sector expertise will also need to incorporate an assessment of how companies, and their earnings potential, will be affected by developments wrought by Covid at a national level in the countries where they operate.

Might, for example, commodity and extractive firms find themselves facing increased levels of resource nationalism? 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”. 

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. 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 $190bn (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 $300m in taxes and other charges, and ceding to the government stakes in three mines.

What would happen if the Covid pandemic led other countries to take similar positions, and perhaps on other commodities than just those which are mined? 

We’ve already seen Côte 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”. How might this affect different companies, with operations in a range of countries around the globe?

Sector expertise also needs to anticipate how Covid-19 might impact on companies also at sub-national and local levels. Analysts will need to understand how businesses engage with and work with the communities in which they operate, and what implications this has for their licence to operate.

It already seems clear, for example that, literally, “corporate citizenship” has become a key issue – how companies are responding to the pandemic 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, when company 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.

It is clear, therefore, that the “sector expertise” so prized by Bain Consulting will indeed be vital, but that the issues it needs to encompass have expanded way beyond what might have been the norm before the pandemic. What then of due diligence? Bain argues that its scope will have to expand, but how?

Perhaps most obviously, a stock analyst needs to conduct due diligence as to whether the company being assessed has itself a clear grasp of the challenges it faces. It is not impossible, indeed, that in the post-Coronavirus world, some business models may no longer be viable. One example of this may be industrial agriculture. 

As reported by Yale University, over the past 50 years, increased usage of chemical fertilisers, irrigation systems, pesticides, and mechanised 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 organisations 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.

From the perspective of an investment analyst, a key facet of due diligence, therefore, will be to assess whether a company grasps these new realities, or whether it is blind-sided, or refuses to accept the challenges which need to be addressed.

However, it is not just whether a company is sighted on the issues it faces, but also is able to manage them effectively. Investors’ due diligence therefore needs to be expanded to assess whether businesses that they are assessing are serious about addressing Covid-related issues, rather than simply paying lip service to them. 

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 organisation’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, “informal methods (namely, the ‘social norms of the organisation’) is perceived by employees to have the most influence on their conduct”.

It is clear that, in a limited way, Bain Consulting is correct in saying that sector knowledge and due diligence will be central to effective investment analysis in the post-Covid world. Yes, it is correct that these factors will be vital, but its conclusion is limited because they need to be expanded to include issues which would not previously have been considered, such as the examples given above.

The question therefore is how this might be achieved. How can the concepts of sector expertise and due diligence be expanded to be relevant to very different circumstances? There can be no single, ‘magic bullet’ answer to this question, but there are some approaches, which would be extremely valuable additions to the post-Covid investment analyst’s toolkit.

In recent years, asset managers, BlackRock, for example, have stressed the importance of “harnessing the power of Big Data … [to] find investment insights”. This approach will remain important, but in the current situation it is limited because it focusses primarily on quantifiable data. The challenge in the post-Covid world is that many developments will be driven by subjective, qualitative factors. For example, how will governments and institutions at all levels react to different facets of the Covid pandemic, and what role will popular opinion play in the decisions that get made?

Political economy analysis (PEA) is an ideal tool to use in understanding and rigorously analysing these types of factors. So how then is this to be done? What PEA does is do dig deep into the nuts and bolts of how power and authority affect economic choices, and to use this understanding to inform what might happen. It is a process used by development institutions such as the World Bank and explores three key dynamics:

In the post-Covid world, it will be vital for investors to home in on those developments which are likely to have the most material impact on the companies in which they might invest: political economy analysis will allow them to do just that.