- The durability of individual company business models in North America has become increasingly important amid the economic circumstances brought on by the COVID-19 pandemic.
- While most businesses have been tested severely and unexpectedly, opportunities have emerged amid the crisis.
- Importantly, identifying competitively advantaged business models may reduce the risk of permanent capital loss that, in our view, should be a primary concern for long-term investors.
Market shocks and economic uncertainty can bring the importance of business models sharply into focus. This certainly proved to be true earlier this year in North America as companies were forced to cope with a near-total shutdown of the economy. The disrupted economic environment has exposed clear differences in businesses and their long-term viability. Our belief is that by uncovering misunderstood, undervalued and underappreciated business models, investors may reduce the potential for permanent capital loss and could increase the probability of long-term gains.
Crisis and opportunity
The pandemic-induced economic environment has tested business models in ways we’ve never seen. The service economy – businesses that historically tend to do well during recessions – has been particularly impacted. Though the economy has begun to reopen, companies typically resistant to cyclicality have seen demand delayed or destroyed: medical procedures have been postponed, concert and sporting event attendance has been canceled, and travel has been significantly curtailed, among many other impacts. Nonexistent and/or severely decreased revenue for these businesses is something that no one would have predicted, and markets have reacted in rather unanticipated ways, with historical precedent an unreliable guide.
Leveraged companies (that rely, to some extent, on debt to finance their operations) were punished disproportionately (and somewhat indiscriminately) during the initial pandemic-related market volatility. Extremely low interest rates and Federal Reserve (Fed) support allowed many companies feeling the strain of weaker balance sheets to raise debt and equity capital. As markets have begun to discern between those companies that did and did not impair capital, we have seen certain high-quality companies with a degree of leverage rebound strongly. Thus, the ability to understand businesses that were financially suited to weather the environment and emerge in a position of strength has been critical.
Perhaps the most notable effect has come as a result of widespread digitization of the economy, a theme firmly in place prior to the pandemic that has accelerated markedly as a result. Because of digital disruption, competitive advantages have been magnified for companies able to not only function but also thrive in the midst of crisis. This gulf can be seen in the tremendous performance discrepancy between growth and value stocks, mainly due to the dominance of a handful of large-cap technology stocks. While certain technology companies have been the primary beneficiaries, strong business models on the correct side of digital disruption can be found across the economy. These are companies in less obvious areas that, nonetheless, stand to come out stronger on the other side of the recession.
Because of digital disruption, competitive advantages have been magnified for companies able to not only function but also thrive in the midst of the crisis."
Volatility at levels seen in markets this year can offer opportunity for those with the ability to buy durable business models with a long-term time horizon. We have seen opportunities in stocks whose business models continued to perform (or improve) but the stock price lagged significantly, typically as a result of financial leverage. Companies whose businesses had clearly been hurt by the sudden stop in the economy but whose stocks were punished much more than we deemed warranted also presented opportunities.
Risk as the permanent loss of capital
We prefer to define risk in an absolute sense as the permanent loss of capital because it becomes difficult to achieve the goal of long-term capital appreciation when one has permanently impaired capital in an investment. Permanent loss of capital can arise when the terminal value of a business is impaired, for instance, when a company is at risk of becoming obsolete, such as a brick and mortar retailer or a company heavily tied to fossil fuels. Again, widespread digitization has exposed many business models that are at risk of obsolescence.
Capital can also be impaired when a company is forced to issue additional stock to address liquidity or leverage concerns, diluting the value of existing shares. The pandemic has set off a boom in equity issuance, yet some companies have been able to avoid these offerings by maintaining strong balance sheets and stable cash flows.
To guard against the risk of permanent capital loss, we believe it is essential for investors to know what they own. It is important to understand and invest in durable business models, companies that can sustainably generate attractive returns, in order to capture the value of compounding growth over time. It is also crucial to focus on valuation, buying companies at a significant discount to estimated fair value with the goal of fully realizing that value during the investor’s ownership. Ideally, an investment achieves both the objectives of compounding growth and value realization due to the strength of its business model.
As we have seen, the pandemic has presented a set of unique economic challenges that have exposed certain business models and created opportunity for others. This year has confirmed our view that a focus on durable business models and avoidance of a permanent loss of capital can be powerful tools in an investment process focused on the long term.
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