Inexperienced Denizens of a Brave New World

The economic picture continues to darken and most investment asset classes continue to flounder in lockstep. To say it's been a trying time as an investor would be akin to saying you might get wet in a monsoon. These last few weeks the bulls and many of the bears have been trying to find reasons why the market should stop going down, but the technical, fundamental and sentiment indicators remain burdensome.

I'm not an economist and am not going to pretend to know just how bad things will ultimately get, or how long they'll last that way. But I do trust my instincts and have the good sense to listen to people smarter than me who deign to share their views when asked. Times are tough. Times will get tougher. And, as I said several times over the last few months, be wary of thinking bad news is priced in, or that valuation is, in and of itself, a catalyst to move markets.

We're no longer debating the issue of recession, but rather the magnitude of said recession. We have a tendency to find false comfort in prior comparison. When something has "happened before", it's easier for us to wrap our minds around the eventualities and potentialities. That's been a huge part of this market correction. For most of us, the velocity, breadth and severity of this economic downturn is unprecedented. As a result, we have no safety net with which to react.

It would be one thing if investors were the only ones wading into uncharted waters; as an industry we've proven quite adept at adjusting to the paradigm du jour. But here's the rub...this is a generational problem that permeates every rung of our society.

Let's focus our attention on an industry near and dear to me, the information technology sector. Let's say, for argument sake, this recession is going to resemble the early 70s recession in magnitude [I think we have to go much further back to any reasonable comparable]. How many publicly traded technology companies even existed 35+ years ago? Those that did, for example IBM and Hewlett Packard, were entirely different constructs back then. And they're the exceptions to the rule. Think of a technology bellwether today and realize that, with near certainty, they haven't had to deal with an economic environment like the one we're currently enduring.

• The internet didn't exist the last time things were this tough
• Online advertising models are untested in a time of global deleveraging
• The cellphone industry has never had to deal with a period when worldwide GDP was as slow as we can reasonably expect in the next 6-12 months
• Semiconductors were a high growth cottage industry in the last slowdown of any magnitude
• Will the video game cycle really survive unscathed in a consumer-driven recession?
• ...and so on and so on

How will companies react? How will their employees handle the new reality? Will executives have the appreciation for history to make the tough decisions? There's a lot of talk about the strong getting stronger, but are they prepared to take truly dramatic measures?

I don't mean to pick on the technology industry, although I think it has unique challenges because of the relative newness and embedded sense of "growth over all else" that's driven the industry for the last few decades. But this systemic inexperience I'm referencing extends far and wide. Precious few management teams have handled this kind of global picture, and fewer still have navigated it successfully, in any industry.

What's the moral of the story? Uncertainty abounds. Logically you can't have any faith in forward estimates right now, particularly those over the next 6-12 months. So my advice? Don't try. Focus on companies that you believe are survivors, those that have a history of doing right by shareholders in good times and bad. Those who are targeting secular trends that will supersede a multiyear recession if you're patient enough. Understand that valuations as most of us have known them are irrelevant now. Right now it's about surviving. Unless you have to catch the bottom, don't try. Roughly 50% of the S&P500 is trading at 10x or less trailing GAAP earnings now, so just because something is "cheap" doesn't mean it's investable. Appreciate dividends and the power of compounding. REALLY appreciate a company's ability to generate cash flow, preferably sustainable FREE CASH FLOW. And recognize that anything you buy today, probably wll be cheaper tomorrow. These are humbling times, and we are all inexperienced denizens of this brave new world.

Disclaimer: At the time of writing, neither the author nor the firms affiliated with the author maintained a position, long or short, in the publicly traded companies mentioned or any related instruments. The author and the firm reserve the right to alter their investment positions at any time in the future. The content on this site is provided as general information only and should not be taken as investment advice. Content should not serve in any way as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of firms affiliated with the author. Any action taken as a result of information or analysis on this blog is ultimately your responsibility. Consult your investment adviser before making any investment decisions. 

Comments

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[BXBrian]

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[Kendall Gordan]

While I agree with the old adage, "Those who do not learn from History are destined to repeat it" comparing this time to earlier times may not be accurate. The good news is that some of our losses lately have been paper losses, not backed by gold or silver. The bad news is that the sharks are out to set up the same house of cards as before (100% morgages, etc)

Kendall Gordan, SE
www.foxfiresoftware.com

[Jason Wood]

Hey Jeff,

Fair point [and I would expect nothing less from you]. But I guess where we'll have to agree to disagree is the comparison of this with 2001-2003. Totally different beast. The tech wreck certainly had meaningful ramifications, particularly for equity investors, outside of technology. But that was a period where the bubble was, very much, equity prices themselves. This time, we're talking about systemic bubbles in liquidity and, in order to rationalize things, we're going to need societal changes, not industry ones.

[Jeff Nolan]

Jason,
All good points, however I do want to take issue with a central thesis that you base your argument on. I do want to emphasize that I'm not singling you out on this because I have heard the same commentary from basically all the cable news commentators as well.

Essentially it boils down to the notion that this is an unprecedented economic downturn. Aside from the rather obvious historical comparison to the Great Depression, the fact is that the 2001/02 cratering in the markets was also a severe event, most definitely unprecedented given the terrorism component. The tendency today is to portray that as a speed bump when it was actually massively disruptive at the time, featuring huge job losses across all segments of the economy, a real estate correction (definitely not as severe as today), and across developed and developing economies.

Of the bullet points you raise, many applied in that earlier time as well, some more severely than today.

- online advertising was definitely untested in 2001 which is why the correction then was so severe. Today, pricing is not overvalued in online ads so the correction is just that, as opposed to the rug being pulled out.

- The internet certainly existed and was the foundation for an entire business segment. Again, given the valuation explosion the correction was extremely severe, not the case today.

- the semiconductor market is not monolithic. NAND flash will be hurting and hurting badly, and probably DRAM as well but this isn't the first time that the DRAM market has collapsed. PC demand defies the broader market conditions though.

- Video games are an open question, but again needs to be looked at from title and console perspectives. Console sales numbers were pretty strong in October.

- Mobile phone markets are also a question mark but one thing that is unique about this period in time is that the dependency on mobile in many global markets is total, as in this is the infrastructure. The monopoly power the carriers have also insulates them to some degree and they are less dependent on capex investment than in years past because their infrastructure is largely in place.

[Jason Wood]

Charlie - Certainly you're right and, when the dust settles, there will be those who clearly operated at an optimum level and are the stronger for it. It's always easy to crown the winners after the crisis is over, the trick/concern is whether it's possible to handicap the winners in the midst of the chaos.

Tom - You are certainly right, and I think that's my main concern. To my mind, breaking out of old thinking means accepting that IT is, in most subsegments, a mature business now. Yes, in good times it will grow faster than nominal GDP, but not orders of magnitude faster anymore. Too many of today's tech companies have "growth" instantiated in their DNA.

Vinnie - An interesting counterpoint but one I don't share. The tech wreck was a perfect example of the problem I'm discussing. To anyone outside of the industry, once the turn came it was evident things were going to get much much worse before they got better. Yet, most technology companies kept lowering expectations modestly until their stocks lost 80%-90% of their value. It was only then when execs began talking tough.

[vinnie mirchandani]

In some ways tech having gone through a deep recession in 01-03 is actually better prepared than many other industries.

But selectively there are some headshakers - some software companies trying to raise maintenance in the recession. Indian firms actually believing they can get away with $ 90, 100 an hour rates, telcos who believe their mobile services are economy proof...

[Tom Foydel]

The key to surviving this brave new world is coordination and agility. Industries that have the greatest ability to change purposefully are the ones who will endure. The auto companies are calcified around union contracts and pension/healthcare obligations, so are naturally the first to feel real pain. Everyone will feel pain, question is will you recover from it.

Technlogy companies, though they do not have the same union issues, have other obligations like the need for 50% yoy growth in order to maintain stock price. This is as close to a calcified idea as there is in technology. Growth is going to slow down this year and companies that cannot contain costs and adjust to a deep recession reality are going to be hurt badly.

The key to finding value in the market is to find those companies who have really broken out of their pre-crisis thinking and are ready to run the business by breaking old rules. Tech companies that rein in Sales and Marketing expenses and learn to run with much smaller growth rates, while continuing to fund product engineering, will survive and set up for recovery. Those who continue massive Sales and Marketing spend while cutting engineering will falter. So which CEO's can look the market in the eye and tell this new story?

[Charlie Wood]

Jason-

While it's true that few companies and people alive today have experienced this kind of broad economic crisis, many of them have survived crises of their own. Look at Apple, which was on the brink of destruction just a decade ago. Then, they were totally screwed. Now, they're killing it. Of course Apple will be affected strongly by lower consumer spending, but they've become masters at managing their supply chain. They also have room to cut margins and still be profitable. Finally, they have a mountain of cash to help absorb the impacts of the economic storm.

The executives at Apple haven't lived through--let alone managed through--an economic depression. But they've fought back from what might be an equally challenging localized environment. Other examples?

-c

[Jason Wood]

Samir -

I certainly think that institutional memory is an expansive risk, but it really depends on the company and the industry, as well. I would imagine you understand your clients strengths and weaknesses far better than I could from the outside looking in. Best of luck, and consider yourself better off than most for at least being conscious of the right questions to ask.

[Samir]

This is a scary scenario. Some of our clients are old-school companies (manufacturing, consumer goods) that have been around for over 100 years. They are spending right now, and not all that scared. Do you think they know what they're doing, or is there not enough institutional memory and so they're as clueless as the rest?

[Paul Kedrosky]

Good post, Jason. History is (currently) bunk. We have had one massive credit unwind this century. N of 1. Period. Pretending otherwise is analytical thumb-sucking.